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On income distribution and growth
Journal of Policy Modeling 29 (2007) 545–548
On income distribution and growth William J. Baumol ∗,1 Department of Economics, New York University, 269 Mercer Street, New York, NY 10003, USA Available online 7 May 2007
Abstract The notion that substantial inequality is a stimulus to growth is extremely questionable. It is noted that a highly impoverished sector of the population reduces the productivity of the labor force. Moreover, the evidence that independent inventors and innovative entrepreneurs as a group receive compensation below those of equally educated employees indicates that disproportionate earnings are a questionable incentive. © 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling. JEL classification: O15 Keywords: Sources of inequality; Poverty and growth; Inequality and growth
1. Introduction It has long been recognized that the rate of economic growth in a society and the degree of equality in the distribution of its income and wealth are not independent. Indeed, it seems plausible that the two are mutually interdependent: growth rate affects distribution and distribution affects growth. The records do suggest at least some degree of interdependence in their striking behavior patterns, such as great inequality in the stagnant economies. In contrast, in the economies that have grown rapidly to a state of wealth and prosperity, the income and wealth disparities are often moderated substantially. But this paper will not focus on analysis of empirical evidence, about which much has been written (although not with unambiguous conclusions, as Campano & Salvatore, 2006, report so clearly in their valuable volume). And, unlike much of the literature, I will deal largely with the
∗
Tel.: +1 212 998 8943; fax: +1 212 995 4211. E-mail address: [email protected]. 1 Harold Price Professor of Entrepreneurship and Academic Director, Berkley Center for Entrepreneurial Studies, Stern School of Business, New York University; and Joseph Douglas Green, 1895, Professor of Economics Emeritus and Senior Economist, Princeton University. 0161-8938/$ – see front matter © 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling. doi:10.1016/j.jpolmod.2007.05.004
546
W.J. Baumol / Journal of Policy Modeling 29 (2007) 545–548
influence of inequality, and of widespread poverty accompanied by extreme wealth of a fortunate few, upon rapidity of economic growth. 2. Poverty and growth There are two obvious sources of the influence of inequality on growth: (1) low productivity of an impoverished labor force (poverty as a physical and mental handicap), and (2) large financial rewards as incentive for vigorous productive effort. Clearly, these influences work in opposite directions. The first asserts that inequality can be a powerful impediment to growth, while the second claims that the prospect of success in attaining the upper strata in a highly unequal community is a vital and perhaps indispensable stimulus to rapid growth because it supposedly is the fuel that fires the exertions of the entrepreneurs. Regarding the first of these influences, there can be little question—there seems to be no reason to doubt that a population will not provide a vigorous labor force if it is beset by malnutrition and a variety of debilitating illnesses for which the funds required for medication and medical attention are lacking. And if there are no resources for even rudimentary education, the use of plant and equipment of any sophistication will obviously be precluded. Moreover, in such societies, even moderately advanced capital stock does not long endure because means (or incentives) for preservation and repair are all but absent or unknown. An example drawn from my own experience is at least suggestive. Some decades ago, when I visited Port-au-Prince in Haiti, I was told that within the two preceding years a Swiss telecommunications firm had been engaged to install an entirely new network, using the latest and most sophisticated technology. This was done and the immediate results were reportedly entirely satisfactory. No one, however, had been engaged to keep the new system in repair, or perhaps no one there was capable of doing so. By the time of my family’s visit to the capital city, the system had broken down completely, indeed, to such a degree that it was impossible for our hotel to communicate by telephone with any of the neighboring hotels. This does not mean that generous contributions for the alleviation of extreme poverty can be relied upon to produce a takeoff in the recipient economy. There are all too many apparently contrary examples in which such grants, although arguably inadequate, came and went with no noticeable contribution to enduring prosperity. Clearly, more is needed and, as Easterly (2002) points out so cogently, such a program takes no account of the probability that incentives matter. Patently, it is here that the opportunities for wealth accumulation would appear to play an indispensable role. If any economy offers an avenue to abundant wealth to a John D. Rockefeller or a Bill Gates, it is plausible that entrepreneurial individuals will be found waiting in the wings, ready to undertake the exertions that bring prosperity to themselves and to their societies. 