The prevalence of income inequality in free market economies indicates that inequality may be the result of a market failure. Those who are born rich are more likely to become rich, while individuals who are born poor are more likely to live a life of relative poverty. In a “free” market, it is believed, all individuals possess an equal opportunity to succeed, but due to a mis-allocation of resources in a purely market economy, this may not always be the case.

The resources I refer to here are those required for an individual to escape poverty and earn a higher income. These include public and merit goods that those with high incomes can afford to consume, while those in poverty depend on the provision of from the state, including:

• Good education
• Dependable health care
• Access to professional networks and the employment opportunities they provide

Whenever a market failure exists, it can be argued that there is a role for government in regulating the market to achieve a more optimal distribution of resources. When it comes to income inequality, government intervention typically comes in the form of a tax system that places a larger burden on the rich, and a system of government programs that transfer income from the rich to poor, including welfare benefits, unemployment benefits, healthcare for low income households, public schools and support for economic development in poor communities.

Many politicians and some economists like to argue that income inequality is not as evil as many people make it out to be, and that greater income inequality can actually increase the incentive for poorer households to work harder to get rich, contributing to the economic growth of the nation as a whole. Allowing the rich to keep more of their income, in this way, leads more people to want to work hard to get rich, as they will be able to enjoy the rewards of their hard work.

Another common argument is that higher income inequality leads to social and economic disruptions that can slow economic growth and bring an economy into a recession or a depression, since the middle and lower income groups in the nation will not benefit from a relatively equal share of the nation’s output, and over time will see their living standards drop and their overal productivity and contribution to national output decline.

The debate over inequality and what government can or should do about it is at ther root of many other economic debates today. A recent study by the Political Economy Research Institute of the University of Massachusetts, Amherst, provides support for those who support the second argument above. Here are some of the main discoveries from the study, “Searching for the Supposed Benefits of Higher Inequality: Impacts of Rising Top Shares on the Standard of Living of Low and Middle-Income Families”.

Discoveries of the study:

Some believe that increase inequality leads to more growth, others argue that it leads to less growth.

A more interesting question is whether rising income inequality leads to a higher standard of living for everyone in society, or whether standards of living decline for those in the middle as the percentage of total income earned by the top 10% increases.

The study found that the higher the percentage of income earned by the top 10%, the incomes of those in the middle and bottom of the income distribution actually decreases. Not just the percentage of total income, but the actual incomes of these groups falls as the rich get richer.

The popular belief is that reducing taxes on the rich increases the amount of investment in the economy, creating more jobs and helping increase incomes of the middle and lower income households. This theory is sometimes referred to as “trickle down” economics, as the increased incomes and wealth at the top will “trickle down” and raise the incomes of the rest of society as well.

However, actual data shows that a 10% increase in the share of total income earned by the top 10% of income earners leads to a 2% decline in the incomes of households in the middle of the income distribution (based on data for the period between 1979 and 2005).

It’s not just that the rich get richer and the poor get poorer, rather that the rich getting richer makes the poor (and the middle income earners) poorer. This is a breakthrough discovery.

Possible explanations:

• The rich contribute to growth abroad, rather than at home: Rich households’ higher incomes allow them to consume more domestic output and imported goods and services, but it also allows them to save more, which sometimes translates into more investment. But more investment does not always translate into domestic economic growth, since investment is now global. A rich American saving more does not mean American firms will have access to cheaper capital, as domestic savings may fuel investment in emerging markets or elsewhere abroad. Foreign investment resulting from savings among rich Americans counts as a leakage from America’s circular flow of income, leaving less income within America for the middle and low income earners. Essentially, much of the income earned by the rich is saved abroad, contributing to employment and growth overseas, reducing incomes of the middle class at home.
• Reduced support for the provision of public goods: When examining living standards, more than just income must be considered, but also access to education, provision of health care and other public goods such as public safety and security. Richer households are less interested in things like public schools and social welfare programs, as they do not rely on these for their own well-being. Therefore, the richer the top 10% become,  the greater their incentive to work against efforts to fund public education, public health and public safety. The underprovision of these social welfare enhancing goods by govenrment further widens the gap between the living standards of the richest and the middle class. Economist Robert Reich refers to this phenomenon as “the secession of the successful”.
• Wage competition reduces incomes in the middle: Business owners, who make up a large percentage of the richest households in America, increase their own incomes to the extent that they can drive down the wages they pay their employees. In this way a higher share of national income is enjoyed by a smaller proportoin of society. The minimum wage has barely increased over time, and workers have less bargaining power as fewer workers than ever are members of labor unions; this has allowed business owners to pay lower wages over time, concentrating an increasing share of national income in business profits, and less and less in wages for workers.

