Economic Inequality: Facts, Theory and Significance

Policy Reports | Economy | Government | Social

No. 312
Tuesday, June 10, 2008
by David R. Henderson

The Economic Justification for Income Inequality

Economists tend to justify substantial inequality of earnings on the grounds that it is required to give people a strong incentive to be productive.  In the extreme case of total equality of earnings, what would be anyone’s incentive to become educated, to take a job on the Alaska Pipeline, to work overtime, or to start a risky business?  The pay incentive would be literally zero.  Therefore, substantial pay differentials are justified on narrow grounds of efficiency.  As economist Finis Welch points out:

Wages play many roles in our economy; along with time worked, they determine labor income, but they also signal relative scarcity and abundance, and with malleable skills, wages provide incentives to render the services that are most highly valued.22

That is what economists tend to say when questioned about the justification for inequality.  But is that all?  Is there something major left out?

The answer is yes.  What is left out is that those who have the highest incomes in a free society by and large earned them.  Either they earned their income as wages and salaries, or as interest, dividends and capital gains.  In this sense, inequality is justified.

Conversely, concern about income inequality would be justified if a large part of the income inequality came about due to a lack of freedom — in short, in a society of privilege.  The term “privilege” is often used today as a synonym for wealth, but the 19th century British definition of a society of privilege is one in which the government grants special status to certain groups or people.  For example, slave owners were privileged and slaves were the opposite of privileged.  In today’s society, politicians, farmers who grow subsidized crops, labor union members, students whose college costs are subsidized and beneficiaries of government systems of racial quotas are all privileged.  If income inequalities come about because of privilege, those income inequalities are wrong.

One rough indicator of privilege is the Census data on U.S. counties with the highest median household incomes.  In 2006, five of the top 10 (including the top three) were in or around the Washington, D.C., metropolitan area.23 One reason for this is that government work — working for the government or lobbying it — attracts highly skilled people who would likely do well elsewhere.  But much also has to do with the coercive-transfer state — a large government whose major activity is using tax money and regulatory power to benefit some at the expense of others.  Moreover, these explanations are not necessarily competing; the transfer state attracts smart people.  Indeed, this is one of the main arguments against the transfer state:  huge amounts of resources are wasted on investment in transfers.

“Inequality due to government-granted privileges is wrong.”

The income inequalities that result from state transfers are derivative wrongs.  They are not the fundamental wrong.  The fundamental wrong is the government granting of privilege.  If, for example, households whose incomes were raised by government privilege squandered their wealth so that their only source of income were their wages and salaries, and not dividends, interest and capital gains, there would be less inequality but just as much injustice.

Read Article as PDF