As a follow-on to my review of two economics books on inequality, I'd like to spend some time analysing the problem in more depth. It is an incredibly complex problem, and it's very easy to forget the big picture and get lost in minute details. As a programmer, I deal with complex problems all the time, trying to find the best solution in a field of non-optimal trade-offs. Sometimes it feels like trying to find the least-worst solution, and that seems to be the case with inequality as well. Every potential solution has its own set of issues, and even defining the problem is difficult and open to endless debate. Regardless of the difficulties involved, let's see what the problem space looks like.

Defining Inequality

Inequality means many different things to different people. In this context we'll deal primarily with financial or economic inequality, so that narrows the idea somewhat—but not much. Bill Gardner over at The Incidental Economist has a great deconstruction of the different ways of thinking about equality, so we'll use his framework of answering three questions to define equality.

Equality among whom? Throughout America's history the idea of equality has expanded to encompass more and more people. Equality first applied only to white male landowners. With much blood, sweat, and tears it has grown to include women, all races, and the poor and middle class, at least on paper. (Racial inequality is still a huge problem in the U.S., and it's closely intertwined with economic inequality.) Immigrants are still excluded in many ways, and global equality is not in the forefront of most people's minds.

It's reasonable to expect that most people would think first about their own country. Not that it's right in a moral sense, but it's hard to believe that most people will find the energy or good will to care about the world's poverty while inequality is growing so much in the U.S., with more people struggling to make ends meet. In some ways we need to put our own house in order before we can expect our citizens to look outward. However, we should still pursue international aide whenever we can, if for no other reason than it is also in our own best interests.

Equality of what? Should we strive for equality of outcomes, opportunity, or well-being? There may be other dimensions, but these are the big three. Trying to create equality of well-being has the problem of who decides what constitutes well-being. Different people have different ideas about how they want to live, and who is to say what's right? There is also the problem of free-loaders. Not everyone wants to work, so how do we encourage everyone to be productive members of society?

Equality of outcomes and opportunity are hard to separate because the economic outcomes of parents heavily influences the economic opportunities available to their children. We may be able to come up with programs to improve opportunities for children—subsidized or even free post-secondary education, better public secondary and elementary education, school lunch programs, free preschool and day care, prenatal care, etc.—but it's hard to know where to start and where to stop. In reality, outcomes and opportunity cannot be separated, and programs to improve one will necessarily impact the other.

Why do we want equality? Is it equality for its own sake, is it to give everyone the wherewithal to survive, or is it because everyone deserves a basic level of respect as a human being? Mark Thoma gives an excellent reason why we should all want equality:
...people who, because of their incomes, cannot participate fully in society are poor. A child getting enough to eat, and with clothes to wear, who cannot afford the toys needed to be part of the group of kids in the neighborhood is socially isolated and socially disadvantaged (we don't want to play at your house because you don't have a TV, you can't come with us because you don't have a bike, you didn't get my text message about baseball practice being moved?, etc., etc., etc.). Giving people, children in particular, what they need to participate in the society around them is an important element of how successful they will be in the future. It helps to determine their ability to give back to society as fully participating adults. ...
Having more successful, participating adults would benefit all of us. In addition to requiring less support from everyone else, they could contribute more to the productivity and advancement of our society.

In the end, we could want equality because of our own self-interest. Having a more equal society increases everyone's safety and improves everyone's opportunity. We would all have a better chance of being a successful entrepreneur or productive employee, not just because everyone would be better educated and healthier, but because more people would have the means to afford more products and services. One of the reasons Henry Ford paid his assembly line workers good wages was so that they could afford to buy his cars. We should remember that powerful idea.

What causes inequality?

The basic opposing views on what causes inequality are that it is because of structural issues or individual decisions. Structural causes would be things like technology displacing workers, globalization moving jobs overseas, differences between regions of the country, or variations in the quality of education. I have a hard time believing that technology is having any more of an effect on inequality than it ever has in the past. The technologies being created today may be new, but the fear that technology will leave a vast swath of the population unemployed has followed every major technological advancement. In every case we found that there was more work to fill the gaps, and at the same time, we were able to enjoy more leisure. This time is probably no different. We just don't know what future work will look like, yet.

As for the other structural causes, globalization does effect some jobs, like manufacturing, but not others, like retail and most services. Over time the living standards of foreign workers will increase to the point where their wages and the increased costs of shipping, logistics, and management will increase the incentives for domestic manufacturing. On the other hand, regional and educational inequality pose real, persistent issues that should be addressed.

Individual causes of inequality are generally thought to result from poor decision making, laziness, or some combination of the two. This kind of reasoning smacks of a blame-the-victim mentality, but it is a fairly commonly held view, especially by certain out-spoken politicians.

Chris Dillow has an interesting analysis of structural vs. individual poverty, and he discusses why it is hard to separate them, much like equality of outcomes vs. opportunity. His comments stem from a debate between Matt Bruenig and Noah Smith on the same topic, and Smith has a great post with a number of thought experiments dealing with structural and individual inequality. In particular, he theorizes about what it would mean if everyone stopped working:
Suppose everyone, acting independently and on their own, just stopped doing any sort of work. The entire world would instantly fall into poverty. But would that poverty be "structural" or "individual"? Note that if you're the one person who wants to work in a society of people who do no work at all, you're not going to be very productive, because you can't specialize. So in the case where no one works, no individual's behavior can hoist him or her out of poverty. So that's "structural", right? But if you simultaneously persuaded a large fraction of people to work, then large numbers of people would climb out of poverty. So is the poverty "individual"?
He makes a strong case for both structural and individual causes of poverty playing a role simultaneously, and he also brings up another major cause—randomness. It is certainly the case that some people are poor for no other reason than a run of bad luck. It's not their fault. It's not society's fault. Sometimes bad things happen, and that's a completely legitimate factor that needs to be taken into account.

