Monday, February 17, 2014

Income inequality

Many people think that economic freedom will necessarily lead to wealth being concentrated in the hands of a few powerful elites. “Why, if people are free, wealth won’t be distributed fairly!” they claim. Here are some reasons why that argument is completely fallacious:

1) Wealth isn’t distributed, it’s earned.
In the market, people earn money by being productive, allocating resources more efficiently than their competition, making wise financial decisions, etc. Naturally, there are inequalities between people’s abilities to do each of these things; thus, any inequality arising in a free market comes about because of inequality of skills, intelligence, work ethic, luck, etc. In the end, income inequality shouldn’t matter because one man does not gain at the expense of another (people must create wealth in order to earn money).

As Milton Friedman once said, “Most economic fallacies derive from the tendency to assume that there is a fixed pie [of wealth] that one party can gain only at the expense of another.”

2) For those who actually care about income inequality:
Empirical research continually finds that economic freedom is positively correlated with income EQUALITY. For example, a 2007 study of the relationship between economic freedom and income equality concluded, “the estimated relation between economic freedom and income inequality is positive, statistically significant, but relatively inelastic” [1]. A 2013 study found similar results. According to the authors, “Using fixed effects regression analysis, we find evidence that increases in economic freedom are associated with lower income inequality, but the dynamic relationship between the two variables depends on the initial level of economic freedom” [2]. Since economic freedom is positively associated with income equality, it is impossible to claim that increasing economic freedom will lead to wealth concentration among the very rich.

NOTE: Keep in mind, the US’s economic freedom rating has been dropping for a decade whilst income inequality has risen.

In conclusion, the claim that in a free market wealth would be concentrated at the very top is not supported by empirical evidence. And even if it were true, all that would indicate was that the people at the very top of the income ladder are extremely productive (or had more valuable skills, knowledge, etc) relative to the rest of the populace. Unfortunately, today the US has a government which is so powerful that it can manipulate interest rates, tax codes, and the law to favor special interest groups engaged in rent seeking. Ultimately, if people are worried about inequality, they should be more concerned about what the government is doing to promote it than the free market.



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