TWO

INCOME INEQUALITY ON THE RISE

The poverty problem we examined in Chapter 1 is closely related to a wider problem—namely, the growing gap in the share of income going to the rich, the middle class, and the poor. One of the key issues in capitalism is whether it must inevitably lead to great and growing differences in personal income and wealth. Under capitalism, will the poor remain poor and will the rich acquire a growing share of income and wealth?

The grand idea of capitalism is that those with capital will apply it to create more wealth that will lead to more jobs and income for everyone. Not only will the wealthy benefit, but their wealth will “trickle down.” All boats will rise. In recent times, however, wealth is more likely to “trickle up.” A growing GDP no longer means that poverty falls. The wealthy become better off, and the others don’t benefit very much, if at all. The rich use their lobbyists in Congress to write rules that end up in tax loopholes that benefit the already affluent. Big Politics has aligned with Big Business. Many wealthy individuals pay lower tax rates than those on normal salaries. Warren Buffett and Mitt Romney both pay lower tax rates than their secretaries, because capital gains are taxed at a lower rate. The difference is that Warren Buffett doesn’t think it is right. Billionaire Buffett says that he and the rest of the super-rich are under-taxed.

Those defending the super-rich put forth many arguments for not taxing them more. One is that an economy attains a “Pareto optimal level” when no one can be made better off without making someone worse off.¹ Vilfredo Pareto argued that taking a dollar from a millionaire and giving it to a starving person to buy food does not mean that we’ve increased the amount of total satisfaction in the whole socioeconomic system. Because satisfaction is a subjective state, the millionaire could derive as much or more satisfaction from that dollar as the starving person spending it on food. The Pareto optimal is another defense for the rich remaining untouched and the poor remaining poor. Little wonder economics has been called the “dismal science.”

Buffett has joined with Bill Gates to persuade the world’s wealthiest individuals and their families to sign a Giving Pledge to dedicate the majority of their wealth to philanthropy to improve the lives of people.² So far 132 people have signed up, and their individual pledges are posted on a website for all to see. This organized approach to volunteering a share of one’s wealth is unprecedented and bound to do much good.³

In addition, a growing group called Patriotic Millionaires in the U.S. has lobbied Congress to raise the taxes on the rich and to close tax loopholes. They believe that no millionaire should pay at a lower tax rate than middle-class Americans. They favor a more progressive tax on the rich in order to raise money to improve education, health, and infrastructure in this country.⁴

THOMAS PIKETTY ARRIVES ON THE SCENE

Thomas Piketty, a French economist who specializes in income distribution, argues in his book Capital in the Twenty-First Century that inequality will inevitably worsen under free market capitalism.⁵ He asserts that capital owners will become increasingly dominant over those who only receive wages. To Piketty, the fundamental question is whether the rate of return to capital will be greater or less than the rate of growth of the world economy. Piketty claims that during the six decades between 1914 and 1973, the rate of economic growth exceeded the rate of return to capital and led to the material improvements in the lives of workers. This was the period of two world wars and a Great Depression that destroyed a lot of capital.⁶ He sees this as a unique historical period that is not likely to be repeated. In the forty years since 1973, the rate of return to capital has exceeded the rate of economic growth, which has slowed down. Piketty says that the higher the rate of return to capital is in comparison to the rate of growth of the economy, the greater the inequality will be. He asserts that this is the more natural condition of capitalism and leads to growing inequality.

Piketty sees wealth today as rising faster than income. In the 1970s, the ratio of wealth to income was about 250 percent; nowadays it is about 500 percent. Income has slowed down because of slower productivity growth and slow population growth. Wealth has grown because of relative peace and heavy capital gains.⁷

The inevitable consequence is that the wealthy become dominant. The wealthy set their own pay or the company boards pay very generously. Each company board, in hiring a new CEO, feels it must pay as much or more than the competitive companies pay their CEO, rather than using the firm’s earnings or share price or some other yardstick. In many sectors, especially in the financial sector, there is more collusion than real competition. The wealthy see their pay as describing their worth, and they rely on their wealth and political influence to defeat democratic measures to contain or tax them sufficiently. Democracy is therefore in danger of being destroyed by capitalism. Unless there is higher taxation on wealth and more regulation to promote real competition, democracy is subverted.⁸

HOW IS INCOME DISTRIBUTED?

