Tanzi: too high income inequality is bad for growth

From the same paper by Vito Tanzi, a chapter on income distribution. Tanzi underlines that "high income inequality can, over the long run, lead to adverse social and economic consequences. See Alesina and Rodrik, 1994, and Persson and Tabellini, 1994, for empirical support of this plausible thesis." And this comes from the former longest serving director of the IMF's Fiscal Department...

Complexity and the Income Distribution
In democratic countries, to retain legitimacy and political support for its outcome, the private market must (a) allocate resources efficiently, to promote economic growth, and (b) distribute income in a manner that is considered legitimate and fair by the majority of the country’s citizens. When the distribution of income becomes very uneven, and a majority of the citizens comes to consider that distribution as unfair, sooner or later populist politicians will appear proposing economic policies that would damage the market economy. The more the distribution of income comes to be considered unfair, the more votes the populist politicians will get from the electorate. Thus, high income inequality can, over the long run, lead to adverse social and economic consequences. See Alesina and Rodrik, 1994, and Persson and Tabellini, 1994, for empirical support of this plausible thesis.
In the past couple decades the income distribution has become much less even in industrial countries, and especially in the United States. Between 1967 and 1980 there was little change in the U.S. income distribution, as measured by the Gini coefficient. That coefficient remained around 0.40, a not particularly good value by industrial countries’ standards, but a stable one. After 1980, it started rising rapidly and reached 0.47 by 2005. At this level it enjoyed the company of mostly Latin American and African countries. By comparison, the most recent data available give a Gini coefficient that is 0.40 for Russia and 0.44 for China. Other industrial countries have Gini coefficients far below that of the United States.
Another indication of the increasing inequality in the United States can be seen from the comparison between the mean and the median income. In 1967 the median income was 89.4 percent of the mean income. By 2005 the percentage had fallen to 73.1 percent, reflecting the increasing concentration of income at the top. Between 1967 and 2005, while the median income, that reflects mainly the income of workers, had grown by 30.7 percent in nominal terms, the mean income had grown by a remarkable 59.8 percent. Workers have hardly experienced any increase in their real wages over this period. Much of the income growth had gone to those at the top. This deterioration has had an impact on the results of surveys that indicate considerable unhappiness, on the part of a majority of those interviewed, about the economy. This has happened in a period of remarkable economic growth that should have made everyone happy. In its annual “Special Report on the 400 Richest Americans,” Forbes Magazine has concluded that these were billionaires in dollars, with a total combined wealth of $1.25 trillion, that is close to the GDP of Italy. In 1982 there had been only 13 billionaires on the list.
The deterioration in the income distribution has been attributed to various factors and especially to the effects of globalization and technological developments. The question to be raised here is whether complexity, interpreted in a broad sense, might not have been one of these factors. It may not be a coincidence that the very high incomes were received by individuals that were either in sectors characterized by complexity (such as those working in the financial market) or that could themselves create complexity to get larger compensations (such as the CEOs of large corporations). See also Forbes’ list.
We have already reported the earnings of some of the managers of hedge funds. Those working in investment banks did not do so badly either. For example the 25,647 employees working for Goldman Sachs received an average compensation of $521,000 in 2005. The five top executives in that enterprise received a combined $143 million. Compensation in 2006 is expected to be even higher. The CEOs of corporations benefited from a different kind of complexity. They could often select the members of the boards of their corporations, that is the individuals who must approve their compensation package. In large corporations the shareholders hardly play a role. Much of the real power rests with the CEOs who are hired to run the corporations. Their compensation contracts are often complex, and their details are generally kept confidential. The use of stock options and bonuses and the ability of managers to date the options at a time that maximizes earnings can lead to enormous compensation packages. These maneuvers have recently attracted the attention of the Federal Bureau of Investigation (FBI).
Huge salaries have been reported even for heads of corporations that do not do particularly well or lose money. A recent article in the New York Times called attention to this problem. As the article put it, “watching mountains of money go to managers who destroyed value in recent years, stockholders have learned that while their shares may sink, executive pay rarely does”. Italics added. Citing a report by Glass Lewis and Company, the article states that: “At… 25 companies… chief executive pay averaged $16.7 million in 2005. The stock of these companies…fell an average 14 percent while [the companies’] overall net income dropped 25 percent, on average.” Furthermore, “…the average chief executives’ pay totaled 6.4 percent of these entities’ total net income”. This is not an example of an economy in which incomes reflect a person’s contribution to total output. .
What can be the consequences of increasing inequality for market economies? An interesting paper by Glaeser et al., 2002, provide a formal answer to this question. The paper argues that (high) income inequality can be damaging, over the long run, to institutions that are necessary for the good functioning of and especially to institutions that secure property rights, institutions that have been shown to be of great significance for growth. Inequality allows the rich to capture and distort these institutions to their advantage. As they put it, inequality “enables the rich to subvert the political, regulatory, and legal institutions of society for their benefit”. “If political and regulatory institutions can be moved by wealth or influence, they will favor the established, not the efficient”. The rich will be able to do so “…through political contributions, bribes, or just deployment of legal and political resources to get their way” p. 2. Lobbying will be an integral and important part of this process. It is easy to see how, in addition to its initial role in increasing income inequality, complexity could greatly facilitate this subversion process. The subversion of institutions will be made easier by the increasing complexity of laws and regulations. This has clearly happened with the tax system and is happening more and more in the regulatory system. Inequality, assisted by complexity, creates an asymmetry between the power of the rich and that of the masses, an asymmetry that can be exploited to the advantage of the rich but that an also damage the market economy over the long run. To some extent the tax system and the legal system are becoming tools of the super rich in the United States.