The Price of Inequality: How Today's Divided Society Endangers Our Future (20 page)

Third, as we noted in the last chapter, much of the lack of progressivity—the low rates faced by those at the top, including the presidential candidate Mitt Romney—comes from special provisions of the tax code, like the low rates on capital gains taxation, the broad definition of capital gains,
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and loopholes in both corporate and individual income taxes. These distort the economy, lowering productivity. As we commented, one of the reasons that so many of our corporations pay so little is that they are not taxed on income of foreign subsidiaries until they bring it home, a provision of the tax code that encourages these firms to invest abroad rather than in the United States. Eliminating these provisions would both increase progressivity and strengthen the U.S. economy.

Moreover, to the extent that incomes at the top arise from rents and to the extent that it is possible to target these rents, again one can have a more-progressive tax system without any adverse effects on incentives.

The fact that tax cuts for the rich have increased the deficit and the national debt substantially has another effect: it has created pressure to reduce government support for investments in education, technology, and infrastructure. The Right has underestimated the importance of these public investments, which not only can yield high returns directly but provide the basis of high-return private-sector investment. Earlier I mentioned the contribution that government investments in research and technology had made (including the first telegraph line that spanned North America in the nineteenth century, and the creation of the Internet and the foundations of the first browser in the twentieth). Recent research has shown that the years before World War II were years of high productivity increase, which set the stage for even more productivity increases in subsequent years. Among the reasons for this is government investment in roads (which interestingly played an important role in increasing productivity in railroads).
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Such public investments can be financed sustainably only through taxation, and given the level of inequality, what is required is well-designed progressive taxation that can be less distortionary than regressive taxation. A corporate CEO will not exert less effort to make the company work well simply because his take-home pay is $10 million a year rather than $12 million. In any case, the possible loss of effort in socially productive activities from taxing the few in the top 1 percent—which, because of the huge inequality in our society, raises large amounts of money—pales in comparison with the effects on the many more numerous who would have to face higher tax rates to raise the same amount of money.
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C
ONCLUDING COMMENTS

Some of the adverse effects of inequality might be smaller if those who are poor today were rich tomorrow, or if there were true equality of opportunity. As the Occupy Wall Street movement drew attention to the growing inequality, the response of the Right was to say, almost proudly, that unlike the Democrats, who believe in equality of outcomes, they were committed to equality of opportunity. According to Paul Ryan, the Wisconsin Republican who heads the House Budget Committee, responsible for making the critical budgetary decisions affecting the country’s future, a central difference between the parties is “[w]hether we are a nation that still believes in equality of opportunity, or whether we are moving away from that, and towards an insistence on equality of outcome.”
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He went on to say, “Let’s not focus on redistribution; let’s focus on upward mobility.”

There are two factual problems with this perspective. First, it suggests that while we are failing in equality of outcomes, we are succeeding in equality of opportunity. Chapter 1 showed that that was not true. The quip of Jonathan Chait seems to fit here: “The facts shouldn’t get in the way of a pleasant fantasy.”
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The second factual problem is the claim that the progressive perspective argues for equality of outcome. As Chait expressed it, the reality is that the Democrats are not arguing for equality of outcome, only for policies “that leave in place skyrocketing inequality of income, just ever so slightly ameliorated by government.”
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Perhaps the most essential point is this: no one succeeds on his own. There are plenty of bright, hardworking, energetic people in developing countries who remain poor—not because they lack abilities or are not making sufficient effort, but because they work in economies that don’t function well. Americans all benefit from the physical and institutional infrastructure that has developed from the country’s collective efforts over generations. What’s worrying is that those in the 1 percent, in attempting to claim for themselves an unjust proportion of the benefits of this system, may be willing to destroy the system itself to hold on to what they have.

This chapter has explained that we are paying a high price for the inequality that is increasingly scarring our economy—lower productivity, lower efficiency, lower growth, more instability—and that the benefits of reducing this inequality, at least from the current high levels, far outweigh any costs that might be imposed. We have identified numerous channels through which the adverse effects of inequality operate. The bottom line, though, that higher inequality is associated with lower growth—controlling for all other relevant factors—has been verified by looking at a range of countries and looking over longer periods of time.
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Of all the costs imposed on our society by the top 1 percent, perhaps the greatest is this: the erosion of our sense of identity in which fair play, equality of opportunity, and a sense of community are so important. America has long prided itself on being a fair society, where everyone has an equal chance of getting ahead, but the statistics today, as we’ve seen, suggest otherwise: the chances that a poor or even a middle-class American will make it to the top in America are smaller than in many countries of Europe. And as inequality itself creates a weaker economy, the chance can only grow slimmer.

There is another cost of America’s inequality, beyond this loss of a sense of identity and beyond the way it is weakening our economy: our democracy is being put at peril, a subject to which we turn in the next two chapters.