3. Inequality and growth I will argue now that matters are here not nearly so simple. Two things should give us pause here. I will cite evidence that casts doubt on the indispensability of such unimpeded avenues to wealth and I will show that the availability of opportunities for such accumulation, if not appropriately circumscribed, can impede prosperity and growth rather than enhancing them. First, there is strong evidence that the inventors and innovators, as a group, rather than acquiring vastly superior financial rewards, are substantially underpaid relative to others with comparable education and training. In other words, in the jargon of our discipline, their expected economic profits are negative. Freeman (1978) and Benz and Frey (2004), for example, show that the
W.J. Baumol / Journal of Policy Modeling 29 (2007) 545–548
547
average earnings of self-employed individuals are significantly lower than those of employees with similar qualifications, and the same is presumably true, in particular, of self-employed innovative entrepreneurs. Yet their accomplishments and their contribution to growth in productivity and living standards in the past two centuries are unparalleled in human history. At least two studies support this conclusion explicitly for innovative entrepreneurs. Astebro (2003) reports—on the basis of a sample of 1091 inventions—that, “The average IRR [internal rate of return] on a portfolio of investment in these innovations is 11.4%. This is. . .lower than the long-run return on high-risk securities and the long-run return on early-stage venture capital funds. . .only between 7 and 9% reach the market. Of the 75 inventions that did, six received returns above 1400%, 60% obtained negative returns, and the median was negative” (p. 226). Added to this, some recent results of Nordhaus (2004) are striking: “Using data from the U.S. non-farm business sector, I estimate that innovators are able to capture about 2.2% of the total surplus from innovation. . .the rate of profit on the replacement cost of capital over the 1948–2001 period is estimated to be 0.19% per year” (p. 34). Clearly, then, it is questionable whether the entrepreneurship and innovation that apparently play so large a role in the unprecedented economic growth of the past two centuries can be attributed to any special rewards to these activities. This surely is a weak reed on which to support the idea that inequality is a necessary contributor to growth. So much for the conjecture that inequality is a necessary requirement for rapid growth. I come now to my second point related to the sufficiency of this state of affairs—that inequality and high reward to activity in pursuit of wealth is reliably conducive to growth. History screams the contrary. Julius Caesar acquired his enormous wealth through aggressive warfare, as did Simon de Montfort, who before his downfall rose from minor nobility to enormous wealth and the most powerful position in England, ultimately even making prisoners of the King (Henry III) and his heir (later Edward I). These two were hardly alone. The American “robber barons” of a century ago, the captains of private armies and, today, the drug lords and mafia chieftains—all have pursued wealth and often obtained it in abundance. But, surely, their contribution to economic growth was and is distinctly negative. These are the more flamboyant cases, but probably more significant today are the overpaid business CEOs who routinely enter contracts that guarantee them spectacular incomes regardless of performance. As we know, they are led by the terms of the abundant employee stock options that accrue to them to mislead the public about the prospects of their firms and to tamper with the accounts and records. In the process, they often end up undermining the viability of their enterprises. Altogether, their exculpatory pleas that they did not know what was going on, even if based on truth, would only show how little their large reward served as an incentive for diligence in contributing to the growth of the firm or the economy. The extreme but prototypical case in which inequality serves as a prime impediment to growth is what my coauthors and I have referred to as “oligarchic capitalism,” in GOOD CAPITALISM BAD CAPITALISM and the economics of growth and prosperity (Baumol, Litan, & Schramm, 2007). Such economies are found in Africa and Latin America, and their oligarchic attributes go far in providing a credible explanation of the dreadful economic performance of those countries. These economies are, for all practical purposes, ruled by a few families that have made themselves into islands of wealth fit for a king, while the rest of the population is mired in poverty. In such circumstances, the oligarchs typically do not merely refrain from expenditure of the effort that would be entailed in steps to stimulate growth in their economies. Rather, they actively oppose such change for fear that it might undermine their comfortable positions and lead to developments that they could not control.