Let’s look more closely at the vastly different levels of incomes and wealth in different countries. Measured in terms of median income (which is a better measure than average income), Australia leads with $220,000, followed by Luxembourg, Belgium, France, Italy, the U.K., and Japan. The United States falls way down the list on this measure, with a median wealth of just $45,000. The remaining countries trail all the way down to the poorest of the poor.

Oxfam is an international charity focused on fighting poverty and empowering impoverished individuals around the world. It released a 2014 report containing the startling fact that the richest eighty-five people in the world are worth more than the poorest 3.5 billion.⁹ “Our estimates suggest that the lower half of the global population possesses barely one percent of global wealth, while the richest 10 percent of adults own 86 percent of all wealth, and the top one percent account for 46 percent of the total,” the report states. This means that we are living today in a time of wealth distribution similar to that of the pharaohs of ancient Egypt or the royal court of Louis XIV before the French Revolution.

About one percent of the U.S. population has extremely high incomes and wealth. Let’s call these people the super-rich. This group consists largely of executives and managers; many come from the world of finance. In 2012, the average household in the bottom 90 percent of the income distribution earned about $30,997 while the average household in the top one percent earned $1,264,065 and for the top 0.1 percent about $6,373,782.¹⁰ In 2012, $16.7 billion were paid to the top forty hedge fund managers and traders, which was equivalent to the wages of 400,000 ordinary workers.¹¹ This contrast highlights the excessive pay of the few.

Below the super-rich are the affluent, who are about 5 percent of the population. They enjoy discretionary income well beyond that needed for basic food, clothing, and shelter. They can take expensive vacations, eat at expensive restaurants, send their children to expensive colleges, and invest in capital growth for personal wealth and trusts.

Below them is the middle class. Capitalism created the middle class! Earlier times consisted of only the rich and the working poor. The middle class enjoys stable jobs and pleasant homes and can eat out and buy the latest appliances. At the same time, they have to be careful in their expenditures. Usually their income requires two working parents who are finding it harder to send their children to expensive colleges and who want to save enough to support their aging parents and themselves in case they incur heavy medical expenses. They hope that their pensions and homes hold up in value.

The middle class is becoming a myth for many people ever since the Great Recession. There are former professionals who now stock grocery shelves and retired persons whose savings have nearly disappeared. The Pew Research Center says that the middle class has fallen from 53 percent to 44 percent of the U.S. population.¹² Studies show that upward mobility in the United States is decreasing and is lower than in Britain, France, and a number of other Western countries. Given the low quality of U.S. public education and the lessening affordability of higher education, it is becoming harder to get into the middle class. By the time young people go to school and have their ability judged, their path in life has been set by their family and the economic circumstances that they are born into.

Below the middle class is the working class, whose jobs enable them to earn just enough to meet their bills and have enough for basic food, clothing, and shelter. If married, both partners are already working. Many are single-parent or single-person households, and some earn only a minimum wage.

Below the working class are the poor, who would not get enough food and shelter if it weren’t for food stamps, the earned income tax credit (EITC), subsidized housing, and Medicaid. The U.S. Census Bureau reported that in 2012, 15 percent of Americans, or 46.5 million people, are poor. One in four American children are poor. Some argue that the poor of today are much better off than the poor of yesterday, because of Medicaid, unemployment insurance, food stamps, and other benefits. They probably have a TV set, running water, and a toilet in their home. Granting that “being poor” is a moving concept, it still doesn’t make up for the fact that so many poor go hungry, lack a regular doctor, and cannot afford higher education or to hire a lawyer if they need one.

The problem of inequality and social justice occurs when there is a great distance between the earnings of the poor and the working class and the affluent and the super-rich. Consider that the poor make up the largest population group in the world. Jeffrey Sachs estimates that 5 billion of the 7 billion people living on the earth today are poor.¹³ Something is wrong in human society or in human nature when 5 billion people don’t have adequate food, clothing, and shelter while 2 billion people enjoy an appropriate or even a plentiful life.

And what about the super-rich? The labor economist Sylvia Allegretto estimates that in 2007, the six Walton family members on the Forbes 400 had a net worth equal to the bottom 30 percent of all Americans—that is, the 100 million Americans at the bottom.¹⁴ These are six persons lucky enough to be born into the right family. They didn’t do anything to create their wealth. They are simply the beneficiaries of the brilliance of Sam Walton who founded Wal-Mart. Should Sam Walton have been taxed at a much higher rate to prevent this great wealth from accumulating? Would Sam have worked this hard at the higher tax rate? These are tough questions without simple answers.

