Saturday, December 16, 2006

On Income Inequality

Expressing opinions on distribution of income and wealth leads to a grave danger of being labeled leftist or rightist. Hoping that the readers of this essay will be somewhat more forgiving than that, I am stating some general feelings and analyses in this area.

For the purpose of income distribution I like to classify income in three categories namely wage income, returns on assets and entrepreneurial income. Here I am including income on only individuals and am also aspiring to include illegal activities in this. Hence the heads wages and entrepreneurial income need to be appropriately broadened.

In the following, we will see how income differs across people due to various factors influencing these three. For a new entrant in the economy, she has to either inherit assets to earn good asset income or have good skills to command a good wage rate or be entrepreneurial (with sufficient funding) to earn above average. Else she joins the labor pool and earns the average. Statistically speaking, only a minority ever manages to earn above average. But that is a tautology. That is the meaning of averages and distributions. What would be relevant is to see if the average moves up or down over time and whether the difference between the generally rich and generally poor changes over time. It amounts to tracking the changes in the mean and standard deviation of income distribution.

Keeping aside productivity improvements due to technological changes, the average generally goes up with time. That is of course based on an assumption of surpluses. The surplus left after consumption in crude terms, is invested. These investments generate further income and so on. Now the question is, how is this incremental income distributed? The income generated due to incremental investments goes to investors of the same. The income generated due to extra work created in the process goes to the wage earners. How does the standard deviation of income distribution change?

For a while, let us club the income from assets and entrepreneurship under same heading of “return on assets.” Then there are essentially two factors namely capital and labor each expecting some income from the economy. What they actually get is a function of demand and supply of each. With population increase aided by advances in medical science, the supply of labor increases significantly while capital growth may be more or less depending on various other factors. The industrial revolution led to an equally strong growth in stock of capital keeping the balance between capital and labor to some extent. However, it seems in twentieth century, convergence of multiple factors actually tilted the balance in favor of capital in a big way.

First factor is technological improvements leading to two things. One is productivity improvement of those working and two is the replacement of humans by machines across various processes. Both these reduce the demand for labor. Second factor is increase in growth rate of population. This is again culmination of two things. First is the increased “stock” of human beings.

Second is the great advances in medical science reducing infant mortality and increasing life spans as well. Combined effect of the two is effectively an explosion in population. That increases the labor supply many times over.

Third factor is the introduction of structural barriers in movement of people up the socio-economic strata. Increasingly, it is not merely entrepreneurship that one needs to make big money but is a combination of skills, credibility and access to angel investors which enables one to start a business. While that may seem a minor factor, what it does is to exclude a fairly large section of population from moving upwards in socio-economic pyramid.

The last but in no way the least significant is the introduction of formal professional education. Unlike the past where apprenticeship with appropriate professionals led to taking up that profession later on, introduction of formal professional education saw people investing a significant amount of time as well as money in being qualified for a certain job. That led to two things. First is a dissociation (or at least “distancing”) of actual demand from number of apprentices. Second is elimination of poor sections of society from aspiring to get into jobs which require costlier education. No longer could the apprentice pay through man hours of assistance (barring research assistants in universities though).

Due to these four factors, post the great depression and through middle of twentieth century we had a picture of a constant oversupply of labor leading to what is generally called “unemployment.” Much has been written on this topic. What is most intriguing though is the very existence of it. I shall not delve further into this due to lack of competence. My overall feeling is that unemployment exists due to structural barriers in the job market such skill requirements. But this is anyway not the topic of our interest as of now.

What I was coming to was essentially the stronger growth in labor supply than in capital supply in the previous century. Owing to this, we can quite comfortably claim two things. The mean of income distribution has gone up and that the standard deviation has gone up too. While everyone is richer on average, the richer earn many more times over the poor than they did earlier.

Where are we headed? I can foresee two scenarios. Which one will unfold will depend on whether the crucial inflexion point I will describe later will come before the gradual reversal of the demand supply mismatch.

It is obvious that the rate of labor supply is coming down (not the labor supply itself though). Population growth is dwindling overall and is in fact negative in some parts of developed world. On the other hand the capital is growing faster and faster. Part of it is owing to simple base effect. Part of it is also the emergence of financial institutions which have led to increase in the productivity of capital owing to greater scrutiny of investments and dedicated expertise in financial investment. It is clear that the directions of changes in labor supply and capital supply are opposite. What is not clear is one the absolute values of these changes and two the starting points of these changes. These two together decide how long will it be before, in an abstracted sense, the “returns” on labor exceed those on capital. In essence, how long before the labor earns enough to match the income of investor in some per capita sense.
On the basis of when it can potentially do so, we can draw following two scenarios. The first is when the population of the world actually has been falling for a long time and is now stabilized somewhere much lesser than where it was in the middle of twenty first century. The capital in the meantime has grown significantly and the avenues for investment have not kept pace. The capital is employed in assets which generate meager income owing to large labor rates. The labor has become scarce and commands a large premium across the globe. Over time, even the poorer sections of society have caught up owing to easier access to education partly fuelled by subsidizing by governments and corporates to increase the labor supply. The increased incomes across wider sections of society are leading to greater savings even by the “poorer” (mostly defined only as being on the other side of income distribution) leading to them having increasing asset income. Overall, just as the mean of income distribution has increased, the standard deviation has come down. Over time, society is moving towards equilibrium where means of production are owned by firms which in turn are owned by financial institutions and run by professional managers. These financial institutions are instruments of investment by the entire population though individual investments differ on account of saving vs consumption preferences.

