Economics

Consequences of inequality

Cover image: Battlers and Billionaires (Black Inc.)

Edited extract from Battlers and Billionaires: the Story of Inequality in Australia by Andrew Leigh, published by Black Inc. RRP $19.99. Available in print and ebook. www.blackincbooks.com

 

LET'S take a moment to look at inequality on the sporting field by comparing one of the most unequal contests – English Premier League football – with one of the most equal – the Australian Football League. Of the last twenty EPL championships, Manchester United has won twelve.  In the same period, no AFL team has won more than three premierships.

There are simple structural reasons for this difference. English football operates much like feudalism. The money from television rights is shared out according to each team’s finishing position, with the top-ranked teams getting the most. Players are signed by scouts, who search the globe for promising players. A recent report put Manchester United’s salary bill at £174 million (around AUD$265 million). The AFL is a great deal more egali­tarian. Television revenue goes to the league, which shares it out evenly among the teams. Players enter the game via a draft, in which lower ranked teams get first pick of promising players. And a team’s total salary bill is capped at about $9 million. Teams such as the Geelong Cats have argued that the AFL should do even more redistribution, but everyone admits there is more equalisation in AFL than English football.

Supporters of the more unequal game might point to the innovations that English football engenders. With such vast resources, Manchester United is at the cutting edge in its use of technology, development of game strate­gies, medical treatment of injured players and selection of new recruits. A phenomenally rich club is able to pioneer techniques that are then adopted by other teams.

But inequality comes at a cost. Economists describe the Australian Football League as having more ‘competi­tive balance’ than the English Premier League, meaning that you’re more likely to see an upset at the AFL. The main reason to make any sport more equal is so that it becomes interesting to watch. English football these days tends to be tiresomely predictable.

It wasn’t always like this. If you look back over the eleven decades of both tournaments, you’ll find that the top-scoring team has won a similar number of times. Manchester United has been the champion 17 per cent of the time, while in the AFL (and its predecessor, the VFL), Carlton and Essendon have each won 14 per cent of premierships.

Yet in recent years, the two tournaments have radi­cally diverged. English football has become increasingly unequal, while the AFL has been fairly equal. Take the Adelaide Crows: in 1996, they came twelfth on the ladder. In 1997 and 1998, they won the premiership. In 1999, they came thirteenth. Such a story of rags to riches to rags is inconceivable in English football. For over twenty years, Manchester United has been among the top three teams (with the result that half of all English fans follow United). As the sports economist Stefan Szymanski points out: ‘even if United fans don’t care about the rest of the English Premier League, surely their own interest in the League is made more interesting by having credible rivals?’

Inequality not only has costs across sporting teams; even within teams, larger gaps can reduce performance. A recent study looked at the significant rise in salary inequality in US major league baseball. It found that teams with large gaps between the best and worst paid players underperformed those with more equal wage distributions.

In this chapter, I will discuss why inequality matters, addressing head-on the criticism that the gap between rich and poor shouldn’t concern policymakers. This puts me at odds with some prominent economists. For exam­ple, Robert Lucas argues that ‘of the tendencies that are harmful to sound economics, the most seductive, and in my opinion, the most poisonous, is to focus on questions of distribution’. One of the arguments most often made by such critics is that discussions of inequality distract from the more important problem of improving outcomes for the truly disadvantaged. Why worry about the gap between the rich and the rest, the argument goes, when we should be concerned with the wellbeing of the poor?

The problem with this argument is that while we might be able to set an appropriate poverty line for a decade or two, rising incomes for the middle class will eventually change our notions of what poverty means.

You can’t define poverty without thinking about what’s normal in a society. As the British historian Richard Tawney neatly noted: ‘what thoughtful rich people call the problem of poverty, thought­ful poor people call with equal justice a problem of riches’.

The interrelationship between the wellbeing of the rich and poor was recognised by the grandfather of modern economics, Adam Smith, who argued:

This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect persons of poor and mean condition … is … the great and most universal cause of the corruption of our moral sentiments.

To Smith, it was only fair that everyone should get a share of the national wealth, that schooling be free, and taxa­tion be progressive. A focus on inequality has marked the writings of several Nobel laureates in recent decades, including Simon Kuznets, Amartya Sen, Joseph Stiglitz and Paul Krugman.

Broadly speaking, arguments about inequality fall into two groups. The first are ‘instrumental’ arguments: inequality matters because it affects something else that you care about (such as growth or mobility). The second are ‘intrinsic’ arguments: inequality matters inherently.

Let’s start with the instrumental arguments, begin­ning with the question: do unequal countries grow faster or slower? Christopher Jencks (Harvard), Dan Andrews (now at the OECD) and I took data for the past half-century and looked at whether initial inequality predicted economic growth. We found an effect, although not in the direction I had expected. Our study concluded that countries with higher income inequality experienced more rapid economic growth.

One reason for this might be that inequality spurs entrepreneurs to take risks. Starting a business can often be exhausting and risky. If your start-up idea means working sixteen-hour days and taking out a second mort­gage on your home, you’re probably more likely to take a shot if the rewards of success are very high. Another reason might be that today’s rich provide tomorrow’s start-up capital.