In the video below, the study’s author shares some of the findings discussed above. Watch the video and respond to the discussion questions that follow.

Discussion Questions:

1. Summarize the argument against a government taking measures to redistribute its nation’s income to reduce the level of inequality between the rich and the poor.
2. Summarize the argument for a government reducing inequality.
3. Popular belief holds that “a rising tide lifts all boats”. In other words, if the total income of a nation is increasing, it does not matter if the rich are enjoying a larger percentage of the higher income than the poor and middle, because everyone is likely to be better off than if total income were not growing at all. Does the study discussed above support this popular view? Why or why not?
4. What measures can a government take to assure that higher national income leads to higher standards of living for everyone in society, including the middle class and the poor? Why might the highest income earners be opposed to such attempts by government?
5. Should government intervene to reduce the level of income inequality in society?

I have lived in Singapore for two years now and am always interested in the nuances of the city state’s economy. In some measures Singapore has the one of the highest levels of Gross Domestic Product per capita in the world. As measured using Purchasing Power Parity, Singapore is ranked 7th in the world with $53,900 GDP per capita

Singapore also has a high, and growing level of income inequality which has been associated with the form of rapid economic growth. In 2009 Singapore was ranked as having the second highest level of income inequality in developed countries, with a Gini Coefficient score of 0.425. Hong Kong was 1st and USA 3rd. In most rapidly developing economies (China, Brazil, India) strong economic growth is leading to growing income inequality. The gains from growth are not being shared equally between all citizens and the rich continue to get richer at the expense of the poor. Here are some economic indicators from Singapore.

• During 2010 Singapore’s Gross Domestic Product expanded by 14.7%. This is the fastest rate of economic growth in the world.
• Since 1989 it’s GDP per capita has risen from $16,000 to $48,000.
• Total Gross Domestic Product in Singapore Dollars has increased from $56 Billion in 1989 to $265 Billion.
• The bottom 10% of the population now account for only 5% of the national income, compared to the top 10% of people who account for 49% of the income.

Each of the above statistics support the economic goals of Singapore except for the last bullet point. Singapore believes in inclusive growth and attaches a high degree of importance on the ideals of social cohesion. These statistics are a challenge to the goals of the country, which aims to allow all families to live in dignity and with material self sufficiency.

Therefore one possible way to increase the income of the lowest people is to introduce the concept of a minimum wage. Currently the free market determines the market wage. For some occupations such as cleaners, constructions workers and domestic helpers the market is awash which cheap labour from neighbouring countries such as the Philippines, Indonesia, India and Bangladesh. This drives down the market wage. The average domestic live in helper in Singapore would make $120 a week and construction workers slightly more. These workers also have the lowest bargaining power and are often unable to negotiate for higher wages. Thus free market wage seems to disadvantage low income workers in Singapore.

Introducing a Minimum Wage:

The minimum wage is a wage floor. In Singapore, employers would not be allowed to pay their employees a rate below the minimum wage and this presumes the minimum wage was binding and set above the prevailing market rates. Some would call this a living wage and would be set to enable citizens to enjoy a basic standard of life and subsistence.

The negative aspects of the minimum wage legislation would be an increase in unemployment. After the introduction of the minimum wage the market demand for workers would fall to LD. At a higher wage firms have less incentive to hire workers. The other important feature is that Labour Supply would increase at the level of the new minimum wage. More workers would be attracted into the workforce. This therefore creates a disequilibrium where Labour Demand does not equal Labour Supply. In the Labour Market this is known as unemployment. In Singapore potential foreign investors could be less willing to invest in a country with higher labour costs and the nations competitiveness with other economies could fall. After the introduction of minimum wages in Japan (1959), South Korea (1988) and Taiwan (1956) researches found no evidence of a fall in foreign investment or economic competitiveness.

Positive aspects of introducing a minimum wage?