C
HAPTER
F
IVE

A DEMOCRACY
IN PERIL

W
E HAVE SEEN HOW
A
MERICA’S CURRENT INEQUALITY,
and that of many other countries, did not arise spontaneously from abstract market forces but was shaped and enhanced by politics. Politics is the battleground for fights over how to divide nation’s economic pie. It is a battle that the 1 percent have been winning. That isn’t how it’s supposed to be in a democracy. In a system of one person one vote, 100 percent of the people are supposed to count. Modern political and economic theory predicted that the outcomes of electoral processes with one person having one vote would reflect the views of the average citizen—not that of the elites. More precisely, standard theory, based on individuals with well-defined preferences who are voting in their self-interest, predicts that the outcome of democratic elections would reflect the views of the “median” voter—the person in the middle. In the case of public expenditures, for instance, it says that half would want more spending and half less.
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But polls consistently show that there are large discrepancies between what most voters want and what the political system delivers.

In the aftermath of the Great Recession there is disillusionment not only with the global economic system but also with how the political systems in many Western democracies have been working. This disillusionment found expression in the Occupy Wall Street and
indignado
movements around the world. That there are major failures in our economic system is obvious; but it is equally evident that the American political system has not even begun to fix them. Most Americans don’t think the new financial regulations (Dodd-Frank) went far enough, and they’re right. Even before the crisis, there was an awareness of widespread predatory lending practices. It was in the interests of most Americans to curb those as well as the abusive credit card practices. But that didn’t happen. The federal government has done little to prosecute banks that violated the law—as we will see in chapter 7, much less than it did in the much less serious Savings and Loan crisis two decades ago. The
New York Times
has described how the Securities and Exchange Commission, which is supposed to protect investors from fraud, “has repeatedly allowed the biggest firms to avoid punishments specifically meant to apply to fraud cases.”
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Why hasn’t the middle had the political influence that standard theory predicts it should have, and why does our current system seem to operate on “one dollar” one vote instead of one person one vote? In earlier chapters, we saw how markets are shaped by politics: politics determines the rules of the economic game, and the playing field is slanted in favor of the 1 percent. At least part of the reason is that the rules of the political game, too, are shaped by the 1 percent.

This story has two critical elements. One, shaping individuals’ perceptions—so that the 99 percent adopt the interests of the 1 percent as their own—is the focus of the next chapter. The current chapter focuses on the economics and politics of voting itself.

U
NDERMINING
D
EMOCRATIC
P
OLITICAL
P
ROCESSES

The voting paradox and voter disillusionment

One of the puzzles in modern political economy is why anyone votes at all. Very few elections actually turn on the vote of a single individual. There is a cost to voting—although no American state has an explicit charge for voting today, it takes time and effort to get to the voting booth. Registration can also be a burden, requiring planning well in advance of elections. People who live in sprawling Western cities with poor public transportation may be at a disadvantage for reaching their polling stations. People with limited mobility may find it difficult to get to the polling station even when it is nearby. For voters’ troubles, there is little personal benefit. Indeed, it almost never happens that the individual’s vote is pivotal, that is, makes any difference to the final outcome. Modern political and economic theories assume rational self-interested actors. On that basis, why anyone votes is a mystery.

The answer, of course, is that we’ve been indoctrinated with notions of “civic virtue.” It is our responsibility to vote. Each individual contemplating not voting worries about what would happen if everyone acted like him: “If I and other like-minded people didn’t vote, that would leave the outcome to be determined by others with whom I disagree.”

Such civic virtue should not be taken for granted. If the belief takes hold that the political system is stacked, that it’s unfair, individuals will feel released from the obligations of civic virtue. When the social contract is abrogated, when trust between a government and its citizens fails, disillusionment, disengagement, or worse follows.
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In the United States today, and in many other democracies around the world, mistrust is ascendant.
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The irony is that the wealthy who seek to manipulate the political system for their own ends welcome such an outcome. Those who turn out to vote are those who see the political system working, or at least working for them. So if the political system works systematically in favor of those at the top, it is they who (disproportionately) are induced to engage in politics, and inevitably the system serves best those whose voices are heard.

Moreover, if voters have to be
induced
to vote because they are disillusioned, it becomes expensive to turn out the vote; the more disillusioned they are, the more it costs. But the more money that is required, the more power that the moneyed interests wield. For those with money, spending it to shape the political process is not a matter of civic virtue; it is an investment, from which they demand (and get) a return. It is only natural that they end up shaping the political process
in their interests
. That, in turn, increases the sense of disillusionment that pervades the rest of the electorate and boosts the power of money further.

Lowering trust

I have emphasized how the country has to act together, cooperatively, if the country’s problems are to be solved. Government is the formal institution through which we act together, collectively, to solve the nation’s problems. Inevitably, individuals will differ in their views of what should be done. That’s one of the reasons that collective action is so difficult. There needs to be compromise, and compromise has to be based on trust: one group gives in today, in the understanding that another does in another year. There must be trust that all will be treated fairly, and if matters turn out differently from how the proponents of a measure claim it will, there will be change to accommodate the unexpected circumstances.

But it’s easier to act together if the interests and perspectives of the members of a group are at least loosely aligned; if everyone is, as it were, in the same boat. But it is evident that the 1 percent and the rest are not in the same boat.