Let’s look at some other interesting facts. Here is a list of the annual take-home pay of the top five U.S. CEOs in 2013, including salary, bonuses, stock, and stock options:¹⁵

1. Larry Ellison, Oracle	$78.4 million (or $37,692 an hour)16
2. Robert A. Iger, Walt Disney	$34.3 million
3. Rupert Murdoch, 21st Century Fox	$26.1 million
4. David M. Cote, Honeywell International	$25.4 million
5. David N. Farr, Emerson Electric	$25.3 million

The median pay going to CEOs is $10 million (aside from exceptions such as Tim Cook of Apple taking home $378 million in 2011). Michael Dorff attacked the whole system of high CEO pay. He says that during the period of the late 1940s to the late 1960s, CEOs were paid salaries. Then performance-related pay came into the system on the unproven argument that CEOs would work harder if they received performance pay. Dorff argues that pay for performance can lead to short-run planning and risky behavior. It has resulted in a dramatically increased proportion of profits going from the shareholders to the CEOs. Dorff advocates returning to straight salaries for CEOs.¹⁷

The pay to CEOs even pales compared to the pay received by the highest paid hedge fund managers. Here are the 2011 incomes of the three top hedge fund managers:¹⁸

1. Ray Dalio, Bridgewater Associates	$3.9 billion
2. Carl Icahn, Icahn Capital Management	$2.5 billion
3. James Simons, Renaissance Technologies	$2.1 billion

Paul Krugman has noted that the top twenty-five hedge fund general partners made a combined $21 billion in 2013.¹⁹ Doesn’t the hedge fund pay system require some correction?

Now let’s consider severance pay packages. General Electric’s Jack Welch received a $417 million farewell package from GE’s board upon retirement. William McGuire left UnitedHealth Group—in the midst of a stock option scandal—with a $286 million severance package. Are these severance pay packages right for the shareholders and workers?

Public companies are also generous in compensating their board directors. Many years ago, I received about $25,000 to attend individual board meetings, usually four a year. By 2013, the average annual total compensation per director (excluding the independent chairman) was $245,842, consisting of stock grants, option grants, cash fees, and other compensation).²⁰

Not every CEO is greedy. Several CEOs managing top companies are satisfied with receiving total annual compensation under $6 million: Edward S. Lampert of Sears ($4.6 million), A. G. Lafley of P&G ($2 million), and Steve Ballmer, formerly of Microsoft ($1.2 million).²¹ Given that these executives have the skills to manage huge companies, why are the other executives receiving such high pay?

One explanation for excessive CEO pay levels is an addiction to greed. These CEOs know they will never be hungry and they can acquire any material possessions they desire—personal airplanes, yachts, or several mansions. Sam Polk, who had accumulated a huge income, wrote how one day he regained his life by overcoming his wealth addiction. His manic drive for “more” no longer made any sense.²²

Let’s ask a simple hypothetical question. Suppose Larry Ellison, CEO of Oracle, suddenly feels overpaid with his yearly income of $78.4 million. He decides that he can live on $3.4 million and wants to give his Oracle employees higher pay so that they can pay down some debt on their credit cards, given that the average worker carried a credit card debt of $15,000 in 2012. Ellison decides to give a one-time gift of $10,000 to 7,500 of his employees to ease their credit card burden. Larry Ellison has made 7,500 families happier without sacrificing hardly anything in his own family’s lifestyle. But readers may ask alternatively why the excessive income is not distributed to shareholders as dividends. Did the Oracle shareholders overpay the CEO?

If companies paid less to the excessively paid CEOs, would that cause the companies to underperform? There are probably enough hardworking and able managers who would be motivated and satisfied to be paid 50 times the average wage versus 200 times the average.

People clearly have different attitudes about the rightness or wrongness of extremely large differences in income and wealth. Here are some commonly held opinions:

“I am only concerned with whether I have equal opportunity and not with income differences.”

“There will always be extreme differences in income. It is the survival of the fittest.”

“High incomes are mostly the result of differences in ability that lead to differences in income.”

“High incomes come from having the right parents. If you are born into a wealthy family, you will be brought up with more advantages and go to the right colleges and get excellent jobs, partly through your parents’ connections.”

“The super-rich have rigged the system to make us complacent by feeding us the ‘candy’ of television and other distractions so that we don’t notice their thievery.”

“From a social justice point of view, I think that the rich should be taxed proportionately higher than the average income earner.”

