In many respects, the sun is awful. It can blind, cause cancer, burn skin, dry up lifesaving ponds, scorch the Earth, and inflict much other harm. As true as those horrible facts are, however, we would not fare well if the sun went away.
Similarly in many respects, income inequality is awful, but we would not fare well if it went away. An idea has set in across America that income inequality is one of our most pressing problems. Because the real and imaginary ills spawned by income inequality are so incessantly chronicled,* they need not be belabored here. Conversely, what is so essential and positive about income inequality is rarely discussed. So let’s sort out why income inequality is more than it’s cracked up to be.
While the point need not be belabored, before we delve into what is good about income inequality, it should be noted that there are certain causes of income inequality that are irredeemably bad. For example, income inequality can be the result of theft, of the government (or society) bailing someone out of an irresponsible risk, or enticing politicians to use public resources to grant special business favors. Income inequality as a result of those actions is unalloyed evil. This should not, however, be confused with the bogus Marxian notion that capitalists steal the labor of workers (the extent to which this exists is insignificant) or that there is something evil about making a profit.
As discussed in my blog on Wealth, wealth is not the be-all and end-all of human flourishing. On the other hand, compared to the number of problems that can be alleviated with money, the number of problems that cannot be alleviated with money is relatively small. Consequently, wealth enables human lives to be less “solitary, poor, nasty, brutish, and short” than would otherwise be the case. Consequently, social norms and policies that facilitate and motivate humans to create wealth are beneficial to human flourishing.
As with all human activities, there are dark sides to the creation of wealth. The news is constantly replete with examples of this, and although many are imagined, a fair number are real. What is not consistently chronicled is the inherent goodness of wealth creation. When a human creates something at a cost of $X that other humans value at $X + $Y, she has created wealth. When I say “value at $X + $Y,” I mean that there are other humans who would be better off if they traded $X + $Y for the creation rather than if they kept $X + $Y in their pockets. When parties trade things that they value less for things that they value more, they are better off, i.e., wealthier. Humans’ ability to engage in activities that serve others’ wants and needs while also helping themselves is a wonder of nature and wonderful. Trade is fundamentally good. The more trade there is, the more good there will be in the world. In order to trade, however, people must use their backs or brains or both to produce something to trade.
Of course, the prospect of income or gain is not the only factor that motivates people to produce and/or invest. On the other hand, the prospect of acquiring significantly more wealth is a primary motivation of many (if not the vast majority) of the activities that cause wealth to be produced. Lastly, wealth is what funds the innovation, development, production, and delivery of goods and services that are more efficient, useful, and/or fun than the pre-existing goods and services. In short, the creation of wealth is a primary driver of human advancement and flourishing.
The simple but apparently not obvious truth is that income inequality is the engine of wealth creation (prosperity). In fact, the greater the income inequality, the higher the engine’s horsepower, i.e., the more rapidly prosperity accelerates. (The extreme importance of the pace of wealth creation is also discussed in my blog on Wealth. In a nutshell, improvements in standard of living increase exponentially as the pace of wealth creation increases linearly.**)
So why is income inequality the engine of prosperity? The primary reason that people get out of bed, go to work, and push themselves to be creative and productive is that doing so will greatly improve their chances of having better lives. In general, the higher a person’s motivation to work, the more she will produce. In a free market, the more that people produce, the better off they will be. For the most part, furthermore, the greater the actual and potential rewards from working, the greater people’s motivation to work is.*** Such rewards include the pay earned for the work currently being done by the employee and the prospects of getting a promotion to a higher-paying job. The higher the jump in pay from one job to the next, the greater a person’s motivation is to work hard enough to earn the promotion.
People earning more pay when they work harder has serendipitous effects on the prices of what’s available in the market. The more that people produce (that is, increase the supply of things that other people want), the more downward pressure and ability to lower prices there will be. As the prices of goods and services go down, a greater number of people will have money left over after they have bought what they usually buy. In other words, people become wealthier by virtue of falling prices. The more excess cash that people have, furthermore, the more they can afford (create a demand for) products that they previously could not afford. This additional demand provides a reason for new businesses to be started and for existing businesses to expand—which creates more jobs (i.e., opportunities for people to be more productive).
The creation of more jobs has serendipitous effects on wages as well. As discussed in my blog post “Investment Income and Universal Basic Income Are Not ‘Basically The Same,’” a primary reason that the wages of middle- and low-income people have been stagnant for so long is because there has been a glut in the supply of low- and middle-income people wanting to work and a dearth of low- and middle-income jobs to absorb that excess supply.**** (Supply in excess of demand pushes prices down.) The prices for labor (wages) go up as the ratio of qualified workers per job decreases. With robust wealth creation, businesses will be started and expanded to absorb the excess supply of middle- and low-income workers. This is because having fewer qualified workers in the queue looking for jobs forces employers to compete to hire the scarce workers.
To sum up, the more that people produce things that are valued by their fellow humans, the more wealth and jobs will be created. As more wealth is created, more money becomes available to invest in new businesses to better serve humans’ needs and desires. The more new businesses there are, the more jobs will be created. The more jobs are created, the higher the average income will be.
As you can see, wealth creation enables a virtuous cycle. The motivation to work harder increases individual productivity, which creates more wealth for companies and enables the creation and expansion of businesses, which both lowers prices by creating a demand for more goods and services (by freeing up the extra cash of existing workers) and creates more jobs, which enables more people to work and creates more wealth. Repeat.