Cooperation and trust are important in every sphere of society. We often underestimate the role of trust in making our economy work or the importance of the social contract that binds us together. If every business contract had to be enforced by one party’s taking the other to court, our economy, and not just our politics, would be in gridlock. The legal system enforces certain aspects of “good behavior,” but most good behavior is voluntary. Our system couldn’t function otherwise. If we littered every time we could get away with it, our streets would be filthy, or we would have to spend an inordinate amount on policing to keep them clean. If individuals cheated on every contract—so long as they could get away with it—life would be unpleasant and economic dealings would be fractious.

Throughout history the economies that have flourished are those where a man’s word is his honor, where a handshake is a deal.
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Without trust, business deals based on an understanding that the complex details will be worked out later are no longer feasible. Without trust, each participant in a deal looks around to see how and when those with whom he is dealing will betray him. To protect against these outcomes, individuals spend energy and resources obtaining insurance, making contingency plans, and taking actions to ensure that, should they be “betrayed,” the consequences are limited.

Some social scientists try to account for the effect of “trust” on the overall economy by referring to social capital. An economy with more “social capital” is more productive, just like an economy with more human or physical capital. Social capital is a broad concept that includes those factors that contribute to good governance in both the public and the private sectors. But the idea of trust underlies all notions of social capital; people can feel confident that they will be treated well, with dignity, fairly. And they reciprocate.

Social capital is the glue that holds societies together. If individuals believe the economic and political system is unfair, the glue doesn’t work and societies don’t function well. As I’ve traveled around the world, partly in my job as chief economist of the World Bank, I’ve seen instances where social capital has been strong and societies have worked together. I’ve also seen instances where social cohesion has been destroyed and societies have become dysfunctional.

Bhutan, the remote Himalayan state to the northeast of India, for instance, is protecting its forests as part of a broader commitment to the environment. Each family is allowed to cut down a fixed number of trees for its own use. In this sparsely populated country, I asked, how could one enforce such an edict? The answer was simple and straightforward: in our jargon, social capital. The Bhutanese have internalized what is “right” when it comes to the environment. It would be wrong to cheat, and so they don’t.

Communities that rely on irrigation—whether it’s in the hills and mountains of Bali or in the Atacama Desert of northern Chile—have to work together to manage their water and to maintain the irrigation canals. These communities, too, seem to develop strong bonds, a strong sense of social capital, with little or no cheating on the “social contract.”

At the other extreme, when I visited Uzbekistan after the fall of the Soviet empire, I saw the consequences of the erosion of social capital. Most greenhouses had no glass, making them totally ineffective. I was told that as Uzbek society and economy decayed, each family looked out for itself. The glass was stolen from the greenhouses. Nobody was sure what they would do with the stolen glass, but it provided some limited security, and they were sure that if they didn’t steal it, somebody else would.

More generally, in the aftermath of the breakdown of the Soviet Union, Russia experienced a marked decline in output. This puzzled most economists. After all, there was the same physical, human, and natural capital after the breakdown that there had been before the crisis. Eliminating the old distortionary centralized planning system and replacing it with a market economy should have meant that those resources would, at last, be more efficiently used. But what the analysis failed to incorporate was how seventy-four years of Communist Party rule, along with the suppression of civil society institutions, had eroded social capital. The only thing that had held the country together was a central planning system and an oppressive dictatorship. When these institutions crumbled, the social capital required to hold the country and the economy together just wasn’t there. Russia became the “Wild East,” more lawless than America’s Wild West before it was tamed. Russia was “caught up in a systemic vacuum with neither the plan nor the market.”
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Recent advances in the study of social norms show that many or even a majority of people will abstain from an individually beneficial but socially harmful action if they perceive that most people do too. But the converse is also true. This has an important consequence: desirable behavior can quickly degrade when people are exposed to a sufficient number of “transgressions.”
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In America there has been an enormous erosion of trust in recent years.
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Within the economy the banking sector has been at the forefront of the trend. An entire industry that was once based on trust has lost it. Pick up the newspaper on a random day, and there will almost surely be more than one article describing some bank or someone from another part of the financial sector being accused or convicted of engaging in some fraud, aiding and abetting some tax evasion scheme, or participating in some credit card abuse, some insider trading, some mortgage scandal.

The head of Goldman Sachs, Lloyd Blankfein, made it perfectly clear: sophisticated investors don’t, or at least shouldn’t, rely on trust. Those who bought the products the banks sold were consenting adults who should have known better. They should have known that Goldman Sachs had the means, and the incentives, to design products that would fail, that they had the means and the incentives to create asymmetries of information—where they knew more about the products than the buyers did—and that they had the means and the incentives to take advantage of these asymmetries. Those who fell victim to the investment banks were, for the most part, well-off investors (though they included pension funds managing the money of ordinary citizens). But deceptive credit card practices and predatory lending have made every American understand that the banks are not to be trusted. One has to read the fine print—and even that won’t be enough.