I've been studying inequality for more than 30 years, and for most of that time it's been an issue well out of the limelight. And so I've been delighted to see it enter the political conversation in a big way recently.
But something major is missing from that conversation, which centers on questions of fairness. Fairness clearly matters, but focusing on it presupposes a zero-sum competition between different classes. That's consistent with the conventional view that inequality is good for the rich and bad for the poor, and so the rich should favor it while the poor should oppose it. But the conventional view is wrong.
High levels of inequality are bad for the rich, too, and not just because inequality offends norms of fairness. As I'll explain, inequality is also extremely wasteful.
It's easy to demonstrate that growing income disparities have made life more difficult not just for the poor, but also for the economy's ostensible winners — the very wealthy. The good news is that a simple change in tax policy could free up literally trillions of dollars a year without requiring painful sacrifices from anyone. If that claim strikes you as far-fetched, you'll be surprised to see that it rests on only five simple premises.
1) Frames of reference matter. A lot.
Which of the two vertical lines below is longer?
If you suspect a trick, you may say they're the same, and indeed they are. But if you really think they LOOK the same, you should schedule a neurological checkup. To the normal human brain, the line on the right looks longer, simply because of where it sits.
Economists have been slow to recognize that similar framing effects shape our evaluations of almost every good we buy. Long ago, as a Peace Corps Volunteer in Nepal, I lived in a two-room house with no electricity or plumbing. If I lived in that house in the United States, my children would have been ashamed for their friends to see where we lived. Yet in Nepal it was completely fine; I never hesitated to invite friends over.
If my Nepalese friends could see my house in Ithaca, New York, they'd think I'd taken leave of my senses. They'd wonder why anyone would need such a grand house. Why so many bathrooms? But most Americans don't think that. These aren't bizarre judgments. They follow naturally from the fact that our evaluations depend so heavily on what's nearby. An immediate consequence of these framing effects is that...
2) Each person's spending depends in part on what others spend
Standard economic models assume that each person's spending is completely independent of what others spend.
But if framing effects matter, that can't be right.
People spend more when their friends and neighbors spend more. This isn't some fantastic new discovery made by a young economist. It's a dynamic we've known about basically forever. Many have called it "keeping up with the Joneses." But I've never liked that expression, because it summons images of insecure people trying to appear wealthier than they are. Peer influences would in fact be just as strong in a world completely free of jealousy and envy. And rising inequality has made those influences much stronger.
The median new house in the US is now 50 percent larger than it was in 1980, even though the median income has grown only slightly in real terms. Houses are growing faster than incomes because of a process I call "expenditure cascades."
Here's how it works. People at the top begin building bigger houses simply because they have more money. Perhaps it's now the custom for them to have their daughters' wedding receptions at home, so a ballroom is now part of what defines adequate living space. Those houses shift the frame of reference for the near-wealthy — who travel in the same social circles — so they, too, build bigger.
But as the near-wealthy begin adding granite countertops and vaulted ceilings, they shift the frames of reference that define adequate for upper-middle class families. And so they begin going into debt to keep pace. And so it goes, all the way down the income ladder. More spending by the people who can afford it at the top ultimately creates pressure for more spending by people who can't afford it at the bottom.
The best response might seem to be simply to exhort people to summon more discipline, except for the fact that...
3) The costs of failure to keep pace with community spending norms are not just hurt feelings
The process I describe isn't a law. Congress isn't mandating that people buy bigger houses. So if it's optional, why don't people simply opt out? Because opting out entails real costs that are extremely hard to avoid.
Failure to keep pace with what peers spend on housing means not just living in a house that seems uncomfortably small. It also means having to send your children to inferior schools. A "good" school is a relative concept, and the better schools are almost always those in more expensive neighborhoods.
Here's the toil index, a simple measure I constructed to track one important cost of inequality for middle-income families. To send their children to a school of at least average quality, median earners must buy the median-priced home in their area. The toil index plots the monthly number of hours the median earner must work to achieve that goal. When incomes were growing at the same rate for everyone during the post-World War II decades, the toil index was almost completely stable. But income inequality began rising sharply after 1970, and since then the toil index has been rising in tandem. It's now approximately 100 hours a month, up from only 42 hours in 1970.
The toil index
The median real hourly wage for men in the US is actually lower now than in the 1980s. If middle-income families must now spend more than before to achieve basic goals, how do they manage? Census data reveal clear symptoms of increasing financial distress among these families. Of the 100 largest US counties, those where income inequality grew most rapidly were also those that experienced the largest increases in three important symptoms of financial distress: divorce rates, long commutes, and bankruptcy filings.
In OECD countries, higher inequality is associated with longer work hours, both across countries and over time. Standard economic models predict none of these relationships.
Expenditure cascades have also occurred in other areas, such as celebrations to mark special occasions. Like a good school, a "special" celebration is a relative concept. To seem special, it must stand out from what people expect. But when everyone spends more, the effect is merely to raise the bar that defines special. The average American wedding now costs $30,000, roughly twice as much as in 1990. No one believes that couples who marry today are happier because weddings cost so much more than they used to.
The multi-million-dollar coming-of-age parties staged by the wealthiest families have similarly raised the standards that govern spending on such events by families further down the income ladder. Many middle-income children are now disappointed when birthday parties fail to feature a professional clown or magician.
