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How to Decrease Income Inequality

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[Originally published November 2013]

The Globe and Mail has been up in arms over the growing wealth divide in Canada. Or at least the perception of a growing wealth divide. As part of its Wealth Paradox series, this weekend’s edition looked at some policies aimed at reducing income inequality in the country.

Before assessing whether these measures will indeed reduce income inequality—and thus preserve what the Globe claims to be that “cherished” Canadian value of “equality of opportunity for all”—we should look at whether or to what extent income inequality is rising.

One way to measure income inequality is through the Gini index. This index looks at the statistical dispersion of incomes. Thus, a value of one indicates a maximal inequality of incomes, as would be case if one Canadian earned all of the country’s salaries. A value of zero indicates no inequality, and can be thought of as everyone earning the exact same amount. Stephen Gordon at Worthwhile Canadian Initiative posted this graph awhile back:

Two facts stand out. First is that most of Canada’s rising inequality occurred prior to 1995, and has been relatively constant since. (Even declining a little.) Second is that the trend in Canada seems to parallel other countries, such as the UK and Sweden. Notably all three countries and especially the latter have well-developed welfare states aiming to equalize the playing field through wealth and income redistributions.

This graph will cause unease amongst some, as there is a clear perception that income inequality is growing and that someone is getting a leg up on the rest of us. Partly this perception is because generally rising prices are impoverishing almost all of us, and partly it is a statistical anomaly. Some are getting wealthier at the expense of the rest of Canadians, but the group is so small so as to have little effect on the broader measure of income dispersal.

Writing for the GlobeJames Mirtle laments that the price of hockey is steadily rising and the national pastime now risks becoming an option for only the upper class. Yet what Mirtle overlooks, and which many comments to the article point out, is that hockey was always an expensive sport.

The fact that it is more expensive now than it was in the past can be explained in three ways.

First, decades of steady inflation at the hands of the Bank of Canada have driven down the value of the loonie. As a result we have to pay more for all goods and services that we buy – hockey included. Second is that with some rising wealth in certain areas we see a change in preferences. The wealth effect sees increased spending on certain leisure activities as incomes increase. The price of vacations and steak have also risen much over the past 25 years, but I don’t read too many articles claiming this as a problem of income inequality in need of a solution. Finally, Canadians are having fewer children and one result is that parents are able to spend more to pamper them. The total fertility rate in Canada today stands at 1.63 children per couple. Contrast this with the 3.81 figure in 1960 and you can see that the average Canadian couple is now able to plough more money into their child’s development. This means they are willing and able to pay higher prices, and we should expect the prices of certain activities – like hockey – to increase as a result.

As part of its series, the Globe hosted a poll over the weekend to determine which policies would best reduce the effects of income inequality in Canada. None of the policies get to the bottom of increasing inequality, and most would have the opposite result.

1. Restore fairness to the tax system. It is true that the current tax system with its complicated set of deductions, exemptions, credits and transfers benefits the wealthy. After all, who is most likely to be able to afford an accountant or tax lawyer to navigate this complex maze? Yet the last fifty years have seen a steady increase in the use of credits, exemptions and deductions to reduce income inequality and yet it still rises. Parents can today claim more deductions and receive more tax credits for their children than ever before. If increasing fairness to the tax system would somehow restore income equality, don’t you think it would have achieved or at least promoted it by now? (As I’ve argued before, there are some criteria you can use to gauge whether a tax is fair—in many cases, the tax itself is the cause of unfairness or undue redistribution and not the solution to it.)

2. Emulate Germany’s approach to skills training. Possibly this would could work, except for the obvious identification problem of which the best skills are and how they should be best promoted. Right now the federal and provincial governments try to promote post-secondary education through subsidized tuition, scholarships and bursaries for students. Yet students are graduating with a skill set that has little relation to those demanded by businesses. How can we trust a new policy aimed at skills training to be successful when prior attempts at similar policies – such as broad education policies—have been so unsuccessful?

3. Boost support for the working poor. Economist Miles Corak explains that giving more money to the working poor by an earnings supplement for low-wage workers would help lower-class people move up the ladder. Two of the most basic principles of economics are that, 1) incentives matter, and 2) look for the unintended consequences of an action. What makes you think that making it easier to be a low-wage earner will reduce income inequality by moving people up the ladder and not by moving higher wage earners down? Indeed, economists commonly cite unemployment insurance and minimum wage laws as examples of policies that promote unemployment or underemployment by levelling the playing field between higher and lower wage earners. Why put in the effort to get ahead if one can be guaranteed nearly the same result with less effort?