548
W.J. Baumol / Journal of Policy Modeling 29 (2007) 545–548
One can, of course, conceive of reward structures that entail payment by results, particularly in our own giant corporations, and it is plausible that this would indeed contribute both to inequality and growth. But my point here is that it ain’t necessarily so: one simply cannot rely on economic inequality and opportunities to profit from it, to achieve that result. 4. Conclusion I conclude that there is still a good deal to be learned about the relationship between economic growth and inequality in the distribution of income and wealth. Yet we can conclude with considerable confidence that extreme poverty of the population is a powerful handicap to growth. On the other side, there is little reason for confidence that an economy with an extremely wealthy few will surely be characterized by substantial growth, even if the way up the economic ladder is relatively unimpeded. A carefully circumscribed reward arrangement with payment only for results seems more promising, but there is some evidence that should lead us to question whether even this is either necessary or sufficient. More than that. If we agree with George Bernard Shaw, as I do, that there is no greater crime than poverty, then even if some non-negligible degree of equalization leads to some slowing of growth, I would consider the tradeoff to be favorable and even urgent. Given the ambiguity and inconclusiveness of the arguments claiming that the imposition of measures that increase equality would have that result, I am prepared to lend avid support to such measures. But, at the same time, my coauthors and I (in the book mentioned above) urge care in designing such programs to ensure that their benefits are not entirely transitory. As the matter has been put, the impoverished can benefit more from the gift of a fishing pole than they can from the presentation of a meal of fish. References Astebro, T. (2003). The return to independent invention: Evidence of unrealistic optimism, risk seeking or skewness loving. Economic Journal, 113, 226–238. Baumol, W. J., Litan, R., & Schramm, C. (2007). Good capitalism, bad capitalism. New Haven, CT: Yale University Press. Benz, M., & Frey, B. S. (2004). Being independent raises happiness at work. Swedish Economic Policy Review, 11, 95–134. Campano, F., & Salvatore, D. (2006). Income distribution. Oxford, UK and New York, NY: Oxford University Press. Easterly, W. (2002). The elusive quest for growth: Economists’ adventures and misadventures in the tropics. Cambridge, MA: MIT Press. Freeman, R. B. (1978). Job satisfaction as an Economic variable. American Economic Review, 68, 135–141. Nordhaus, W. D. (2004). Schumpeterian profits in the American economy: Theory and measurement. Cambridge, MA: National Bureau of Economic Research, Working Paper 10433.
On income distribution and growth William J. Baumol ∗,1 Department of Economics, New York University, 269 Mercer Street, New York, NY 10003, USA Available online 7 May 2007
Abstract The notion that substantial inequality is a stimulus to growth is extremely questionable. It is noted that a highly impoverished sector of the population reduces the productivity of the labor force. Moreover, the evidence that independent inventors and innovative entrepreneurs as a group receive compensation below those of equally educated employees indicates that disproportionate earnings are a questionable incentive. © 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling. JEL classification: O15 Keywords: Sources of inequality; Poverty and growth; Inequality and growth
1. Introduction It has long been recognized that the rate of economic growth in a society and the degree of equality in the distribution of its income and wealth are not independent. Indeed, it seems plausible that the two are mutually interdependent: growth rate affects distribution and distribution affects growth. The records do suggest at least some degree of interdependence in their striking behavior patterns, such as great inequality in the stagnant economies. In contrast, in the economies that have grown rapidly to a state of wealth and prosperity, the income and wealth disparities are often moderated substantially. But this paper will not focus on analysis of empirical evidence, about which much has been written (although not with unambiguous conclusions, as Campano & Salvatore, 2006, report so clearly in their valuable volume). And, unlike much of the literature, I will deal largely with the
∗
Tel.: +1 212 998 8943; fax: +1 212 995 4211. E-mail address: [email protected]. 1 Harold Price Professor of Entrepreneurship and Academic Director, Berkley Center for Entrepreneurial Studies, Stern School of Business, New York University; and Joseph Douglas Green, 1895, Professor of Economics Emeritus and Senior Economist, Princeton University. 0161-8938/$ – see front matter © 2007 Published by Elsevier Inc. on behalf of Society for Policy Modeling. doi:10.1016/j.jpolmod.2007.05.004
546
W.J. Baumol / Journal of Policy Modeling 29 (2007) 545–548
