Ian McAuley. Inequality matters

Jun 17, 2015

Policy Series

Australia has a reputation for egalitarianism, as a country where, in comparison with Old World countries, wages were good and, to quote Lawson, where people “call no reason to call no biped lord or sir”.

Up to around 1980, Australia’s distribution of income was becoming more equal, but since then inequality has been on the rise: our income distribution is now back to where it was 80 years ago, in the years before the Pacific War. We still do better than the UK and the USA – our usual points of comparison – but in comparison with other prosperous countries, particularly those of northern Europe, we have slipped a long way behind.

And as income inequality persists so wealth inequality also grows, and wealth inequality tends to be enduring as the advantages of high wealth, and the disadvantages of poverty are passed from generation to generation. We are on the way to having an entrenched “upper class” and a class, not even accurately described as a “working class”, for whom opportunities for economic mobility are blocked.

It is tempting for governments to dismiss rising inequality with the aphorism “a rising tide lifts all boats”. The idea is that just so long as no one goes backwards in material living standards, all is well.

This economic philosophy, which has become the basis of undergraduate economics teaching – and therefore the ideas that dominate government treasury departments – is attributed to the Italian economist Wilfredo Pareto, an adviser to Mussolini’s fascist government. It’s not that academics and bureaucrats are attracted to fascism, but they are attracted to the simplicity of Pareto’s economics, absolving them from having to think about moral questions about inequality. It’s a neat cop-out rationalisation for allowing privilege to become more entrenched.

Pareto’s stamp is on many government policies. The projections of the 2015 Intergenerational Report suggested that over the next 40 years gross income per person will rise by 75 percent, but not for those dependent on the age whose income was to be frozen at 2017 levels.

It’s extraordinary that any government could have the gall to produce such a projection based on its preferred policy settings, and it’s even more extraordinary that they received such a tame reception in the media (including the ABC). Perhaps this shows the extent to which Pareto’s dismal brand of economics has been absorbed into our thinking.

Maybe, in the land of the “fair go”, we have come to accept Pareto’s amoral indifference. We get upset when public policy actually takes from the poor (as was the case with the 2014 Abbott-Hockey budget), but not when policies allow for widening inequality.

Inequality does count, however. It is costly to all – not only to the most disadvantaged. Even those on the right, who pay lip service to the benefits of capitalism and market forces, and who assert that good public policy is about economic progress, should be able to understand that inequality is a problem, because a high level of inequality is symptomatic of deep problems in the economic system.If a society cannot achieve a fair distribution of income, wealth, participation and opportunity there is something wrong with the country’s economic structure. Politicians may see inequality as an unavoidable collateral outcome of a successful economy, but an economic structure that sees most of the benefits accrue to a few while others are left behind can hardly be called a success. It is flawed thinking to assume there must be some tradeoff between “economic” and “social” outcomes.

Of course many on the right will argue that inequality simply arises from different individuals’ contributions, which in turn arise from different people’s talents and effort.

But when inequality gets to a high level we must seriously question that assumption. Is a bank CEO paid $10 million really 300 times as talented and hard-working as someone earning a basic wage?

It’s hard to imagine differences on that scale being innate: it’s more likely that the connection between contribution and reward, which has always been a fairly fragile connection, has become further weakened, and that many people have been unable to develop their full capabilities.

Market capitalism, as a theoretical system, is based on a linkage between contribution and reward. Even the most right wing economist would agree with that proposition. But when inequality results from inheritance, privilege bestowed by government policy, “old boy” (and “old girl”) networks, corruption and theft, the basic incentives that are supposed to operate in a market economy don’t function.

There’s no point in working hard or creatively if others will enjoy the benefits. There’s no point in studying difficult courses at university if there is no return for putting in the effort: better to spend one’s student days finding a well-connected spouse, or cultivating friendships with those who have already made it into the ruling class. And if one has mathematical talents, there’s no point in becoming a teacher, engineer or scientist when there are such lucrative rewards in the finance sector, shuffling other people’s money around and taking a commission on the way.

And when people lack the opportunity to develop their full capabilities there is an additional cost to society. Equality of opportunity is another essential plank of market capitalism and if it is blocked by misallocation of education resources and inadequate attention to children at risk, there is a big opportunity cost of unrealized talent.