I can imagine one system of income distribution that would be worse than today’s. The worst would be if everyone was limited to getting the exact same income, regardless of age, family size, ability, effort, and other factors. There would be no incentive to work or to innovate. The system we have today of extreme income and wealth disparity has existed throughout most of history. Areas were run by a tribal leader or a king or queen who, along with close followers and courtiers, would amass great wealth. There was hardly a middle class. There was a peasant or working class, and most of the laborers were serfs or slaves living on a bare subsistence level.

But today, with not only newspapers and radio and television but also with Google and Facebook and YouTube and other digital media, more people are learning about the vast differences in the earnings of the median American household ($51,000) and the super-rich. For example, a New York Times article revealed that in 2012, the top one percent took more than one-fifth of the income earned by Americans. The top 10 percent took more than half of the country’s total income in 2012.²³ That kind of vast income disparity gets noticed.

The rich have raced far ahead. In 2012, the incomes of the top one percent rose nearly 20 percent compared with a one percent increase for the remaining 99 percent. The median income of households in the top 5 percent stands at $318,052. The income of these highest-earning Americans has recovered completely from a fall after the financial crisis, compared with the 8 percent decline for the median American household.²⁴ The share of the highest income earners is close to its highest level in a century.²⁵

DANGERS OF THE INEQUALITY

There is a growing concern about growing income inequality. Some level of income inequality is needed to propel growth. But most economists agree that high and growing income inequality will slow down the rate of economic growth. Those with low incomes often have poorer health and lower productivity. Growing income inequality frays social bonds and may lead to class conflict. The high level of youth unemployment can trigger social protests. Young people were a key force in the Arab Spring uprisings and the Occupy Wall Street protests. They see a shrinking economic pie and they receive a shrinking share of that pie. Widening income inequality raises deep questions about social justice and “class warfare.” President Obama has declared that inequality is “the defining challenge of our age.”

Income inequality is not only felt by the poor and the working class, but also by many members of the middle class. Many managers in the middle class wonder why top management has to be paid so much when they earn $100,000 or less. Some CEOs of smaller businesses who take home about $1 million to $5 million a year and have the skills to run much larger companies question the super payments of $10 million to $80 million a year to other executives.

Even when income inequality is excessively high, it can be reduced by redistribution payments. Economists use the Gini index as a measure of income inequality. The Gini index ranges from 0, representing perfect equality, to 100, where all income flows to one person. Germany’s Gini index before any redistribution is 55. But redistribution programs are strong in Germany and the Gini index for Germany falls to 30 after redistribution is taken into account. By contrast, the United States has a lower Gini index of 47 before redistribution. But the U.S. has a weaker redistribution push, reducing its Gini index to 37.

A study involving scholars from the Harvard Business School and Duke University asked Americans which country they would rather live in. They were shown the income distribution of country A and B (and were not told the countries were actually Sweden and the United States). About 90 percent of Americans preferred to live in a country with the Swedish post-redistribution income distribution!²⁶ Sweden uses redistribution to cut its Gini index from 45 to 22.²⁷ However, there is some evidence that too much redistribution may reduce growth. Some assert that Europe’s slow growth rate is due to its high social costs.

Pope Francis of the Roman Catholic Church has complained about “the tyranny of unfettered capitalism.” He said to the wealthy: “I ask you to ensure that humanity is served by wealth and not ruled by it.”²⁸ In his January 1, 2014, message, he said that huge salaries and bonuses are symptoms of an economy based on greed and inequality and called for nations to narrow the wealth gap. Others have wondered whether the increased financial risk taking of “Casino Capitalism” will lift the lives of ordinary people or only fill the coffers of the rich. We begin to suspect the growth mantra that says “a rising tide lifts all the boats.” We note the high dropout of workers from the labor force who have given up looking for work as if the earnings are too low to be worth the effort. The government doesn’t even count them anymore as being unemployed.

From an economics point of view, we can assert that the high concentration of income and wealth leads to a reduced level of consumer demand, thereby continuing the economic malaise. The working and middle class meet their needs by using credit cards to pile up more debt than they can repay, thus laying the conditions for an eventual boom and bust. With consumers lacking enough earnings, businesses are cautious and keep their production and employment at a low level.

The social fabric is further hurt because both parents have to work and give less time to their children. Money stress leads to divorce and the growing number of single-parent households. Working-class parents before 2008 were tempted to buy a home saddled with a substantial mortgage in the expectation that home value would increase. All this ended in a terrible bubble of falling home prices and foreclosures when some people simply walked away from their homes. This meant that their college-age children couldn’t go to college unless they took substantial student loans. Student loan debt has grown to over $1 trillion. We are finding that education and health care costs are growing at rates exceeding income and wealth growth for the working and middle class.

