The Great Gatsby days of inequality and social polarisation

Is Australia on its own ‘Great Gatsby curve’? Victoria Pickering/Flickr, CC BY-NC-ND

In the popular novel of F. Scott Fitzgerald, James “Jimmy” Gatz (The Great Gatsby) climbs from his poor, rural North Dakotan origins to New York’s high society. His parties are as glamorous as they get and his guests do not seem to mind his shady business connections, which in the end are just a means to an end: the American dream.

Gatsby’s time, the roaring 1920s, is one of sharp disparities in the distribution of income. Still, this does not prevent him from moving up the ladder, reaching a socioeconomic status that would be just unthinkable for his parents.

If this were always the case; that is, if in spite of inequality people were not denied social mobility, then inequality would likely be less of a concern.

Unfortunately, the evidence tells us a different story: higher inequality is associated with lower social mobility. This relationship, known as the “Great Gatsby curve”, means that when distinctions between socioeconomic groups are more marked, moving from a lower to a higher group becomes less likely.

The implication is that growing income inequality will lead to a self-fulfilling spiral of social polarisation and as a result set the stage for new, more frequent crises.

Several economists already blame inequality for the global financial crisis, as the pressure to achieve a higher social status led households to intensify leverage while the influence of the rich on policymaking favoured speculative bubbles.

The prospect of living in such a world is not appealing, hence we worry about inequality, or at least most of us do.

Fighting divergence

The question of how to tackle inequality is multifaceted. The obvious way to take care of the problem is to redistribute wealth. In its basic form, redistribution involves taxing the rich to pay subsidies to the poor.

This of course raises a number of fundamental questions: what type of wealth should be taxed (labour income, capital gains and profits, bequests, or consumption) and at what rate?

Should the poor be subsidised with cash transfers that they can then use as they wish? Or should instead the government use revenues from taxes to supply public education and health, pursuing some form of equality of opportunities (rather than equality of outcomes)?

Answering these questions has proved challenging for the economics profession.

Probably, the most critical challenge is the “efficiency-equity trade-off”. In a nutshell, the rich tend to own capital, while the poor supply labour. Therefore, the redistributive mechanism should hinge on higher taxes on capital and profit.

However, as taxes on capital increase, the rich tend to send their capital abroad (if they can) or invest less. In both cases, the risk is a slowdown in the pace of physical capital accumulation and hence in the rate of economic growth.

Luckily, the efficiency-equity trade-off is not inescapable. When taxes are progressive and revenues are used to supply public goods and to support productive expenditure, then dynamic efficiency is likely to be preserved, in the sense that inequality can be reduced without this resulting in lower growth.

Politics, obviously, might get in the way. Even in a democracy, the rich are much better equipped than the poor to influence decision-making.

This in turn reduces the extent of redistribution, essentially because the rich oppose any type of progressive taxation that heavily penalises the top percentiles of income distribution.

And when the government misunderstands its role and/or the terms of the equity-efficiency trade-off, the likely policy outcome is a mix of low taxation and low expenditure that fails to deliver any meaningful redistribution, without necessarily delivering faster growth.

Gatsby in Australia?

In his new book “Capital in the Twenty-First Century”, economist Tomas Piketty, a leading scholar on inequality and redistribution, uses the term “patrimonial society” to indicate a society where a small group of wealthy rentiers lives lavishly on the fruits of its inherited wealth, and the rest struggle to keep up.

This, in the view of Piketty, might be the ironic destiny of the United States if the current trends of rising inequality and polarisation are not stopped.

And what about Australia? Well, the picture is more comforting here than on the other side of the Pacific. The income of the bottom 10% of the population is growing faster than in most other OECD countries and, in absolute level, inequality is quite a fair bit lower than in the US.

Nevertheless, inequality is increasing and it is doing so at a faster pace than the OECD average. This is a call for action, to which someone might respond by arguing in favour of re-introducing death duties.

The logic would seem to be simple enough: if the problem is that inequality can lead to a situation where a child’s prospects are heavily (if not almost exclusively) determined by their parents’ income, then we should take a chunk of the wealth transferred from rich parents to their child and give it to the child of poor parents.

However, in Australia, the elasticity of children’s wages with respect to their parents’ wages is about 50% lower than in the US. This means that intergenerational mobility in Australia is still relatively high, which in turn makes inheritance or estate taxes redundant.

On the other hand, there are other policies that combine efficiency and equity and that might be more relevant in the case of Australia. Two in particular are worth a mention.

First, reducing inequality requires an education system where access to learning opportunities is open and independent of a family’s income. This means using tax revenues to strengthen public schools and to prevent a situation where better schools are systematically accessible only by rich families.

Second, in a recession, individuals in the bottom percentiles of income distribution suffer disproportionately more than the others. To alleviate their suffering and ensure that recessions do not worsen income disparities, fiscal policy ought to be used counter-cyclically as a tool of stabilisation.