1. To reduce poverty: To help reduce poverty for the bottom 20% of households in Singapore, a binding minimum wage set above the market wage would lift incomes. The lifting of incomes should also reduce the level of income inequality for low income households.
2. Taxes and Benefits: If workers begin to earn higher wages then tax receipts should increase. At the same time the level of financial support for such families will likely fall as they become more self sufficient. This could also help reduce government spending. Both of these effect will likely have a positive impact on the government budget.
3. The effect on worker productivity: Some economists believe that the increased wage might improve labour productivity. Workers may respond to their higher wage rate by working harder, possibly as a result of worrying about losing their job now that the increased wage rate has made it a more ‘sought after’ job. Employers may force through productivity improvements. Some workers will work shorter hours and achieve a greater work life balance and hopefully be more productive during these hours at work.

Market interventions are obvouisly not the only way to improve the incomes of low income households. Singapore currently does many small things to improve the quality of life for low income households. In my opinion in the long run the economy needs to think of other ways to increase incomes of low income households so that Singapore holds the value of social cohesion and does not become a infamous country of unequal incomes and  extremes of wealth and poverty.

• Subsidized Housing and Grants for first home buyers – HDB Scheme
• Free education from Kindergarten to Secondary School.
• Subsidized health care
• Various financial assistance schemes including the Workfare Income Supplement

Resources and Background :

• Minimum Wage Theory – S-Cool UK | Economics
• “Don’t knock the minimum wage yet” | Tommy Tan – see commentary here (The Straits Times, A32, November 11th 2010)
• CIA Factbook | Singapore Overview

Discussion Questions:

1. Describe the kind of tax system which could be developed to reduce income inequality?
2. Outline the difference between income and wealth?
3. What is the more concerning problem for governments, the inequality of wealth or income? Explain.
4. Evaluate the methods available to government to reduce income inequality.

Also posted at economic and eLearning – digging a little deeper

The Danish people are a notably generous and happy group of people and for many years they have had the most extensive welfare system in the world. Danish citizens pay nearly 50% income tax, which allows its citizens to enjoy a high quality of life, free education, healthcare and lavish unemployment benefits.

Since the Global Financial Crisis in late 2008 unemployment in Denmark has more than doubled from 1.7% to 4.2% now. This is still far below levels in other parts of Europe, such as Spain with 19% unemployment. The Danish government is however evaluating the level the unemployment benefits, as the government budget tightens. An unemployed worker in Denmark is entitled to an unemployment benefit which is between 70-90% of their prior salary. Currently they can receive this compensation for up to four years.

High unemployment puts two specific strains on the governments budget during a recession. There are decreased tax receipts as workers are forced out of work, but at the same time expenditure on transfer payments to the unemployed workers will simultaneously increase. Therefore a swift rise in unemployment in the recent recession, lead to some governments such as the United Kingdom falling into a deep budget deficit very quickly. The opposite effect occurs in an economic boom where transfer payments fall and tax revenue increase, leading to a swelling of the budget surplus.

Policy makers in Denmark are therefore planning to trim the generous safety net provided to its workers,

Having found that recipients either get work right away or take any job as their checks run out, officials are also redoubling longstanding efforts to move Danes more quickly out of the safety net.

“The cold fact is that the longer you are out of a job, the more difficult it is to get a job,” Claus Hjort Frederiksen, the Danish finance minister, said during an interview. “Four years of unemployment is a luxury we can no longer allow ourselves.”

New York Times – Liz Alderman – 16th August 2010

Statistics from Denmark show that in the Global Financial Crisis of late 2008, 100,000 Danish people were registered as unemployed. Approximately 62% of these people found another job within two months, and only 6% of these people had been unemployed for longer than two years. This highlights the fact that Denmark has a very flexible labour market. Meaning in simple terms, that workers can freely move between jobs, and can be hired and fired more easily than in comparable European nations such as Germany or Sweden. The flexibility and security of the Danish system is nicknamed “flexicurity”. The following comments highlight the elements of the flexicurity culture.

“It’s no surprise the government is saying that programs that are highly expensive and give a Rolls-Royce treatment to citizens have to be trimmed,” said Iain Begg, a professor at the London School of Economics. “So the search will now be on for labor market policies that deliver more people in work with less money, which has an inevitable air of the holy grail about it.”

