The Inefficiency of Inequality

http://www.foreignpolicy.com/articles/2014/01/22/the_inefficiency_of_inequality

Why America's staggering wealth disparity is an economic problem -- not just a moral one.

BY Daniel Altman
JANUARY 22, 2014

The debate about inequality inflames many passions because of its moral and philosophical trappings. But inequality is also an economic phenomenon with enormous consequences that we are just beginning to understand. In fact, inequality's impairment of economic growth may dwarf its more apparent social costs.

To understand why, consider what happens when economic opportunities are in short supply. When any market has a shortage, not everyone gets the things they want. But who does get them also matters, because it's not always the people who value those things the most.

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This problem, which economists call inefficient allocation, is present in the market for opportunities as well. It's best for the economy when the person best able to exploit an opportunity is the one who gets it. By giving opportunities to these people, we make the economic pie as big as possible. But sometimes, the allocation of opportunity is not determined solely by effort or ability.

To a great degree, access to opportunity in the United States depends on wealth. Discrimination based on race, religion, gender, and sexual discrimination may be on the wane in many countries, but discrimination based on wealth is still a powerful force. It opens doors, especially for people who may not boast the strongest talents or work ethic.

Country club memberships, charity dinners, and other platforms for economic networking come with high price tags decided by existing elites. Their exclusion of a whole swath of society because of something other than human potential automatically creates scope for inefficient allocation. But it's not always people who do the discriminating; sometimes it's just the system.

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Yet running for office takes money -- lots of it -- and there are no restrictions on how much a candidate may spend. As a result, the people who win have tended to be very wealthy.

Of course, political life isn't the only economic opportunity with a limited number of spots. In the United States, places at top universities are so scant that many accept fewer than 10 percent of applicants. Even with need-blind admissions, kids from wealthy backgrounds have huge advantages; they apply having received better schooling, tutoring if they needed it, enrichment through travel, and good nutrition and healthcare throughout their youth.

The fact that money affects access to these opportunities, even in part, implies some seats in Congress and Ivy League lecture halls would have been used more productively by poorer people of greater gifts. These two cases are particularly important, because they imply that fighting poverty alone is not enough to correct inefficient allocations. With a limited number of places at stake, what matters is relative wealth, or who can outspend whom. And when inequality rises, this gap grows.

And rise it has. According to the Federal Reserve's Survey of Consumer Finances, the share of American wealth held by the top 10 percent of families (ranked by net worth) climbed from 67 percent in 1992 to 75 percent in 2010. In the 2010 survey, the average net worth of the bottom half of families was $11,400. For the next quarter of families, the average was $168,900. Clearly, these two groups face vastly different economic opportunities in our society, regardless of their raw aptitude.

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The easiest way to redistribute wealth continues to be the estate tax, yet it is politically unpopular and applies to only about 10,000 households a year. All of this might change, however, as more research estimates the harm caused by inequality through the inefficient allocation of opportunities.

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