4. Enhance early childhood education. See point 2 above. We today have the most formally educated young population in Canada’s history. Children have seen a myriad of options for early childhood education that never existed decades ago. If this was the solution to the problem why has the problem proceeded despite the remarkable advances in these types of policies in the past? Indeed, the same identification problem surfaces as concerns all government policies – how to best determine which skills are needed and useful.

5. Create a new “social contract”. The Globe’s policy strategist Jamison Steeve explains that introducing broader social supports such as guaranteed health care (in addition to that already publicly provided?) and pensions would be a costly through necessary policy to help temporary and part-time workers climb the income ladder. Actually, it would likely have the opposite effect as it has in other countries with similar well-developed schemes in place. As a basic truism, the more expensive you are to fire the more expensive you are to hire. New “social contracts” that supposedly increase job security for those currently deemed insecure typically result in these people losing their jobs. Why should a business be forced to take on the risk of a new employee? In Spain the current rate of unemployment for under-30 year olds is hovering around 50%. Spanish workers have some of the best work contracts in the world, plush with guarantees concerning social security and barriers to getting fired. That might seem great, but only if you have a job. Businesses facing uncertain and high costs to terminate employees are reluctant to hire them in the first place. As a result there are fewer job opportunities for the young and inexperienced.

6. Do nothing, there’s no major problem.

If you’ve read this far you may think that I am most sympathetic to this final suggestion. In fact I am not. Although I have my doubts that growing income inequality is as bad an outcome as many believe I do recognize that there are at least some who are being left behind.

However, those getting ahead of the rest of us are not as large a group as you might be led to believe. Statistically we know that income inequality is not increasing in general or at least not by as much as we are led to believe (see the discussion on the Gini index above, here or here). We perceive the gap to be widening because there is a very small group of Canadians who are getting ahead of the rest of us, even though the vast majority of us are also seeing a better quality of life than we had in the past. Cars, computers and phones are all better than they were even 10 years ago, and people from the lowest income echelons generally do not lack for too many material goods, as may have been the case with generations past.

If something is to be done, however, it is to halt the advantage that a certain group has above all other Canadians. This group I define as the banking establishment. Banks and bankers have a leg up on the rest of us in two ways.

First, they are able to use a funding source to finance their business activities not available to the rest of us. Under a fractional-reserve banking system banks make use of deposits to finance their lending activities. No other business is allowed to use the assets of its clients to earn profit, as is the ubiquitous case of banking. As a result banks can pursue business activities in both type and magnitude that the rest of us cannot. Not only this, but the funding source is almost costless. Consider the rate of interest your bank pays you on your deposit account versus that which is earns on its mortgage lending – the discrepancy is part of the profit spread the bank enjoys by using your deposit to fund its lending activities.

Second, redistribution effects from monetary policy cause winners and losers. When the Bank of Canada increases the money supply the result is rising prices. These prices do not rise evenly or at the same time, but as a wave that spreads out from the source of new money. Those who receive money first spend it and this causes prices to rise. This spending also increases the incomes of those who next receive the money, though they benefit less than the initial users as prices have risen somewhat. As this process continues we can see that the very last person to get the new money will lose as his nominal income increases but prices had already risen to cancel out any wealth effect. Debtors in general win while creditors and those on fixed incomes lose.

In 2012 the Bank of Canada increased the money supply by about $80 billion. That’s around $2,500 per man, woman and child in this country. If you belong to a family of four, I hope you received your $10,000 cheque in the mail.

Of course you did not, nor did you come into contact with any of these newly created dollars (in all likelihood). But you know who did? Each of these dollars had to have been touched by a bank at some point (some of them were probably spent on hockey fees of bankers’ children, pushing up rink rental rates). After all, the banking establishment is the entry point of new money into the Canadian economy. You can almost think of bankers as the Bank of Canada’s henchmen doing its dirty work. (Understandably most bankers probably don’t realize this, and I don’t hold it against them personally.)

One result is that this new money was spent by someone before another. If there is a source of income inequality it is from this simple fact. The use of money is a great equalizing force in our society. It allows us to quickly and effortlessly keep score and see who has served customers the best. But when the Bank of Canada alters the money supply it artificially changes the rules of the game. Businesses no longer earn profits by best serving customers but by being first in line to use this new money before anyone else, and thus take advantage of it before prices start to rise.

If there is one group getting ahead of everyone else right now it is the banking class. Ending the Bank of Canada’s reign over the money supply would do much to reduce the forces breeding the income gap between bankers and the rest of us.

[First published by Mises Canada.]


Contact David Howden

Dr. David Howden is Chair of the Department of Business and Economics, and professor of economics, at Saint Louis University at its Madrid campus. A Fellow of the Mises Institute, he is the author of over 50 scholarly articles and books. His research focuses on the business cycle and fractional-reserve banking.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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