I would assert that the growing income disparity is not only a disaster for the poor, but also a threat to the rich. Poverty breeds broken families, crime and criminal organizations, beggars, prostitution, mass immigration, social protest movements, and failed states.²⁹ Go to certain cities in Latin America or South Africa where the high crime rates force the wealthy to live in gated communities or in walled homes or to even hire their own militias.

Too often the discussion is cast as a condemnation of either the “idle poor” or the “heartless rich.” But most workers are not the “idle poor” and most rich people are not the “heartless rich.” This is dealing in stereotypes rather than addressing the real issues.

One of the best indications that some wealthy people are becoming concerned about growing income inequality is the May 27, 2014, Inclusive Capitalism Conference held in London and attended by Bill Clinton, Prince Charles, Christine Lagarde, and other elite who control a third of the world’s wealth.³⁰ The aim of the conference was “to discuss the need for a more socially responsible form of capitalism that benefits everyone” and that is less likely to produce economic disasters like the Great Recession.

The elite do not want to face a global uprising of the disenfranchised against capitalism. Dominic Barton of McKinsey, addressing his elite conference peers, warned that “there is a growing concern that if the fundamental issues revealed in the crisis remain unaddressed and the system fails again, the social contract between the capitalist system and the citizenry may truly rupture, with unpredictable but severely damaging results.” In pondering solutions, the elite group wanted practical solutions. Barton hoped that the government would refrain from intervening with business in what he called “unproductive ways.” “I think that it is imperative for us to restore faith in capitalism and in free markets,” he said.³¹

The elite group did not want to see “increased regulation” and “greater state” involvement in the economy, nor did it seek punishment for responsible parties. In the end, this group decided to invest in a public relations campaign “to influence political and business opinion.”³²

This is a rather weak response to such a serious problem. The fact is that capitalism had failed to produce a “golden age” for the vast majority of the world’s population. The Inclusive Capitalism Conference came up with ideas such as more job training and more partnering with small and medium-size businesses. But those attending refused to consider a whole range of more basic solutions to reduce the growing differences in incomes and wealth.

POLICIES FOR REDUCING THE GREAT DIFFERENCES IN INCOMES

We need to acknowledge that much of the great disparity in income comes from globalization and technology and differences in education, none of which we can do much about except through changing government tax policy. Globalization means that companies will move production to countries with lower labor costs. Technology helps companies replace labor with capital when labor becomes too expensive. And educational differences go a long way to explain the great difference in earnings within a country.

Yet there are a number of measures that can be taken to reduce the great differences in incomes.

Raise the Minimum Wage

One solution is to raise workers’ pay through establishing a higher minimum wage. In the United States, there is growing pressure to raise the national minimum wage, which has stayed too long at $7.25. Thirteen states have already raised their state minimum wage above $7.25. The state of Washington set it at $9.32. The Democratic Party advocates raising the hourly minimum wage to $10.10 by 2016 and thereafter indexing the minimum wage to inflation. Germany and Britain have raised their minimum wage to $11.30 an hour. Denmark is at $20.30 an hour. In 2014, Switzerland, which does not have a statutory minimum wage, rejected a proposal to set the minimum wage at $25 an hour, which would have been the highest in the world. (Interestingly, 90 percent of Swiss workers already exceed that wage.)

In my opinion, the U.S. minimum wage is a disgrace. Yet those opposed to raising it cite two possible undesirable consequences. First, some small businesses, which hardly make a profit paying workers $7.25 an hour, are likely to close shop at a higher minimum wage. Second, employers will search for other ways to replace labor with capital. Both of these consequences may have the effect of reducing the number of jobs, but paying more to those who are still employed.

I’ll have more to say about raising the minimum wage in Chapter 3.

Make the Tax System More Progressive

We are living at a time when the extreme income gap is making daily headlines. The most important civil issue facing the nation may be middle-class stagnation and the growing number of poor people.

In 2014, the U.S. Congress chose not to renew unemployment benefits for another year to the long-term unemployed, even though the government hasn’t done enough to create jobs for these people. In addition, the food stamp program is being reduced, resulting in an average 7 percent decrease in benefits for about 45 million people. As a result, we hear of single mothers—who were once receiving unemployment benefits but no longer are—now learning that food stamps will be cut, so they will have to go to soup kitchens to feed their family.