influence of inequality, and of widespread poverty accompanied by extreme wealth of a fortunate few, upon rapidity of economic growth. 2. Poverty and growth There are two obvious sources of the influence of inequality on growth: (1) low productivity of an impoverished labor force (poverty as a physical and mental handicap), and (2) large financial rewards as incentive for vigorous productive effort. Clearly, these influences work in opposite directions. The first asserts that inequality can be a powerful impediment to growth, while the second claims that the prospect of success in attaining the upper strata in a highly unequal community is a vital and perhaps indispensable stimulus to rapid growth because it supposedly is the fuel that fires the exertions of the entrepreneurs. Regarding the first of these influences, there can be little question—there seems to be no reason to doubt that a population will not provide a vigorous labor force if it is beset by malnutrition and a variety of debilitating illnesses for which the funds required for medication and medical attention are lacking. And if there are no resources for even rudimentary education, the use of plant and equipment of any sophistication will obviously be precluded. Moreover, in such societies, even moderately advanced capital stock does not long endure because means (or incentives) for preservation and repair are all but absent or unknown. An example drawn from my own experience is at least suggestive. Some decades ago, when I visited Port-au-Prince in Haiti, I was told that within the two preceding years a Swiss telecommunications firm had been engaged to install an entirely new network, using the latest and most sophisticated technology. This was done and the immediate results were reportedly entirely satisfactory. No one, however, had been engaged to keep the new system in repair, or perhaps no one there was capable of doing so. By the time of my family’s visit to the capital city, the system had broken down completely, indeed, to such a degree that it was impossible for our hotel to communicate by telephone with any of the neighboring hotels. This does not mean that generous contributions for the alleviation of extreme poverty can be relied upon to produce a takeoff in the recipient economy. There are all too many apparently contrary examples in which such grants, although arguably inadequate, came and went with no noticeable contribution to enduring prosperity. Clearly, more is needed and, as Easterly (2002) points out so cogently, such a program takes no account of the probability that incentives matter. Patently, it is here that the opportunities for wealth accumulation would appear to play an indispensable role. If any economy offers an avenue to abundant wealth to a John D. Rockefeller or a Bill Gates, it is plausible that entrepreneurial individuals will be found waiting in the wings, ready to undertake the exertions that bring prosperity to themselves and to their societies. 3. Inequality and growth I will argue now that matters are here not nearly so simple. Two things should give us pause here. I will cite evidence that casts doubt on the indispensability of such unimpeded avenues to wealth and I will show that the availability of opportunities for such accumulation, if not appropriately circumscribed, can impede prosperity and growth rather than enhancing them. First, there is strong evidence that the inventors and innovators, as a group, rather than acquiring vastly superior financial rewards, are substantially underpaid relative to others with comparable education and training. In other words, in the jargon of our discipline, their expected economic profits are negative. Freeman (1978) and Benz and Frey (2004), for example, show that the
W.J. Baumol / Journal of Policy Modeling 29 (2007) 545–548
547
average earnings of self-employed individuals are significantly lower than those of employees with similar qualifications, and the same is presumably true, in particular, of self-employed innovative entrepreneurs. Yet their accomplishments and their contribution to growth in productivity and living standards in the past two centuries are unparalleled in human history. At least two studies support this conclusion explicitly for innovative entrepreneurs. Astebro (2003) reports—on the basis of a sample of 1091 inventions—that, “The average IRR [internal rate of return] on a portfolio of investment in these innovations is 11.4%. This is. . .lower than the long-run return on high-risk securities and the long-run return on early-stage venture capital funds. . .only between 7 and 9% reach the market. Of the 75 inventions that did, six received returns above 1400%, 60% obtained negative returns, and the median was negative” (p. 226). Added to this, some recent results of Nordhaus (2004) are striking: “Using data from the U.S. non-farm business sector, I estimate that innovators are able to capture about 2.2% of the total surplus from innovation. . .the rate of profit on the replacement cost of capital over the 1948–2001 period is estimated to be 0.19% per year” (p. 34). Clearly, then, it is questionable whether the entrepreneurship and innovation that apparently play so large a role in the unprecedented economic growth of the past two centuries can be attributed to any special rewards to these activities. This surely is a weak reed on which to support the idea that inequality is a necessary contributor to growth. So much for the conjecture that inequality is a necessary requirement for rapid growth. I come now to my second