In Denmark, employers have carte blanche to hire and fire, and in most cases laid-off people are guaranteed about 80 percent of their wages in benefits, a figure capped for high earners. In turn, they must participate in retraining and job placement programs tailored to get them back to work, which the government has intensified.

Each year, a remarkable 30 percent of Danes change jobs, knowing the system will allow them to pay rent and buy food so they can focus on landing a new position. About 80 percent belong to unions, which manage the workplace, help run the unemployment insurance program and press the laid-off into retraining.

New York Times – Liz Alderman – 16th August 2010

If 30% of workers are willing to change jobs each year, this would have a positive effect on the economy. This proportion is high because workers are not scared into becoming unemployed and poor. Some like myself, would consider the opportunity cost of receiving 80% of my previous wage and an unemployed holiday a great trade off. Of course, workers also consider issues such as social dislocation, loss of skills in the decision making process and are therefore keen to get back into work as quickly as possible.

Within Denmark and the flexicurity system; it would suggest that workers are prepared to accept new challenges and develop skills that are required in new jobs. This also opens up jobs to younger graduates each year. During a recession the same system allows firms to reduce thier demand for labour quickly and to restructure the business to the new economic climate. The supporting welfare structures in Denmark which help unemployed people with training and job applications is an important spoke in the system. These elements are considered labour market supply side policies.

Discussion Questions:

1. Describe the concept of “social safety nets”
2. If the Danish government continued to allow up to four years unemployment benefit, what could be the potential impacts on the Supply of Labour within Denmark?
3. Describe why Denmark has the one of the lowest Gini Coefficient scores in the world (0.29, CIA Factbook 2007)
4. How does labour flexibility or the Danish system of flexicurity, improve economic growth?
5. Evaluate the relative merits of Denmark having one of the highest income tax rates in the world.

I wonder how many people in countries like Switzerland, Brazil, Canada, Russia, and China, and the United States would be surprised to learn that prices of products and services in their countries have become much less expensive over the years.

Say what? You must be crazy, you say! Prices are rising way too fast!

Yes, most citizens see their purchases as becoming more expensive when, in actuality, things are becoming less expensive. Of course, the paradox is that although nominal prices (the actual price tag) are, in fact, increasing, nominal income (the average wage or salary) has been growing faster. This is a topic that in economics is called “real income” or a measurement that compares a nation’s income growth relative to the growth in prices that the same income buys.

Let’s take some specific facts for the United States:
In the United States real median household income grew from $41,318 to $50,811 from 1970 through 2006 for a total percentage gain of 23% (source: Pew Research Center). Both of the aforementioned median household incomes are stated in 2008 or current dollars which makes the comparison valid. Median household income is an attempt to quantify the progress that the “middle American” family or typical family has made. So, in short, the median household in America can buy 23% more with their income today than they could in 1970. In other words, relative prices are lower to income.

If we look at the same United States income data over the same period for real average household income, there is real income growth of nearly 60%. The higher growth (60%) in real incomes for the average household versus the median (middle) growth rate (23%) is explained by the fact that much of the growth in United States’ real incomes has accrued disproportionately to the college educated & entrepreneurs driving up real income growth rates much faster for the average than the median or middle household. (Hint: continue your education!)

Now let’s get back to the main premise of the title of this blog and the opening assertion that prices are lower than ever. What we are really saying is that you have to benchmark price increases to income increases to really understand whether things are becoming more expensive. The vast majority of products & services are cheaper today in all nations than they have ever been before, which helps explain, excluding the effects of the current recession, why more citizens than ever before can afford to own their own houses, drive more and better cars, and are likely to have cable, cell phones, and computers. The reason we are led to believe differently is because we are victims of our own human nature, which often causes us to focus on the problem areas (rising prices) and not the benefits (incomes that are rising faster). Most citizens’ focus expands out to the last dollar of their incomes and they quickly notice those select products that are rising faster than others like health care, gasoline prices, and education! Hey, even gasoline prices are not at an all relative price high. If gasoline prices in the United States are restated for inflation, or set to comparable 2009 dollars, they are $2.60 per gallon today vs. $3.17 in 1981 and $3.50 in 1918!

