Inequality and the Pandemic, Part 3: Risk and reward

by John Quiggin on October 3, 2020

So far, in this series of extracts from my book-in-progress, Economic Consequences of the Pandemic, I’ve argued that the inequality of incomes in our society is largely a matter of luck rather than inherent personal ability, and that it is only distantly related to the social value of the contributions people make through their work. These conclusions undercut the idea that taxing those on high incomes will harm society by reducing incentives to work for the most able and social valuable workers. Although the evidence was already strong, the pandemic has brought these points into even brighter relief.

Now I want to consider the claim that we need inequality in order to encourage people to take risks. The simplest response is to point to the empirical fact that high income earners take (or, more accurately, are subject to) less risk than average not more[1].

Hardy and Ziliak (confirmed in general terms by many other sources) give the numbers https://onlinelibrary.wiley.com/doi/full/10.1111/ecin.12044?casa_token=2_dvANjFw2EAAAAA%3AiKxuB6Tn34GJBIOZlN9Hs55w9MxJlkgR0Ns1z-1UAPIosDi2G8Yq3WF9hjUTVy8HQb95t9DwLzCRel8vyg

in any given year since 1996 the level of volatility among the bottom 10% was 81% higher than the volatility among the top 1%, and this level nearly doubled since 1981

Here’s a graph illustrating this point.

Income risk by income group

https://onlinelibrary.wiley.com/doi/full/10.1111/ecin.12044?casa_token=2_dvANjFw2EAAAAA%3AiKxuB6Tn34GJBIOZlN9Hs55w9MxJlkgR0Ns1z-1UAPIosDi2G8Yq3WF9hjUTVy8HQb95t9DwLzCRel8vyg

This graph shows that those at the bottom of the income distribution experience higher variance than anyone else. But using the variance as a measure understates the problem, since what matters most in an assessment of risk is the discretionary income remaining after unavoidable commitments have been met.

The statistics confirm what anecdotal evidence tells us every day: once someone has made it to the top of the income distribution, they will never become poor as a result of bad luck or business mistakes. Failed business owners wash their debts away with bankruptcy and return to the scene only marginally diminished. Failed CEOs are given multi-million dollar parachutes to soften their fall. Even personal bankruptcy isn’t commonly a problem: careful use of homeowner exemptions, irrevocable trusts and well-timed (but not too obviously well-timed) gifts can allow a bankrupt 1 percenter to live far better than a solvent member of the (shrinking) middle class, let alone a poor person.

If anything, our institutions encourage too much risk-taking at both ends of the income distribution. The rich can take risks secure in the knowledge that (with the current tax system) they will keep most of the benefits of bets that payoff while shifting most of the losses from unsuccessful bets to others. The poor take more voluntary risks because any chance of escaping the bottom of the distribution in a highly unequal society is worth a shot. And freely chosen risks seem less worrying when you are subject to so much risk that is out of your control anyway.

As usual, the pandemic illustrates this point in spades. Throughout his career, Donald Trump has relied on his ability to cash in his (relatively rare) winning bets while shifting the losses onto others. Now having gambled with his own safety and that of anyone who listens to him, he is guaranteed the best medical care money can buy, while thousands of less fortunate victims of the pandemic die every week.

fn1. The idea of the top 1 per cent as entrepreneurial risk-takers is part of a complex of spurious factoids, including ‘executive stress’ and the idea that this stress in turn causes ulcers.

{ 13 comments }

1

Tim Worstall 10.03.20 at 11:58 am

“This graph shows that those at the bottom of the income distribution experience higher variance than anyone else.”

Not entirely and wholly exactly. Not being an academic I’ve not full access to the paper. But they use CPS measures of income. Which are before most of the American welfare state (Medicaid, EITC, SNAP, Section 8 and so on). So the statement “variance of market income” would be true and “variance of income” not necessarily so. At least, not from this measure of income.

2

John Quiggin 10.03.20 at 10:25 pm

Variance of market income is what’s relevant here. The question is whether those at the top take risks in the market that weaken the case for redistribution. As we see, the riskiness of market income strengthens the case for redistribution.

3

Dr. Hilarius 10.04.20 at 12:06 am

In regard to the most able and socially valuable workers, the financial incentives are perverse. Legions of highly compensated workers in finance, marketing, consulting and similar could vanish without creating more than a slight ripple in daily life. But if garbage collectors all ran off to Gault Gulch things would get very bad very quickly.