These are the hard-nosed economic costs of inequality, without even venturing into the moral issues of economic unfairness. When those few politicians who have the courage to speak out on unfairness they are often met with the rebuke that they are raising the “politics of envy”, but fair-minded people don’t envy those who have succeeded through their own effort and who enjoy the rewards of having made a contribution to society. Use of the word “envy” does injustice to those who are disgusted by the perversion of economic incentives in our society and by the tawdry rationalizations those who have accumulated unearned wealth use to justify their privileges.

When people think the cards are stacked unfairly the resulting resentment can have far-reaching consequences. Politics becomes a tussle about preserving or gaining privilege, rather than a contest of ideas about how to improve prosperity for all.

One manifestation of this tussle is our labour relations system, where both sides fight to retain what they hold rather cooperating in ways to increase wealth. (The notion of a class-based dividing line between “employers” and “employees” is an anachronism but it survives in Australia.) Elections and budgets have come to be about “what’s in it for me”, rather than evaluation of economic policy.

A “what’s in it for me” approach to inequality doesn’t work. At best it may divide a shrinking pie a little more fairly. 

Inequality has to be tackled at its root – the nation’s economic structure.

Policy approaches – eliminate or compensate – distribution or redistribution

There are two broad policy approaches to reducing inequality. One is to attend to a nation’s economic structure so that inequality is less likely to arise in the first place; the other is to let inequality to arise and to compensate with progressive income tax and social security payments.

Both approaches have their place, but the emphasis is a matter of policy choice. As a general finding, left-leaning governments tend to favor solutions at source, through attention to labour market, industry, education, regional and other policies, while more right-leaning governments tend to favor compensation through welfare payments. (And, of course, some governments on the right take the view that any form of distributive welfare that goes beyond mere survival destroys the work incentive.)

To illustrate different countries’ approaches, it is revealing to look at a common indicator of income inequality known as the Gini coefficient. When income is exactly equally distributed, as in some hypothetical socialist paradise, the Gini coefficient is 0.00. In a situation of extreme feudalism, with hordes of starving peasants and one rich warlord, the Gini coefficient is 1.00.

The table below shows the Gini coefficients for the world’s 17 most prosperous developed countries. The first column shows the coefficients arranged by what is known as “private income”. That is people’s income before governments intervene with taxes, pensions and other cash distributions (“transfers” in economic terms). The next column shows what happens once taxes and transfers are taken into account, and the third shows the extent of the reduction.

Private income After tax and transfers Reduction due to taxes and transfers
Switzerland 0.372 0.298 0.074
Iceland 0.399 0.246 0.153
Netherlands 0.421 0.283 0.138
Norway 0.423 0.249 0.174
Denmark 0.429 0.252 0.177
Sweden 0.441 0.269 0.172
Canada 0.447 0.319 0.128
Luxembourg 0.468 0.271 0.197
Australia 0.469 0.334 0.135
Austria 0.483 0.269 0.214
Belgium 0.483 0.264 0.219
Finland 0.485 0.265 0.220
Japan 0.488 0.336 0.152
Germany 0.492 0.286 0.206
United States 0.499 0.380 0.119
France 0.505 0.303 0.202
United Kingdom 0.523 0.341 0.182
Gini coefficients 2010, 17 OCED countries with per-capita income >$US 35000

Note that the range generally aligns with what we already know: the Nordic countries are at one end, while the US and UK are at the other end. Australia is around the middle in private income: this is possibly a reflection of our comparatively young age structure and a reasonably high minimum wage. But after taxes and transfers we don’t do as well as most other countries.

Note also two patterns, which I call “distributive” and “re-distributive”. The Nordic countries and Switzerland tend to go for distributive policies – that is to pursue policies making sure that private incomes are reasonably well-distributed before the government kicks in with welfare transfers.  By contrast, France, Germany, Finland, Austria and Belgium all have relatively unequal distributions of private income, and rely heavily on taxes and transfers to achieve a degree of equality, thus bringing their ranking up.  (If we had data for Saudi Arabia, Oman and Kuwait they would no doubt show a very high use of transfers to redress a highly imbalanced distribution of private income.)