Now, you may say to yourself that statistics can lie or mislead and you are sure in your gut that things are getting more expensive relatively. You can try to validate that incorrect “gut feeling” by examining whether your country’s middle class is enjoying less or more products and services. “Real income” really is just a measurement of the quantity and quality of products and services that you have. For example, the average American household has larger homes, more cars, more air conditioning, more gadgets, and better healthcare & prescription drugs than, say, 20 years ago.

But let’s end this blog with a concern. Although everything noted above is accurate, the pace of real income growth has been relatively slow over the last 10 years, especially for the middle class in the United States. Most of that growth in real income mentioned above has occurred up until this current decade. For the last 10 years, median family income growth in the U.S. has been very small and the average income growth has been higher but below the U.S. historical experience. There are many reasons for this slowdown in real income growth, but three big reasons are that

1. the U.S. has now had two recessions this decade (2001 and 2007-current, versus our historical average of only 1 per decade), and
2. energy and health care prices have risen much faster, and
3. foreign labor competition and technology advancement has kept the uneducated/unskilled U.S. workers real income relatively stagnant. More than ever before, a good education is the ticket to your economic future!

Discussion Questions:

1. Inflation is bad, right? Well, what if average prices rise by 2% a year but average incomes rise by 3%. What happens to real income in this situation? Is the average household better or worse off in such a scenario?
2. How have trade and globalization contributed to rising real wages in America and Swizerland?
3. How have trade and globalization contributed to falling nominal wages in America and Switzerland?
4. How do improvments in technology contribute to rising real wages in both developed and developing economies? What about health and education?
5. What types of policies can government pursue to help raise the real wages of the nation’s workers?

At the end of this week, the U.S. Government’s Commerce Department will provide its first estimate of the country’s 3rd quarter (July-September 2008) gross domestic product or GDP. This upcoming GDP report is of particular interest to the world since it will provide an important measurement of how much the U.S. economy has slowed or even recessed over the last several months. Many economists predict that the upcoming GDP report will show either no significant economic growth or, very likely, negative growth.

Let me try and make the concept of GDP easy to understand and explain why it is considered the most important, single macroeconomic measurement.

GDP is simply a calculation that measures the market value (final price) of all the final goods and services produced within the borders of our country. Thus, U.S. GDP includes Toyotas produced in Alabama but excludes Cadillac’s made in Canada. GDP includes all U.S. exports but excludes all U.S. imports since imports, by definition, are produced in some other country and are a part of that country’s GDP.

If you think about it, ultimately our economic satisfaction is better measured by the goods and services that are produced and that we have access to more so than in any other single measurement, which is why GDP is the measurement that is synonymous with “economic growth”. In addition, rising GDP (more goods and services) is the ultimate economic goal of any economy which can best be accomplished through the means of the two other key macroeconomic measurements of employment and productivity.

Let’s describe how the GDP calculation is made. Each quarter, the Government compares the final value of the domestic goods produced and services rendered in the current quarter to the final value of the goods produced and services rendered in the previous quarter. The calculation then takes the percentage gain, current quarter versus previous quarter, and annualizes the percentage. The comparison is always restated for inflation so that the figures are comparable from one period to the next. For purists, we call this “real GDP” which is the only GDP reported by the media, even though the word “real” is almost always dropped to avoid confusion with the average citizen. For example, the second quarter 2008 U.S. GDP report highlighted a 2.8% GDP annualized growth rate. This means that the second quarter final value of goods and services produced was approximately .7% higher than the first quarter final value of goods and services produced. Thus, the quarter over quarter growth of approximately .7% was reported at an official 2.8% annual growth rate for the second quarter.

Now let me get to my favorite point on GDP, which even many economists lose sight of. GDP growth is precisely the same as income growth! For example, in the second quarter of 2008 we can say that incomes for Americans grew by 2.8% restated for inflation. You probably never thought about it this way but every time you purchase something, every dollar you spend is going to someone as income, whether it is the workers as wages, the landlord as rent, a bank that has made a loan as interest income, or to the owners of the business as profits. I tell my students that GDP = Income and we review how the Government calculates GDP both in terms of the final market value of the goods and services as well as how that same production value is reconciled to the incomes of others.