point related to the sufficiency of this state of affairs—that inequality and high reward to activity in pursuit of wealth is reliably conducive to growth. History screams the contrary. Julius Caesar acquired his enormous wealth through aggressive warfare, as did Simon de Montfort, who before his downfall rose from minor nobility to enormous wealth and the most powerful position in England, ultimately even making prisoners of the King (Henry III) and his heir (later Edward I). These two were hardly alone. The American “robber barons” of a century ago, the captains of private armies and, today, the drug lords and mafia chieftains—all have pursued wealth and often obtained it in abundance. But, surely, their contribution to economic growth was and is distinctly negative. These are the more flamboyant cases, but probably more significant today are the overpaid business CEOs who routinely enter contracts that guarantee them spectacular incomes regardless of performance. As we know, they are led by the terms of the abundant employee stock options that accrue to them to mislead the public about the prospects of their firms and to tamper with the accounts and records. In the process, they often end up undermining the viability of their enterprises. Altogether, their exculpatory pleas that they did not know what was going on, even if based on truth, would only show how little their large reward served as an incentive for diligence in contributing to the growth of the firm or the economy. The extreme but prototypical case in which inequality serves as a prime impediment to growth is what my coauthors and I have referred to as “oligarchic capitalism,” in GOOD CAPITALISM BAD CAPITALISM and the economics of growth and prosperity (Baumol, Litan, & Schramm, 2007). Such economies are found in Africa and Latin America, and their oligarchic attributes go far in providing a credible explanation of the dreadful economic performance of those countries. These economies are, for all practical purposes, ruled by a few families that have made themselves into islands of wealth fit for a king, while the rest of the population is mired in poverty. In such circumstances, the oligarchs typically do not merely refrain from expenditure of the effort that would be entailed in steps to stimulate growth in their economies. Rather, they actively oppose such change for fear that it might undermine their comfortable positions and lead to developments that they could not control.
548
W.J. Baumol / Journal of Policy Modeling 29 (2007) 545–548
One can, of course, conceive of reward structures that entail payment by results, particularly in our own giant corporations, and it is plausible that this would indeed contribute both to inequality and growth. But my point here is that it ain’t necessarily so: one simply cannot rely on economic inequality and opportunities to profit from it, to achieve that result. 4. Conclusion I conclude that there is still a good deal to be learned about the relationship between economic growth and inequality in the distribution of income and wealth. Yet we can conclude with considerable confidence that extreme poverty of the population is a powerful handicap to growth. On the other side, there is little reason for confidence that an economy with an extremely wealthy few will surely be characterized by substantial growth, even if the way up the economic ladder is relatively unimpeded. A carefully circumscribed reward arrangement with payment only for results seems more promising, but there is some evidence that should lead us to question whether even this is either necessary or sufficient. More than that. If we agree with George Bernard Shaw, as I do, that there is no greater crime than poverty, then even if some non-negligible degree of equalization leads to some slowing of growth, I would consider the tradeoff to be favorable and even urgent. Given the ambiguity and inconclusiveness of the arguments claiming that the imposition of measures that increase equality would have that result, I am prepared to lend avid support to such measures. But, at the same time, my coauthors and I (in the book mentioned above) urge care in designing such programs to ensure that their benefits are not entirely transitory. As the matter has been put, the impoverished can benefit more from the gift of a fishing pole than they can from the presentation of a meal of fish. References Astebro, T. (2003). The return to independent invention: Evidence of unrealistic optimism, risk seeking or skewness loving. Economic Journal, 113, 226–238. Baumol, W. J., Litan, R., & Schramm, C. (2007). Good capitalism, bad capitalism. New Haven, CT: Yale University Press. Benz, M., & Frey, B. S. (2004). Being independent raises happiness at work. Swedish Economic Policy Review, 11, 95–134. Campano, F., & Salvatore, D. (2006). Income distribution. Oxford, UK and New York, NY: Oxford University Press. Easterly, W. (2002). The elusive quest for growth: Economists’ adventures and misadventures in the tropics. Cambridge, MA: MIT Press. Freeman, R. B. (1978). Job satisfaction as an Economic variable. American Economic Review, 68, 135–141. Nordhaus, W. D. (2004). Schumpeterian profits in the American economy: Theory and measurement. Cambridge, MA: National Bureau of Economic Research, Working Paper 10433.