It is not surprising that we hear new cries for increasing taxes on the rich. Bill de Blasio, New York City’s mayor, proposed taxing the “very wealthy” just a little more in order to be able to provide full-day, universal pre-K as well as after-school programs. “Those earning between $500,000 and $1 million . . . would see their taxes increase by an average of $973 a year. That’s less than three bucks a day—about the cost of a small soy latte at your local Starbucks.”³³

This leads to the larger idea of a progressive tax system that would establish higher tax rates for higher income brackets. The U.S. tax system is already progressive. Here are the tax rates in 2013:

Tax rate	Taxable income
10 percent	$0 to $17,850
15 percent	over $17,850 to $72,500
25 percent	over $72,500 to $146,400
28 percent	over $146,400 to $223,050
33 percent	over $223,050 to $398,350
35 percent	over $398,350 to $450,000
39.6 percent	over $450,000

The question can be raised: Is the maximum tax rate of 39.6 percent a high enough tax on the rich, given the growing level of income inequality?

Consider that in 1939, the U.S. top tax rate was 75 percent. It rose to 91 percent during WWII for incomes over $200,000, which was a high income at that time. In 1964, the highest tax rate was lowered to 70 percent. Starting in 1981, President Reagan managed to lower the maximum rate from 70 percent to 50 percent and subsequently down to 38.5 percent. (Reagan has been praised by the right as a tax-cutting president, but he actually raised taxes eleven times.) During President Clinton’s term (1993–2001), the top marginal rate was raised to 39.6 percent. Under President George W. Bush, the maximum tax rate was lowered to 35 percent. His deep tax cuts were scheduled to expire at the end of 2010, but they became permanent. Many people believe that the full Bush-era tax cuts were the single biggest contributor to the deficit in the subsequent decade, reducing revenues by about $1.8 trillion between 2002 and 2009. During the 2008–2011 fiscal cliff confrontation, the top tax rate was raised back to 39.6 percent.

Close Offshore Tax Havens

Profits earned by U.S. companies are subject to a 35 percent tax rate. Clearly, U.S. companies want to reduce their taxes if possible. There are three approaches they use to accomplish this.

The first is to set up a U.S. company subsidiary in Bermuda, the Cayman Islands, or Ireland. A U.S. company making a printing machine for $10,000 in Chicago might sell it to a Miami printing company for $12,000. It would have to pay a 35 percent tax on the $2,000 of profit—namely, $700. Instead, it could sell the printing machine to its own subsidiary in Bermuda for $10,000 at no profit. Then its Bermuda subsidiary can sell it to the Miami printing company for $12,000, making a $2,000 profit in Bermuda. But Bermuda doesn’t tax profits (or taxes substantially less than the U.S.). In this way, the U.S. government lost $700 in taxes on this transaction alone. It is estimated that 362 of the Fortune 500 companies operate tax haven subsidiaries. The U.S. government is losing a great amount of corporate tax revenue, requiring the American public to either pay higher taxes or face reduced social welfare, education, and health benefits.

The second tax avoidance scheme is called “inversion.” If an American company can show that some percentage of its shares are owned by another company abroad, it doesn’t have to pay U.S. taxes on this amount. For example, the Walgreens company might buy an Irish drugstore chain and pay for it by issuing more shares of its stock. Walgreens of Ireland would have to pay taxes to Ireland, but Ireland’s taxes are considerably lower than U.S. taxes.

The U.S. government needs to worry about a third possibility where a U.S. corporation starts thinking about moving its headquarters out of the country. The consulting firm Accenture began as a U.S. company, then moved to the Cayman Islands, went public in 2002, and then moved to Ireland because of its lower taxes.³⁴ Eaton Corporation moved its headquarters from Cleveland to Dublin, saving $160 million a year in taxes. So far, some sixty U.S. companies were “never here” or have been using inversion to avoid U.S. taxes. Not only do these companies substantially reduce their taxes, but in addition they are less burdened by the endless growth in U.S. government regulations that now cover 169,301 pages.³⁵

Gabriel Zucman, an economics professor at the London School of Economics and a protégé of Thomas Piketty, wrote a short book on tax evasion called The Missing Wealth of Nations. According to the New York Times, Zucman estimated that $7.6 trillion, or 8 percent of the world’s personal financial wealth, rests in tax havens as hidden money.³⁶ If this money could be taxed, more than $200 billion a year could be added to tax revenues.