Concerns about relative income are a hard fact of human nature. No biologist is surprised that positional concerns loom so large in human psychology, since relative position was always by far the best predictor of reproductive success. People who didn't care how well they were doing in relative terms would have been ill-equipped for the competitive environments in which we evolved. That's why no thoughtful parents would want their children to be stripped of positional concerns completely.
But even though positional concerns are an essential component of human psychology, not all of their consequences are benign. That's because...
4) Positional concerns spawn wasteful spending patterns, even when everyone is well-informed and rational
Charles Darwin, the great British naturalist, was heavily influenced by Adam Smith and other economists. He saw that competition in nature, like competition in the marketplace, often produced benefits for both individuals and larger groups, just as in Smith's fabled Invisible Hand theory. Keen eyesight in hawks, for example, made both individual hawks and hawks as a species more successful. Yet Darwin also saw clearly that many traits and behaviors helped individuals at the expense of larger groups. When success depends on relative position, as it almost always does in competitive struggles, wasteful positional arms races often result.
Consider the antlers in modern bull elk, which span four feet and weigh as much as 40 pounds. Because they impair mobility in wooded areas, bulls are more easily surrounded and killed by wolves. So why doesn't natural selection favor smaller antlers? Darwin's answer was that large antlers evolved because elk are a polygynous species, meaning that males take more than one mate if they can. But if some take multiple mates, others are left with none. That's why males fight so bitterly with one another for access to females. Mutations that coded for larger antlers spread quickly because they made any bull that had them more likely to win.
But bulls as a group would be better off if each animal's antlers were smaller by half, since they'd be less vulnerable to predators, and each fight would be decided as before. The inefficiency in such positional arms races is exactly analogous to the inefficiency of military arms races. It's also like when everyone stands to get a better view: no one sees any better than if all had remained comfortably seated.
Beyond some point, additional spending on mansions, coming-of-age parties, and many other goods becomes purely positional, meaning that it merely raises the bar that defines adequate. Because much of the total spending in today's economy is purely positional, it is wasteful in the same way that military arms races are wasteful.
These observations are not new. In a 1993 book, the Dutch economist Ruut Veenhoven observed that average happiness levels in Japan were essentially static during the three decades following 1960, even though real per-capita income rose more than three-fold during that period. His explanation was that happiness depends more on relative than absolute income, and when everyone's income rises in tandem, relative incomes are unaffected.
We see a completely different pattern when we plot happiness against income at a given point in time. As the psychologist Edward Diener and his co-authors interpreted this scatter plot based on early 1980s US data, for example, people with higher incomes are happier on the average precisely because they feel relatively well off.
Although positional concerns spawn trillions of dollars of unproductive spending each year, the good news is that...
5) A simple change in the tax system would eliminate many wasteful spending patterns
Elk lack the cognitive and communication skills to do anything about their particular positional arms race. But humans can and do enact positional arms control agreements. We spend too much on houses and parties because as individuals we have no incentive to take account of how our spending affects others. The tax system offers a simple, unintrusive way to change our incentives. We could abandon the current progressive income tax in favor of a much more steeply progressive consumption tax.
Here's how it would work: people would report their incomes as they do now, and also their annual savings, as many now do for tax-exempt retirement accounts. Their income minus their savings is their annual consumption, and that amount less a large standard deduction would be their taxable consumption. For instance, a family that earned $100,000 and saved $50,000 in a tax year would have annual consumption of $50,000. If the standard deduction was $30,000, the family's taxable consumption would be $20,000.
The tax rate would start out low and would then rise steadily as taxable consumption rises. Under the current income tax, rates can't rise too high without choking off savings and investment. But higher marginal tax rates on consumption actually encourage savings and investment.
Many wealthy think higher taxes would make them less able to get what they want. But what happens when everyone spends less is very different from what happens when an individual spends less. In a society with a progressive consumption tax, the wealthiest drivers might buy a Porsche 911 Turbo for $150,000 rather than a Ferrari F 12 Berlinetta for more than twice that amount. But since everyone would be scaling back, that society's Porsche owners would be just as excited about their cars as Ferrari owners are under the current tax system.
There's another important dimension to the argument: a progressive consumption tax would generate additional revenue that could help pay for better roads. Under the current tax structure, the rich can afford their Ferraris but must drive them on poorly maintained roads. Can anyone doubt that the experience of a Ferrari driver on roads riddled with potholes would be less satisfying than that of a Porsche driver on well maintained roads?
My basic claim, in short, is that a simple change in our tax structure would enable us to put trillions of dollars a year to better uses without requiring painful sacrifices from anyone. On its face, this claim will strike most people as as implausible. Yet my argument in favor of it has few moving parts, and none of the premises on which it rests is controversial in the least. Everyone agrees that most income gains have been going to top earners, which has led them to build bigger houses. No one disputes that, beyond some point, across-the-board increases in mansion size don't make the rich any happier. Nor does anyone dispute that larger houses at the top have shifted the frame of reference that shapes the demands of those just below them, and so on, all the way down the income ladder.
Nor is there any dispute that the resulting financial squeeze on middle-income families has not only made it more difficult for those families to pay their bills, it has also made it more difficult for governments to raise revenue. And that, in turn, has led to a decline in the quality of infrastructure and public services. So despite their higher incomes, the rich are now worse off on balance. Their higher spending on cars and houses has simply raised the bar that defines adequate in those categories, while the corresponding decline in the quality of public goods has had significant negative impact.
The encouraging news is that the profoundly wasteful spending patterns caused by rising income inequality could easily be changed. But that's unlikely to happen until our political conversation begins to focus on inequality's practical consequences.