Yet while the effects of inequality on growth are posi­tive, ‘trickle-down’ works slowly. Viewed from the stand­point of the bottom 90 per cent, we found that it took over a decade for them to get enough economic growth to make up for having a smaller income share. Put another way, it takes quite a while for the pie to grow enough to make up for the fact that the poor have received a smaller slice.

Another instrumental reason to care about inequality is its impact on social mobility. Although the data isn’t clear-cut, it looks as though in countries with larger income gaps, the accident of your birth tends to deter­mine where you end up. (Furthermore) equal societies are mobile, while unequal societies are also immobile.

A third instrumental reason to be concerned about inequality is its impact on democracy. Contrary to Plato’s fear that the poor would wield too much power in an unequal democracy, the reverse seems to be closer to the mark.

Inequality can also affect political outcomes by shaping our notion of the common good. Democracy does not require perfect equality, but a strong democracy does depend on a society with enough equality that people ‘bump up’ against those who are different from them. When the most afflu­ent use different hospitals and schools, travel solely by private transport and live among those in their own income bracket, they may lose touch with the need for a strong safety net to protect the most disadvantaged. It works the other way, too. If the poor are cut off from the rich, they may cease to understand how hard you have to work to create a successful business.

Now let’s turn to the intrinsic arguments.

In choosing a society with fair redistribution, we would likely have in mind the fact that our economic suc­cess is significantly shaped by factors we cannot control. For example, the genetic lottery shapes our intelligence, health and looks – all factors that affect earnings. Children who have the luck to be first born have certain advantages, but that doesn’t make them any more meritorious than their siblings. Luck also shapes how our talents are valued. If I’d been born into a competitive hunting society, my poor eyesight and light build would have made me a bad spear-thrower and a lousy fighter, but that wouldn’t have made me any less deserving.

Each of us needs to ask the question: what kind of a society would I want if there was an equal chance that I might be born weak or strong, male or female, with rich or poor parents, able-bodied or with a disability, Indigenous or non-Indigenous? My guess is that if you were faced with the prospect of starting life with myriad disadvantages, you’d probably opt for a rela­tively equal society.

This sense of egalitarianism reflects what Lester Thurow termed ‘the income distribution as a public good’. Anyone who thinks that economics is about maximising money rather than maximising wellbeing hasn’t gotten past first-year university. In maximising wellbeing, inequality matters – because a dollar brings more happiness to a poor person than to a rich person. One analysis asked people to rate their happiness on a zero to ten scale, and looked at how much money was required to move them up by one point. They found that to buy the same increase in happiness cost $6000 for the poorest households, but $100,000 for the richest. This is one reason redistribution makes sense – because taxing a millionaire to make sure a pauper doesn’t become homeless has the effect of increasing aggregate wellbeing.

A mounting body of evidence tells us that humans feel a palpable discomfort at high levels of inequality. My two eldest sons, six-year-old Sebastian and four-year-old Theodore, are constantly benchmarking against one another. I once asked Sebastian whether he’d prefer that he and his brother both got one biscuit, or he got two and Theodore got three. Without hesitation, he replied: ‘I’d prefer one each.’ Puzzled, I pushed Sebastian a little to find out why. ‘Because it would make me sad if Theo had more than me,’ came the reply.

This isn’t confined to children. In a famous economics experiment called the ‘ultima­tum game’, the first player chooses how she would like $100 divided between her and another person. The second player can either accept that split, or decide that both players will get nothing. If all we cared about was being better off, then the second player should accept the division when he gets anything at all. So if the first player proposes to keep $99 and hand over $1, a second player who doesn’t care about inequality should accept. Yet in thousands of settings it has been shown that many people have a cut-off around $25, below which they’d rather get nothing than receive a share that they regard as miserly. It offends our dignity – our sense of justice.

In another economics game, players were given an option to spend $1 of their own money to reduce another player’s earnings by $3. Depending on our political views, we might call this ‘egalitarianism’, ‘taxation’ or ‘punishment’. Regardless of the name, two-thirds of play­ers chose to penalise another, with their targets typically being the richest players. In this game, greater equality came at a price, but most players were willing to pay it. This is consistent with a large literature in psychology showing that people prefer to barrack for underdogs over favourites.

But you don’t have to rely on laboratory experiments. One US study compared individuals with the same income who lived in high-and low-income neighbour­hoods. It turned out that as their neighbours’ incomes rose, an individual’s happiness fell. Another study encouraged staff at a large public university to go online and check out their co-workers’ salaries. The effect was to reduce job satisfaction among workers who earned less than those around them. A cross-country analysis finds that people in more unequal places tend to be less happy with their lives, an effect that holds for both rich and poor respondents. Other research reaches similar conclusions.

John Stuart Mill once noted, ‘men do not desire to be rich, but richer than other men’. He may have been overstating things, but relativities are practically impor­tant if people are competing for ‘positional goods’, such as a home in a desirable suburb, a place in a top university or a sought-after job. In such cases, rising top incomes may lead to an ‘expenditure cascade’, as those in the middle have to spend more to stay in the race. When inequality is modest, a young man can happily wear a $200 suit to a job interview. But if top incomes rise, he may feel a need to buy a $1000 suit to compete.

As any football fan knows, once everyone gets to their feet, you have to stand up too if you want to keep watching the game.

 

Andrew Leigh

Andrew Leigh is the shadow assistant treasurer and the author of Disconnected and Battlers and Billionaires.

@ALeighMP

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