Zucman went further and estimated that 20 percent of all U.S. corporate profits are shifted offshore, with the result that these corporations manage to pay a corporate tax rate of 15 percent rather than the officially correct rate of 35 percent. U.S. corporations have accumulated $1.95 trillion outside of the United States.³⁷ U.S. companies don’t pay U.S. taxes on profits earned abroad as long as that money remains abroad, often in Bermuda, Ireland, Luxembourg, the Netherlands, and Switzerland. In 2013, Apple earned $54.4 billion abroad, IBM $52.3 billion, and Microsoft $76.4 billion. Proposals have been made to either lower corporate taxes to 25 percent or less or to change the tax code to require that these profits be invested in U.S.-located banks.

Zucman recommended that the U.S. and other nations prepare a global registry of personal and corporate wealth (just like there is a global registry of real estate holdings) and force the banks to disclose their holdings. The United States passed the 2010 Foreign Account Tax Compliance Act to enable the Internal Revenue Service to put pressure on foreign banks to disclose accounts held by American residents and corporations. In 2012, the U.S. imposed a $1.9 billion fine on HSBC, a British bank, for poor controls on money laundering. Fines have also been set on Barclays, ING, and Standard Chartered.

In 2010, the Republican House, under the influence of the Tea Party, cut the U.S. Internal Revenue Service (IRS) budget by 14 percent, resulting in a sharply reduced staff, less tax law enforcement, and weaker taxpayer service. Whereas in 2010, the IRS was able to audit 30 percent of income tax returns, in 2013 it audited only 24 percent. This means that the government collected less revenue that could have been used to build roads, clean our air and water, improve our health care, and carry out other vital government tasks.³⁸

In summary, the U.S. maximum tax rate for a married couple was very high during WWII, then subsequently dropped from 70 percent to 50 percent to 38.5 percent to 35 percent before going back up to the current level of 39.6 percent. The Republicans consistently pushed for lower taxes, especially for the rich, on the theory that people need a strong incentive to work harder.

An entirely different tax philosophy operates in Scandinavian countries, where the maximum tax rate is 70 percent in Sweden and 72 percent in Denmark. The Scandinavian countries take care of their citizens’ education and health from birth to death. There is little chance of a medical calamity bankrupting a Scandinavian family and families don’t have to save as much for their future retirement.

In 2014, under President Francois Hollande, France established the highest marginal tax rate of 75 percent on individuals earning an income of over one million euros. The implication is that one million euros a year is a sufficient salary for any person and above that, the state should take 75 percent. Of course, this has led to outcries from the business community, and even France’s soccer teams have threatened to leave the country.

I would add two optional features that might increase the acceptance of this 75 percent level. As option one, the tax money collected could be put into a separate government fund to help improve the education of poor students. Or option two, the money could go into a nonprofit foundation that supports a variety of social causes, and each family can even specify which category of causes it wishes to support.

The International Monetary Fund (IMF) has now taken aim at income inequality. Christine Lagarde, head of the IMF, is factoring in income inequality when deciding on financing programs for member states. A 2014 IMF staff paper said that “income inequality can be of macroeconomic concern for country authorities, and the fund should accordingly seek to understand the macroeconomic effects of inequality.”³⁹

What would a higher tax rate on the rich do to their incentive to work and earn income? Conservatives warn that talented CEOs, financiers, athletes, and movie stars would work less and we would suffer from a lower level of talent and output in these sectors. They claim that if high earners work less and start fewer businesses, the number of jobs would decrease, unemployment would increase, and average incomes will fall. They add that needed philanthropy would decline and long-term investment in infrastructure would dry up. They rail against “class warfare” that would “make everyone poorer.” So why would we put any higher taxes on the rich than 39.6 percent?

Of course, there is no evidence to support this argument. When the U.S. government charged high marginal tax rates on the rich, we often had both high employment and high incomes. There were more periods of prosperity in the United States under the left-leaning Democratic Party than under the right-leaning Republican Party. We can’t assume all high-income earners behave and react in the same way. I remember meeting a CEO of a large cereal company who confided to me that he was having so much fun running the company that he would have gladly managed his company for $1 a year. Mayor Michael Bloomberg, who over a twelve-year period brought New York City to a high level of prosperity, insisted on taking only $1 a year salary because he had all the money he needed to be satisfied.