Another way to think about Smith's 100% unemployment thought experiment has to do with the economic theory of the marginal product of labor (MPL). MPL is the incremental output that one additional employee produces, and the theory suggests that each employee should be paid according to their marginal product. This idea is usually used to justify paying CEOs of large corporations exorbitant salaries and reducing labor costs for unskilled workers as much as possible. But suppose that "everyone" in Smith's thought experiment is everyone at a particular company, and the one person that tries to work is the CEO. In that case the CEO isn't going to be very productive on his (or her) own, and in fact his productivity in the company is partly (mostly?) a result of the rest of the company's employees. If that is true, then why is the pay difference between the CEO and the lowest paid employee so extreme? This argument may be good justification for more balanced wage structures in large corporations and a reduction in rent-seeking behaviour on the part of the CEO.

Rent-seeking is a major source of inequality in many ways. Companies building monopolies or oligopolies is a form of rent-seeking. Patent war chests and litigation are a form of rent-seeking. Aggressive lending using sub-prime mortgages, excessive student loans, or high-rate credit cards are all forms of rent-seeking. In every case, the person or company benefiting from the arrangement is making more profit than they could have in a purely free market, and so they are getting more than their marginal product as compensation. The people on the wrong end of these deals end up poorer as a result, and inequality grows.

How can we reduce inequality?

First, it should be noted that reducing inequality doesn't mean creating a society with perfect equality. We already know such a scheme can't work because there are no incentives to work hard, to innovate, or to take risks—all necessary components of a working economy. We are no where near that extreme on the equality/inequality scale, though. We can certainly make substantial progress towards more economic equality without endangering America's entrepreneurial spirit. Reducing inequality will most likely improve incentives, giving more people the opportunity to take a risk and pursue their dreams.

How do we reduce inequality? One of the first ideas that normally comes to mind is to make changes to the tax system. This discussion on Hacker News, for example, spends a lot of time debating the pros and cons of different taxation ideas. Things like the EITC and the minimum wage currently do a lot to keep families above the poverty line, but there is a problem at the income threshold where these benefits disappear. There is a disincentive to make more than the threshold because the lack of benefits is equivalent to a very high marginal tax rate, and households that are barely over the threshold may actually bring home less income than they did before.

Other ideas like a negative income tax or a basic income for everyone are appealing because they do not have a threshold where a high marginal rate kicks in. These policies improve incentives to work harder and to move up the income scale. The disadvantage is that we would need to decide how to pay for such a policy, especially for a basic income, and people that don't need it are generally opposed to paying for it.

On the other end of the income scale, there is the question of out-sized tax benefits to the wealthy. The share of entitlement benefits is fairly well distributed between the bottom, middle, and top income households, with about 10 percentage points more going to the bottom and 10 percentage points less going to the top, as shown in the following figure:

On the other hand, the share of tax expenditures is grossly skewed towards the top income households, creating a massive tax benefit for the group of people that probably need it the least:

Most of the difference in the share of tax expenditures comes from the mortgage interest, state, local, property, real estate, and charitable contribution tax deductions and the fact that capital gains and dividends are taxed at a lower rate than earned income. Hedge fund managers especially benefit from the lower capital gains rate because they can claim most of their income as capital gains through the carried interest loophole. Finding ways to equalize the distribution of tax expenditures would go a long way towards reducing inequality.

Other effective solutions tend to fall under one of two categories. They either improve security or opportunity. Things that improve people's economic security include better health care and health insurance so that we have a healthier work force and getting sick isn't catastrophic, unemployment insurance or work sharing programs to protect workers in recessions, and retirement insurance so people are not destitute in their old age. Basically, any type of insurance that is widely available and spreads life's risks over the whole of society will help people deal with the rough spots in life. We have some form of each of these types of insurance today, but there is certainly room for improvement.

The opportunity category includes a wide range of things that give people the skills and resources to succeed, if they have the motivation and put in the effort. Quality, affordable education for everyone from elementary school through a college degree or vocational program would greatly improve people's opportunity to succeed. Getting money and special interests out of politics, and setting term limits on members of Congress would tilt the balance of power away from the extremely wealthy and back towards everyone else so government programs and policies would benefit citizens more broadly instead of serving narrow interests and private corporations. Full employment would increase workers' bargaining power and improve competition in the labor force so wages would become more fair and at least some forms of rent-seeking would be more difficult.

These solutions are certainly broad and general, and the details of implementing programs and policy changes that would bring about the reduction of inequality get complicated very quickly. The intent here is to show what the landscape looks like and what paths are likely to get us to a more equal society. There is no one outstanding cause of inequality. It results from a combination of structural problems, individual decisions, and random chance. Likewise, the solutions to the problem of inequality are widely varied. We need to address the distribution of income and taxes, the security of individuals when crisis strikes, and the opportunities available to everyone to achieve a better life. We are at a point in our history where inequality is becoming so extreme that it is damaging our ability to function and dragging all of us down. Turning that trend around and improving equality would go a long way to restoring trust in our institutions and each other.

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