Inequality and U.S. Economic Hegemony

In my last two posts, I've discussed Beale's Law (see here and here). Beale's Law posits that pre-tax income inequality has an "inverse" relationship to top tax rates. Today's post explores the more complex reality underlying the increased economic inequality in the United States.

The Decline of U.S. Economic Hegemony

The political left has convinced itself that inequality of income and wealth is primarily a function of tax rates. The narrative is easy to promote through soundbite politics. It stokes our base emotions (envy) and offers a simple government remedy to economic inequality.

The left clings to this narrative for a several reasons. The narrative is simple and politically expedient. It offers an excuse for failed left-wing policy initiatives that were supposedly enacted to improve equality of opportunity. (If past initiatives have failed to address inequality, why should we trust the same policymakers to implement "new and improved" policies to address inequality?) Most important, the narrative permits left-wing politicians to bury their collective heads in the sand. A simple narrative that 'tax policy drives inequality' fails to acknowledge the decline of U.S. economic hegemony over the last 50 years.

During the second half of the 20th century, the United States had the world's largest, strongest and most stable economy. We had an educated workforce, a developed energy and transport infrastructure, and stable government institutions. Following World War II, we experienced an economic surge associated with the Baby Boom generation. We supported our major trading partners during a period of post-war economic redevelopment. Capital markets activity was largely domestic. Through the 1970s, we ran consistent trade surpluses. From an economic perspective, we were the 'only game in town.'

Fast forward to 2011. The U.S. is now a player on a crowded and competitive international stage. We have no structural advantage relative to our major trading partners (the EU, Canada, Japan and Australia). Developing countries have better educated workforces, and armies of low-skilled workers that cost less than their U.S. counterparts. We have no discernible energy policy, and our dependence on oil imports drives chronic trade deficits. Technology has diminished the economic significance of geography, while promoting the relevance of talent. Financial capital markets are globally integrated. Global capital flows to the most profitable opportunities.

With that historical context, we can isolate on the major causes of U.S. economic inequality:

- On a macro level, the U.S. has been dragged into intense economic competition with its major trading partners and developing economies. We are no longer the 'only game in town.'

- On a micro level, the low-skilled U.S. worker has become far less valuable than his or her counterpart in the mid-20th century. Developing economies have large pools of low-skilled workers, and multinational businesses can access those low-skilled workers at lower costs than U.S. workers.

- Conversely, the best educated and most talented U.S. entrepreneurs have become more valuable than their counterparts in the mid-20th century. Technology has concentrated returns to talent and genius.

- Moreover, the byzantine U.S. regulatory system has created a "lock out" effect. In large sectors of the U.S. economy, only the largest businesses can thrive. If a business requires an army of lawyers or lobbyists to navigate regulatory, commercial or tax issues, it qualifies. The individuals that climb to the top of the pyramid generate economic premiums by "locking out" competitors. In the mid-20th century, how many CEOs depended on armies of lawyers or lobbyists?

Acknowledging the truth about economic inequality requires us to take off the blinders. We aren't going back to a period of U.S. economic hegemony. We are required to compete in markets that are ruthlessly efficient. Our low-skilled workers are at an enormous competitive disadvantage, and will continue to lose ground relative to better educated and more talented peers. The wealth gap will probably get steeper before it flattens out again. We aren't going to reverse the long-term trend by increasing top tax rates on "millionaires and billionaires."

However, all is not bleak. Our country has an extraordinary tradition of innovation and resilience. We need to acknowledge the competitive challenges facing our nation, and coalesce around strategies to align educational opportunities with a knowledge-based economy. We need to re-boot policies and institutions that worked in the mid-20th century to reflect the challenges of the early-21st century. We need to be realists, but realism is not mutually exclusive with optimism.