The preceding paragraphs discussed wealth generation from an economy-wide (“macro”) perspective. Let’s now turn our focus on wealth creation from an individual company (“micro”) perspective. It is here that the “horsepower” of the prosperity engine can be most clearly seen.
In general, companies must motivate their employees to work hard to create and produce. If a company’s competitors are better at motivating their employees, then the less productive company will have higher production costs and will lose business to its competitors. A primary means of motivating employees is monetary compensation. For monetary compensation to be an effective motivator, however, there must be a significant difference in compensation between one job and the next throughout an enterprise’s hierarchy.***** If there is no difference in reward no matter how much value an employee produces, the likelihood of employees exerting themselves on the job will be lower. On the other hand, the extra work that people will put in to reach the next pay level increases as the extra income at the next pay level increases; for example, a person making $7.25/hour will work harder if doing so provides a reasonable opportunity to earn an extra $2 per hour rather than just an extra $1 per hour. In these instances, greater income inequality between one job and the next higher job will clearly cause employees to work harder than in the case of less income inequality. For the same reasons, someone making $750K per year will be more likely to be more productive if she has a reasonable shot at an additional $200K/year than if the next level is just an extra $100K/year. The same is true at even higher incomes. Additionally, the greater the likely return on an investment, the more probable it is that people will invest in it. The more likely it is that a big reward will be denied to investors via taxes, regulation, confiscations, investigations, or lawsuits, the less likely it is that there will be a big enough potential reward to warrant investing. In short, the greater the gap between the rewards for producing more than the next gal, the more likely it is that everyone will produce more.
It should also be noted that the vast majority of people give away a relatively small amount of wealth in order to serve their fellow humans. It may be a higher percentage of their income than some wealthy people give, but the per person amount of money donated to serve public purposes is insignificant compared to the amounts of money that wealthy people donate for those purposes (e.g., Bill and Melinda Gates alone have already donated more than $27 billion and have pledged to give away much more for “agricultural development, emergency relief, urban poverty, global health, and education”). The only reason that they can give away so much is because they created so much wealth (in addition to all of the wealth that Bill Gates bestowed on millions of people as they purchased Microsoft products at prices less than what those products were worth to them and the wealth stolen from Microsoft through piracy). By the same token, unlike wealthy people, most people do not create ideas and run companies that create life-enriching jobs (financially and in other ways) for millions of employees or produce tools that make people more productive (i.e., more valuable) in their jobs.
In conclusion, income inequality creates some social ills, but it is a key component of wealth creation. Honest wealth creation is a good thing for everyone, and income inequality is the engine of prosperity. The greater the income inequality, the higher the horsepower that the engine of prosperity will have.
None of this is to say that people only work for money or that money is the perfect motivator. On the contrary, the rewards from being productive come in many forms. Such rewards also add horsepower to the prosperity machine. Consequently, the effects of promoting or suppressing those other factors must also be considered. That topic, however, must wait for another blog.
(I also recommend the discussion of income inequality in THIS SHORT VIDEO.)
* For example: “Income Inequality: Too Big to Ignore” by Robert H. Frank. This is full of misguided nostrums that I might explore in a future blog. Most of Frank’s errors are captured by this sentence: “There is no persuasive evidence that greater inequality bolsters economic growth or enhances anyone’s well-being.” There is plenty of persuasive evidence to those who do not have blinders to it. More importantly, however, immediately after making the second claim, Frank equates “well-being” with happiness. Frank falsely presumes that the goal of policy is to make individuals happy. The goal of policy should be the improvement of the well-being of “everyone,” not “anyone.” For a different and more extended critique of Frank’s position, see or listen to THIS.
** Society’s willingness to accept income inequality alone will not result in wealth creation. Rapid wealth creation cannot occur in the absence of certain preconditions, such as the rule of law, a reasonable amount of safety, property rights, sufficient mutual trust among trading partners, and virtuous citizens. (Deirdre McCloskey’s work in this area is extensive and very compelling. Also, see THIS JOHAN NORBERG VIDEO.)
*** Of course, there are many other motivations that cause people to create and produce. Despite that, the claim that people are motivated to work at greater levels in relation to the increase of potential rewards is valid.
**** The reason that the pay for highly skilled people has risen relative to the pay for low- and middle-income workers is because investment money has been available to start highly promising companies. Every company needs highly skilled top executives, but not every company needs a large number of low-skilled workers. Technology can more readily substitute for low- and middle-income people than for the multiple and complex tasks that top executives must perform. In other words, top executives only have to compete against other people, not robots, and there are relatively few people with the skills to perform those jobs well. As new companies are formed, the ratio of qualified top executives to the number of top jobs has fallen—creating a continuing scarcity of employees to fill those jobs. Therefore, the value of top executive services keeps getting bid upward.
***** There is an upper limit, however, to how much can be paid for a particular job. Rarely (if ever) would it make economic sense for a company to pay any employee more than the value to the company of said employee’s work.
For an example of what happens to the motivation to create for people at the top end of the incomes, see Stevie Nicks’s comments on the lack of sufficient profit opportunity for successful people who have proven their creativity and abilities. See also Mick Fleetwood on the same subject.