Historically, Australia has strived for distributive policies, backed by targeted (often means-tested) re-distribution. The main policy instruments were tariff protection, centralized wage determination, partial or full nationalization of key industries, and tolerance of restrictive trade practices. (“The Australian settlement”). The economic aspiration in the early post-federation years was that every job should be a well-paid job by the standards of the time.  Universal free public education and good public housing, and later universal health care were important components of the “social wage”. 

The means to realize this aspiration necessarily change. Tariff protection and tolerance of restrictive trade practices are definitely past their use-by dates. So too are many industry-specific subsidies, such as those which have been granted to automobile manufacturers.

But that doesn’t mean other means cannot meet the same purpose. 

Public policy – an economic structure to prioritize distribution over redistribution

As with the past, the starting point should be with structural policies. The vision should be that everyone’s capabilities are developed to the fullest, and that no one so equipped should have to rely on redistributive measures.

Of course that will never be fully achievable, but it should be standard against which policies are assessed. And it is a more egalitarian policy than simply seeking full employment.

Full employment, or near-full employment, can be achieved by forcing people into poorly-paid and demeaning jobs through punitive measures, and cutting support to those who need it most. If minimum wages are pushed low enough, and if the alternative to employment is made miserable enough, of course employment will rise, but it won’t be a very productive or motivated workforce.

Incentives for economic participation should apply across the board. Terms such as “passive welfare”, “lifters and leaners”, “mutual obligation” and the old perennial “dole bludgers”, have some validity if applied to all – the financial planner taking a commission for doing nothing, the “self-funded” retiree enjoying a six digit tax-free income, the executive in a mining firm enjoying government subsidies, the share speculator  making a fortune on lightly-taxed capital gains, and the healthy work-shy twenty-four year old living on an invalidity pension.

But these terms are applied selectively, generally as part of a right wing agenda of preserving privilege for the well-off. and cutting government services – the “small government” agenda.

A “small government” however, won’t provide the public goods – the framework of support – necessary for people to realize their capabilities, and will not adequately defend the public interest against rent-seekers and others who seek to prosper from the efforts of others.

Practical public policy – distribution through investment

The list below, in a rough hierarchical order, covers ten policy principles which can come together to address inequality. All the first eight are “distributive” policies aimed at strengthening the economy’s productive capacity. Only the last two involving transfers through progressive taxation and cash transfers are primarily “redistributive”.