It can however happen that this scenario can take a very long time to unfold. Meanwhile other forces operating within the society can lead to serious disruptions of this development.

Let me start with describing these forces first. These are the forces coming from three major sources. First source is the frustration from unfulfilled ambitions of a large section of population which does not get what it desires. This has always been there since the beginning of civilization. What has exacerbated it in current times is the enabling of the poor to “see” in all its glory the glitter of being rich. Through increased media presence, the poor of today know the rich of today far better (in a general sense) than their counterparts in the past. Many things which one comes across everyday in today’s world reminds a poor person of what all she lacks and can never even aspire to get her hands on in her entire life.

Second source is the anger due to denial of opportunity to poorer people on account of lack of resources, lack of connections/credibility, nexus amongst the established etc. Statistical distribution of gifted individuals in society combined with the fact that the poor people are far more in number than rich would mean that quite naturally; in any given field the “masses” are likely to beget more gifted individuals than the elite. However, several structural barriers usually lead to lack of development of these gifted individuals. In obvious cases of such denial due to inability to go to the right school, inability to get funding, inability to play a certain sport, the poor will eventually develop a strong hatred of establishment which denies them an opportunity. While various mechanisms exist to correct these distortions, the most obvious natural course of capitalist economy will anyway work with such denials as an unavoidable evil.

Third is the possibility of making it big by subverting the legally acceptable system. This is in some ways a fall out of the first two. However, the circle becomes self sustaining only if there are more than enough poor people willing to try subversive paths and are also working in an environment which is not too strict about it. The fear of punishment typically keeps people from subverting the system. The assumption there is that a rational individual will consider the chances of getting caught, degree of punishment and the opportunity cost in terms of what she gives up. For a middle class individual, not subverting may seem the obvious path since the opportunity cost is high. At an appropriately low level of income however, the balance tilts in favor of subversion. Add to that two reinforcing factors. One is the network effect of having more of one’s relatives/acquaintances involved in such activities and the other is formation of organized syndicates which will reduce the degree of punishment even if caught.

These are the forces of disruption. No doubt they will be there all the time and there mere presence is not enough for causing a disruption. Whether they result in an actual disruption is dependent on the rate at which the unrest is growing vis-à-vis the rate at which the restoration of balance of returns on capital and labor is growing. These two in turn are not unrelated. A decrease in inequality of income leads to reduction in the strength of the forces of unrest. However there seems to be a factor in the nature of these forces simply dependent on time. It is quite difficult to explain the same. It really signifies the collective patience of the poor in some ways. A patient poor class may feel fine with the much smaller fruits of development reaching to it and may wait for a tiny increase in the same year after year. Over time, this patience can get stretched. When one views even the poor class as a dynamic system involving the proponents of status quo citing from the expectations of grand future and the opponents of status quo who refuse to believe any claims of poor coming into mainstream, we can get an idea of how the “patience” is really a matter of who is the dominant of the two.

Having thus described the forces of disruption let me come to the scenario in which these forces overpower the path of restoration of income equality. In this case, the poor start out with subverting the system in more and more organized manner. They do not remain poor any longer but they are not rich like rich within the system. They promote many more like them and reduce both the probability of getting caught and degree of punishment. They eventually establish a control over the system which makes them the obvious choice for the remaining poor. Thus is established a parallel economy which is intimately linked to the mainstream but at the same time not answerable to anything in the mainstream. Over time, it can only grow in power. The only thing that can check its growth over and above the mainstream economy is the fundamental restriction on where economic value comes from. This parallel system in a way is a derivative of the mainstream and hence is eventually limited by very size of mainstream. Nonetheless, in spirit, the equalization of incomes begins at a much faster rate than earlier in this case as well. However, the finesse of the equilibrium of the earlier case is missing. This scenario is of two competing modes of thought and action. It is characterized by constant flair up between the two fractions. Everyone lives in a state of fear from the opposite camp. The society gives more and more importance to physical/monetory power and such subtleties as arts and sciences (in areas other than weaponry) are ignored over time. Economic growth is stifled because the labor supply abruptly goes down and a derivative parallel economy based largely on extortions and loot saps most of the savings of the mainstream. The society becomes largely consumerist. The parallel economy spends because it has no legal means to invest fruitfully. The mainstream spends because it has no surety of tomorrow’s existence. Investments dwindle as well. Since the population has not really come down significantly, this leads to overall reduction of income in medium term. So although the standard deviation of income distribution goes down, the mean goes down as well.

Which of the two will unfold? Although life does not need to be so dramatic and can eventually lead to a more mediocre looking middle path instead of either of these, I somehow feel only an extreme is likely owing to the complexity of the society we are.

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