I find the preceding paragraph, GDP = Income, to be a break through moment for a lot of citizens in truly understanding the GDP measurement. It is easier for most citizens to think in terms of income percentage growth in lieu of GDP growth. Most citizens are surprised to find that incomes or GDP, restated for inflation, have increased by 17.4% from 2000 – 2007. This 8-year growth rate in GDP or incomes still equates to a below average historical average performance. More specifically, over the last 8 years our average annual GDP or income growth rate was only 2.2% versus our historical average growth rate of 3.2%. However, the final point of caution is that the GDP or income growth rate is a collective average, thus the growth in GDP or incomes does not indicate how those income gains are accruing to the various socioeconomic classes or professions.

CHICAGO, January 7, 2008 – How much money does it take to be considered rich?  It turns out that $1 million just doesn’t cut it, anymore.

In fact, rich today requires at least $5 million, according to a new survey of affluent households, defined as those with investable assets of $500,000 or more.  When asked how much money it takes to be rich, 45% chose $5 million, 25% selected $25 million, and 8% picked $100 million, according to the research by Millionaire Corner (http://www.millionairecorner.com/index.php), a newly launched website powered by Spectrem Group.  Only 22% said $1 million is enough to be rich.

 Achieving such wealth – and holding onto it for generations – is the topic of a new book by Spectrem’s Catherine S. McBreen and George H. Walper, Jr. titled “Get Rich, Stay Rich, Pass It On: The Wealth Accumulation Secrets of America’s Richest Families” (http://getrichstayrich.net/).  Published this month by Portfolio and available in bookstores now, the book is based on years of research in addition to interviews with ordinary individuals who were able to amass enough wealth to pass on to future generations. “All you really need is to know how to use the same wealth-building tools Carnegie and du Pont and all the other progenitors of sustainable fortunes used,” McBreen and Walper write.  “They created the model but they didn’t patent it.  It’s available for your use, and this book is the operating manual.” 

The authors found that the proper mix of entrepreneurial activities and income-producing real estate is the key to achieving building perpetual wealth. “Get Rich, Stay Rich, Pass It On” walks readers through not only the theory but the practice of building sustainable fortunes.  It not only lays out the model, but provides exercises to help readers bring their own finances into focus and determine what they need to do to develop perpetual wealth of their own.

 

* * *

 The data on how much it takes to be rich are based on 253 telephone interviews conducted in December 2007, with a margin of error of plus or minus 6.2 percentage points.  Interviews were conducted with the financial decision-makers in households with $500,000 or more in investable assets. 

Switzerland “could become a feudal state” claims an economist. – swissinfo

One Zurich economist thinks so:

In Switzerland 71 per cent of the wealth is concentrated in the hands of just ten per cent of the population – a figure that economist Hans Kissling finds alarming.

Kissling tells swissinfo that the gap between the rich and everyone else is growing and that this could threaten traditional Swiss democracy and the economy. He makes a call for an inheritance tax for the wealthy.

Statistics show that the 300 richest people have become 40 per cent wealthier in the past eight years, whereas most of the population has a lower income than at the beginning of the 1990s

Kissling has nothing against wealth, he just thinks that if someone did not earn their wealth but inherited it instead, they should have to share a bit with the rest of society.

I call for a tax on very high inheritances, from SFr1 million ($900.000) upwards, and only on the excess value of that. I certainly don’t want people to think that they can’t pass on their family home to the next generation.

I’m only interested in trying to stop any creeping feudalisation, to avoid having huge clans like in South America, which threaten the economy and the political world

He’s most concerned that if the gap between rich and middle class continues to widen and the middle class of Switzerland don’t start benefiting from the country’s growing wealth, there could be a dangerous backlash against the free market system.

…the richest one tenth of a percent in Zurich – there are no full Swiss statistics – had 677 times more wealth than an average citizen in 1991. By 2003, 12 years later, the richest one tenth of a percent had 1,027 times more wealth. So the gap has really grown.

The middle classes, unlike the lower classes, have not benefited from any concessions, such as health insurance or childcare allowances. Here they have to use up all their assets before they receive any support. The lower classes have help from the beginning. This is why the middle classes are threatened

Discussion Questions:

1. Why does a growing gap between rich and middle class threaten social stability in Switzerland?
2. What would advocates of socialism propose in order to avoid future struggles between the rich and the middle class?
3. What kind of tax system would help re-distribute the wealth of Switzerland and narrow the enormous gap that exists here?