Like a broken record, I repeat myself: A high level of income inequality means nothing in itself. If you think there is some unfairness or injustice involved then show the mechanism that produced the pattern, and then let’s consider whether there is something unjust or unfair about it. Ian Dew-Becker and Robert Gordon’s new VoxEU op-ed is notable, and worthy of emulation, for pointing to a very possibly unjust mechanism behind the rapid rate of increase at the top of the top of the distribution.
While the demand and supply story of SBTC and Goldin and Katz can help explain the 90-10 ratio, increased skewness of incomes above the 90th percentile has been driven by a set of fundamentally different factors. To help understand the evolution of the highest incomes, we divide these workers into three categories. Superstars include the top members of any occupation that provides disproportionate rewards to the first-best as contrasted with the second-best. The superstar phenomenon has at its core the magnification of audiences, the fact that a single performance can be witnessed by an audience of one person or ten million people, depending on the perceived attraction and talent. The second category includes law partnerships, investment bankers, and hedge fund managers, where there is no obvious analogy to audience magnification but where there are steep wage premia for the very best in an occupational niche, and where it is apparent that incomes are highly market-driven.
The most contentious question regards the third category, top executives in public corporations. The core distinction is that CEO compensation is chosen by their peers in a system that gives CEOs and their hand-picked boards of directors, rather than the market, control over top incomes. The idea that managers, rather than stockholders, control directors goes back to Berle and Means (1932). This idea that the principal-agent control of stockholders should be reversed has been applied fruitfully by such authors as Bebchuk and Fried (2004). They argue that managerial power lies behind some of the outsized gains in CEO pay.
In general, we believe that better disclosure and better laws regarding corporate governance can help deal with high CEO pay. Precisely determining what counts as reasonable pay is beyond the government’s abilities. However, there is some evidence, reviewed by Dew-Becker (2008), showing that increases in mandatory disclosure lead to better corporate performance and better designed pay packages.
For some time now, I’ve seen overlapping directorates and reciprocal self-dealing by tightly socially connected corporate board members to be a plausible unjust mechanism behind the level of income inequality. Arnold Kling has a good post that outlines an alternative theory of CEO pay, but he also seems inclined to the view that there is some kind of malfeasance going on here.
Do notice, however, that the authors concede SBTC as a good explanation for much of the gap between the 10th and 90th percentiles. And, within the top 10 percent, superstar markets and the increasing value of talent in certain niches explains a lot of the gap between the 90th and 99th percentiles. It’s not clear just how much of the outsized income gains at the top of the top are due to CEO pay. So even were reforms put in place that would prevent collusive yachting buddies from making each other that much richer, the overall effect on income inequality might be small. Of those who benefit from pure market mechanisms, Dew-Becker and Gordon write,
Their earnings are an outcome of market forces, and the only policy measure available to achieve greater after-tax equality is an increase in tax rates at the top balanced by a decrease at the bottom.
That is to say, they identify nothing untoward about the institutional mechanisms that produce inequality in this way, so there is no reason to try to intervene with new policy to change them. But this of course raises the question of why, in this kind of case, greater after-tax equality is morally desirable at all, or why an equality-aiming increase in tax rates on those with justly-earned incomes would morally permissible.