4

Jonathan Goldberg 10.04.20 at 2:20 am

“So, far I’ve argued that the inequality of incomes in our society is largely a matter of luck rather than inherent personal ability, and that it is only distantly related to the social value of the contributions people make through their work.”

Would you please link to this? TIA

5

John Quiggin 10.04.20 at 11:14 am

@4 Done now, hope links work

6

Phil 10.04.20 at 3:29 pm

a complex of spurious factoids, including ‘executive stress’ and the idea that this stress in turn causes ulcers

A complex which has friends in high places, or certainly had within living memory. A medic friend at college was telling us once about how much more we knew these days about the causes of heart disease – tobacco, obesity, family history and, er, that’s it. Somebody said, what about stress? No, he said, that could be discounted – if you looked at the breakdown by class, heart disease was actually more prevalent in lower socio-economic groups.

7

dilbert dogbert 10.04.20 at 8:19 pm

I was thinking of Bill Gates, Steve Jobs and Larry Ellison. I don’t think at base they were thinking of becoming billionaires and that the tax structure they faced would have discouraged them. I know that I did not even think about taxes as a young man who worked to get two degrees in engineering. I wanted to work on the big things that were going on. In my era that was atomic power and space travel. I think it was the same for these three. Larry’s first wife is a friend of mine. I joked with her that she missed the big time. She responded that she did not care as she got a life after dumping Larry. She also paid for his surgery.

8

CHETAN R MURTHY 10.05.20 at 4:54 am

dilbert dogbert: Heh indeed. Heh indeed.

I can’t imagine any entrepreneur with a few thousands (or even a few hundreds of thousands) in his pocket, who said “Oh, why bother, they’ll just tax away everything after a billion!” Nobody was ever dissuaded from getting their first million, by high taxes on their hundredth million. Crriikey indeed.

Even if the limit were set at …. let’s say, $200m, so you can lose half of it to your first wife, and half again to your second, you’re still left with $50m, which should be enough for anybody to live well for their entire lives and still leave a nice starter trust for their kids. And you wouldn’t want to leave too much, or those kids aren’t gonna work. And we want people to work, right? Can’t put disincentives in place!

9

CHETAN R MURTHY 10.05.20 at 4:55 am

Oh, and I left out: there is no evidence that a startup founder who wins the first time, is any more successful the second time. They’re uncorrelated events. Which should tell you something about the extent to which luck was responsible for the first success, but hey, I’ll leave that lie ….

10

notGoodenough 10.05.20 at 12:31 pm

”These conclusions undercut the idea that taxing those on high incomes will harm society by reducing incentives to work for the most able and social valuable workers.”

Indeed – the Beatles still composed and recorded “Taxman” despite it being a complaint regarding the 95% supertax. IIRC, in the 1970s the highest rate of income tax was ca. 83%, which was reduced to 40% in 1989 – yet one suspects that the degree of industriousness amongst those eligible did not change to a proportional extent.

My hunch is that changing the tax rates won’t make the highest earners work less, but rather encourage them to try harder to avoid paying it in the first place. Good enforcement would, therefore, also seem to be a key component. Yet somehow, and completely mysteriously, this is often neglected by those in charge – no doubt this is completely unconnected to the fact that such changes would also typically affect them and those they are connected with.

To continue the hypothetical, one wonders if what is needed is some sort of global movement which focuses on the needs and welfare of those who must sell their labours to survive? If only such a socio-political movement existed…

11

marcel proust 10.05.20 at 11:39 pm

@dilbert dogbert: She also paid for his surgery.

Let me guess: either an orchiectomy or its opposite?

12

Steve Kyle 10.06.20 at 11:37 pm

I wouldnt want to argue that we “need inequality to encourage people to take risks”. But I would observe that for any given investment opportunity you need somebody who has enough money to make that investment without endangering their ability to survive. That is, there is a precautionary catastrophe avoidance motive . That means that the simple variance of income isnt the only important factor – the absolute values matter too.

13

J-D 10.07.20 at 10:19 am

I would observe that for any given investment opportunity you need somebody who has enough money to make that investment without endangering their ability to survive.

There’s no good reason why it has to be an individual.

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