  1. Invest in human capital. This is primarily about a well-funded public education system as a basis for developing people’s capabilities and achieving equality of opportunity. The most important immediate measure is to implement the Gonski reforms.While school education is important, it is crucial that governments support children at risk. Early childhood is where the foundations for future development are laid down.Also economic disadvantage should not provide a barrier to access to post-school education. Just as in the past we have shifted our norms upwards to what constitutes a basic “free” education, trade certificates and undergraduate degrees should now be fully tax-funded. This is in recognition of the general principle, observed in most human societies for most of history, that the elders have an obligation to support the upbringing of the young.If the community is to enjoy the benefits of a dynamic economy it should make sure that people whose livelihood is threatened by structural change are supported with opportunities for re-training and re-skilling. Public investments in these activities are much lower cost than the alternative – long-term unemployment of displaced workers and political resistance to structural change.
  1. Invest in public goods. A society needs a suite of public goods covering what the market cannot supply or what the market cannot supply efficiently. These include health care, education, security, public health and physical infrastructure. Utilities (water and energy), roads, railroads and public transport remain essential infrastructure for economic participation; to these should be added a national broadband network as originally envisaged.
  1. Use sound counter-cyclical management. Government’s macroeconomic role is to practice counter-cyclical management, compensating for swings in the business cycle, and more actively to use its power to prevent speculative booms and crashes. It has become fashionable to criticize the Rudd-Gillard Government for running a deficit in response to the events of 2008, but that is normal and responsible economic practice. While it is easy to see the cost of a fiscal deficit, it is far harder to bring to measure the cost of the alternative – a loss of employment and output. When, in a downturn, people lose their jobs or close their businesses, some will never get going again.
  1. Develop an economically responsible tax system and regulatory structure. These policies should rewardeconomic contribution and that discourage financial speculation and rent-seeking. In this regard tax reform is crucial – restoring a neutral capital gains tax system (the present arrangements reward short-term speculation while discouraging long-term investment), removing incentives for payment in fringe benefits, closing avoidance provisions such as use of family trusts, re-introducing inheritance and gift taxes, removing the most regressive superannuation tax provisions, removing subsidies for “negative geared” property investments, re-establishing a carbon tax, requiring multinational firms to pay a fair share of tax, and establishing a proper resource rent tax.
  1. Mandate a decent minimum wage. Australia has traditionally had a high minimum wage – it has been a defining feature of our economy. There is an argument that a high minimum wage discourages firms from taking on staff, and this has some validity. But a high minimum wage also ensures that firms have an incentive to employ people productively. When people are employed in low productivity jobs such as parking station attendants, domestic servants and supermarket packers there is a waste of human capital.
  1. Provide social insurance –covering high-cost contingencies. Unemployment benefits, Medicare, drought assistance, age and invalid pensions and the National Disability Insurance Scheme can all be classified as social insurance.Social insurance is necessary because of various failures of private markets to cover risk. Social insurance can be set with high or low safety nets. Publicly-provided social insurance can allow individuals to take more risks in private markets, for example by establishing startup businesses and investing in specialised skills.While social insurance has many similarities with redistributive welfare, and indeed may use some of the same policy instruments (e.g. unemployment benefits), it is redistributive only in the same sense that normal commercial insurance could be described as “redistributive”.   
  1. Support social inclusion.Beyond platitudes about “team Australia” social inclusion does not seem to be a priority of Coalition governments. And there has been a tendency by Labor governments to conflate ideas of social inclusion with redistributive welfare. This conflation has allowed governments to ignore the problem of self-exclusion by the well-off, into literal or metaphorical gated communities, most notably private schools and private hospitals.As a result, services such as public education and publicly-funded health care become re-defined as services for the poor (or “indigent” to use the demeaning American term). Those who are well off, who expect high standards and who have the political clout to demand them cease to have any stake in such services.There should be no taxation or other financial incentives (such as subsidies for private health insurance) that encourage people to opt out of using shared services. Where means-testing is applied to health and education services it should be applied in such a way that supports sharing the services.
  1. Attend to the social wage. The importance of the social wage was asserted in the 1945 White Paper on Full Employmentand re-affirmed by the Hawke Government. It refers to a set of government services and interventions as a complement the minimum wage to support a basic living standard, through provision of publicly-funded health care and education, and attention to important household costs, particularly housing and provision of utilities such as electricity and water. These are areas where markets, left to their own mechanisms, can produce very inequitable effects.Housing affordability has become a major issue in Australia, and needs to be tackled by supply-side interventions, including provision of high quality public housing to exert price competition, public funding of infrastructure for new housing, and spatial policies to quell the arms race pushing up housing prices in desirable locations.
  1. Use progressive taxation. The way taxation is collected can and does have redistributive benefits, but in recent years there has been a concerted campaign towards flattening tax scales because of claimed disincentive effects of high levels of taxation on those earning high incomes.Contrary to mythology justifying the notion of cutting top tax rates, Australia does not have high rates of personal income taxes once compulsory tax-like contributions, such as social security contributions, are taken into account.  Out of those 17 prosperous OECD countries mentioned earlier, only four (Switzerland, Iceland, Luxembourg and Austria) have lower top marginal tax rates than Australia when these compulsory levies are included. Whether high marginal tax rates discourage work is a matter of dispute among economists. Whatever disincentive effects exist may be fully or partially offset by people’s desire to work harder to sustain a desired standard of living. And, of course, there are many motivations other than material living standards driving people to work hard – motivations which tend to be lost in the simplistic and amoral economic models upon which much public policy is based.

    In any event, if high marginal tax rates do discourage some from paid work, that may be a desirable outcome. Those who voluntarily move out of the paid workforce or reduce their hours are not necessarily ceasing to make economic contributions – many are moving to unpaid work, including care for others and volunteer work. And few would dispute the need to distribute work and leisure more evenly.
  1. Use social security payments to support those in need. There will always be a need for cash transfers to those in need, but this form of assistance should not be seen as the first response to rising inequality. The priority should be to measures that allow people to develop their capabilities and to contribute in whatever way they choose.

Ian McAuley is Adjunct Lecturer, University of Canberra. He has worked on consultancies for Australian and foreign governments, and for international agencies, the UN and the OECD. 


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