Monday, August 01, 2005

Essay: What generates wealth? How is it measured? 

I got a note last week from longtime reader and friendly antagonist Michael Boucher. He wrote:

You may have seen the StarTribune Opinion section today. It has a lot of very interesting articles that I may use in a future class (perhaps sociology). I assume you disagree with the Commentary "Peter Sammond: Concerned about distorted wealth distribution"

If so, I would like a favor.

I would like a 750-1000 word response, in the blog or not, in common language, on what is it about his reasoning and/or data that you find incorrect.

I will use it alongside the Sammond article if I have the opportunity to do so.

I'd be quite pleased to learn that Boucher used the below. I refrained from a point-by-point response or some sort of "fisking" so that it can be in the language that would fit a classroom such as Boucher's. Here is my answer to his request (a copy has been emailed to him as well.)

We live in an age of great transformation, from an age of producing goods to producing information. The rewards to education have never been higher. Capitalism is a system of economic change, though, and it handles the changes we are experiencing by rewarding those who move to areas of higher production. And during those periods of change, inequality will tend to increase.

This is of great concern to those who advocate for the poor, such as
Mr. Sammond. Yet Sammond makes three fundamental mistakes in his analysis. First, by focusing on a single point in time he ignores the progress in income inequality made over time in America, and the causes for occasional rises in it. Second, relying on the simple census data is causing him to overstate the size of the inequality. And last, he does not understand what causes income.

First, it is worth noting that income inequality has improved greatly over time. In the period before the Great Depression, a time in which we went through great change, the top 1% of income earners held between 35-40% of wealth. (
Source.) This is part of the famous U of economic development given to us by Simon Kuznets. If we are undergoing a new revolution of income generation in America, a rise in inequality would be expected. It has little to do with government policy.

Second, government policy already has done much to reduce poverty, and yet people citing inequality statistics continue to use only cash income to measure income distribution. Robert Rector and Rea Hederman
performed a set of corrections for the redistribution of income back to poorer families from richer, so that post-tax rather than pre-tax income is examined. They also correct for the fact that for every person in the household in the bottom quintile, 1.7 persons are in the top quintile. Correcting for this leads to a finding that the top 20% of the income distribution have less than 40% of national income, not the 50% often claimed.

It�s worth noting as well that Sammond keeps citing statistics about the amount of tax cuts going to the rich. Well, how much tax does the top 1% pay?
About a third, the same as they received in the last set of tax cuts which Sammond declaims.

Third, Sammond cites corporate behavior as being the culprit for American income inequality. Yet that misses the point of how income is created. We gain income by persuading someone else to give it to us, by offering them something they value more than the money (or in-kind payment) they offer back to us. As ever, the way we can offer someone more is to increase our knowledge and become more creative. Education and entrepreneurship have always been the means by which the poor have lifted themselves from poverty. The returns to education are as high as recent memory �
as high as they were around WWI � and the ability and desire for self-employment is equally high. And this may drive the belief by many that they can become millionaires, because for many self-employment is seen as a way to the top, even in the rural economy.

If you look at the top 1% of the wealth distribution for families headed by someone age 65, only 10% of them earned their income by being a CEO or president of a corporation owned by someone else. 10% were doctors and lawyers,5% were salespeople, and maybe 1% of them were entertainers or pro athletes. 74% of them got their money from owning their own business and running them. (See
The Millionaire Next Door.) Only 20% of wealth is inherited, according to one Nobel economist. Sammond spends time worrying about big corporations and worries not a whit about the effect of the taxes which his group wishes to maintain for redistribution on small companies. Perhaps that�s because they think higher taxes will discourage the formation of competition.

In a period of great transformation, where there are new technologies waiting to be implemented for the betterment of our world, the last thing we would want is a decrease in competiton.

UPDATE: This poll won't make Mr. Sammond happy either.