• Peter Lyons

Does Income Inequality Really Matter?

Updated: Apr 26, 2020

I have been chugging away on writing a book for over a year. It's a book of stories about key economic concepts. I am often asked to recommend a simple "easy to read" book about basic economic concepts.

A topic I am struggling with is income inequalities. It is certainly a problem of the modern capitalism, version 103. But income inequalities are also a necessary feature of a free market system. They ensure incentives.

A free market system is based on incentives, particularly the profit

motive. People start businesses and put their money and time and effort on the line in the pursuit of profits. Whenever we walk out the door we encounter such daring ventures. We seldom appreciate this. Someone has taken a huge risk in starting a business. They are the wealth creators. They need to be encouraged, rather than penalised by excessive taxes or rules and regulations. The local barber, dairy owner, cafe operator, travel agent have all responded to the siren call of profit. They have put themselves on the line in the pursuit of profit. And they deserve all the legal returns they get. This is how free societies prosper. This is a core lesson of human history. Free enterprise creates prosperity.

So why has income inequality become such a maligned feature of modern economies? If everyone was paid the same, there would be little incentive to start businesses and create jobs and incomes and wealth.

My issue with rising income and wealth inequalities is twofold. The first is, it ignores the lottery of birth. The second is that some very high income earners generate little positive outcome for society. In fact they may detract from the welfare of society.

In a free market economy the lottery of birth matters greatly. Children born into affluent families usually hAve access to better educational opportunities and healthcare.

The recent measles epidemic in New Zealand was a stark symptom of the inequalities in our society. The outbreak was concentrated in areas where the advantages of birth are more limited.

The educational opportunities for affluent children also provide networks of contacts that further enhance the advantages of birth. Their parental expectations often turbo charge their material success. They are also more likely to inherit substantial wealth.

The mAterial starting line is different for all of us. Standard Economic textbooks are silent on the inherent advantages of some people due to the lottery of birth.

Any country should assess the fairness and effectiveness of its economic system on the basis of equality of opportunity for all its children. We are likely failing on this criteria. Headline economic growth means little if the gains mainly accrue to a minority of the population. It's costing all of us in lost potential. Either the loss of unrealised talent due to poor education and healthcare, or the huge costs of paying for those who are left behind.

My second concern about income inequality is more insidious. We have become conditioned to the belief that ultra high income earners such as CEOs and celebrities and financiers are entitled to their exorbitant incomes because they are genuinely worth it. There's an ironic twist to income inequalities. We can't afford to pay those at the bottom more because this will create unemployment. But we are told we need to pay those at the top more to ensure they have greater incentives. It we tax them too highly they will evaporate.

We need to retain their talent. I call this the "omnipotent man" theory. The belief that super star CEOs and financiers and celebrities are a unique species of uber humans that need to be paid accordingly. They are very different to the rest of us. This has been an old argument for reducing tax rates on higher income earners. Yet I have never met such a divine human being. All humans are fallible and replaceable . The "great man" theory is a delusion. This is not a call for excessive taxation for high income earners. But it is a call to recognise that a progressive tax system is fair. The disincentives have been over stated. The trickle down effect of tax cuts for the rich is vastly over stated by those who benefit.

Large income inequalities in a society lead to economic didtortions. The demand side of the economy becomes distorted. Those with higher incomes tend to invest in speculative assets such as property and shares or conspicuous consumption. Those left behind tend towards crime, substance abuse, violence and homelessness and political extremism. A society becomes splintered and divided.

A well functioning economy needs incentives for people to take risks and start businesses. But it also needs equality of opportunity and a " fair" tax system and distribution of income. We have got the balance wrong in recent decades.

Peter Lyons (MComm) teaches scholarship-level Economics and has authored several New Zealand curriculum economic texts. His inspiration often comes after a dram of whiskey. Just one mind you. So if you're ever stuck in a room full of economists, grab the seat next to him. For a conversation peppered with wit, wisdom and weirdness.

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