I believe that both corporate executives and entrepreneurs are motivated primarily by three things: power, independence, and creativity. I don’t believe that increases in the marginal tax rate would have a major downward impact on GDP, but that can be debated. Economic theory suggests one view on this subject. The law of diminishing returns says that further increments of income tend to produce diminishing returns or satisfaction. The law suggests that making an extra $10,000 will improve the well-being of a worker more than losing $10,000 would reduce the well-being of a millionaire. One study indicates that well-being increases as incomes approach $75,000 a year, but beyond that it does not consistently produce higher levels of personal happiness.⁴⁰ We can assume that it’s easier for a rich person to give up the last $10,000 than a poor person.

Raising the tax rate on the rich may be an almost impossible task when we consider that it would have to be passed by Congress. Politicians get into office by being able to raise money. A new Republican representative must raise $500,000 a year just to give to the Republican Party, aside from what he or she must raise to run his or her own campaign. Most of the money comes from those who are wealthy rather than from small contributions from the working and middle class. Politicians have little choice but to curry the rich and vote for what the wealthy want. And the wealthy, by and large, do not want to pay higher taxes.

Given that the rich are getting a growing share of the GDP, this means that less money is available for the poor and even the working class. This lack of purchasing power in the hands of the average citizen in turn slows down economic growth and leads to further immiseration of the poor. This is partly what led to Occupy Wall Street. The Occupy movement went from some seventy-five people demonstrating in a small Manhattan park to tens of thousands demonstrating in hundreds of cities in eighty countries, all in one month. We can expect more protest movements and political clashes in the future. In the past, these kinds of protesters were labeled “communists,” and the wealthy managed to have them hounded or imprisoned. I don’t see how substantially higher taxes on the rich can be passed politically without evoking another period of Red Scare and the Republican charge of the Democrats starting “class warfare.”

Cap the Ratio of Top Executive Pay to Worker Pay

In 2010, Congress passed a rule requiring public companies to disclose the ratio of the CEO pay to the median compensation at the company. The objective was to help shareholders compare pay practices across companies. President Obama offered a specific proposal for holding down the high pay of executives. He held that executive pay should be related to the minimum federal wage.

At the time, his own $400,000 salary was twenty-seven times the minimum federal wage of $7.25. If the minimum wage rose to $10.10, his salary would be twenty times the minimum wage. He suggested that companies that do business with the federal government should not have their top executives paid in excess of 20 to 1, as the ratio of executive-to-worker compensation. This would mean the government would stop doing business with Oracle (1,284 to 1), General Electric (491 to 1), and AT&T (339 to 1). Although this proposal would be currently impractical, it captures the seed of an idea for limiting excessively high pay in the federal and private sector.⁴¹ The state of Rhode Island is considering not buying from companies that pay their executives more than thirty-two times the lowest-paid worker.

Another idea would be to let companies pay whatever they want to pay their CEOs—but then tax corporations 50 percent to 70 percent on take-home pay in excess of a given ratio of CEO pay to median workers’ pay.

The European Commission is actively encouraging member countries to consider pay-cap policies. Each public company is advised to take into account the ratio of top executive pay to average employee earnings. Companies should consider the impact of high executive pay on the long-run sustainability of the company. The EU is considering banning banker bonuses of more than twice the level of fixed pay, especially after seeing the hefty bonuses given by some of the major European banks.⁴²

Plug the Tax Loopholes

There are many tax loopholes and deductions that collectively are worth more than $1 trillion and are largely benefiting the rich. Tax loopholes are not illegal, but they present a clear advantage to rich Americans without offering any offsetting advantages to poor Americans. These loopholes, along with the deregulation of Wall Street, made the rich richer and made the Great Recession inevitable. They also resulted in multibillions lost to the government that might otherwise have helped reduce the huge U.S. annual deficit. Ralph Nader, America’s leading consumerist critic, holds that he would like to see all income from wages, dividends, capital gains, and rents taxed at the same rate to eliminate loopholes. Here are three major tax loopholes.⁴³

1. Capital Gains Tax Rate. People who invest in securities for more than one year and then sell the securities were formerly taxed at 15 percent rather than at their normal income tax rate. The capital gains tax rate was raised to 20 percent plus another 3.8 percent temporary (or 23.8 percent). The purpose of this tax law is to encourage investors to stay in securities they believe in rather than switch their stock holdings frequently. The problem is that most wealthy people basically put their money into securities that they hold for over a year; therefore their effective tax rate on capital gains is 20 percent to 23.8 percent. This contrasts to wage earners who are taxed on their income anywhere up to 35 percent. It came out during Mitt Romney’s run for president in 2012 that he had earned $13.7 million in 2011 but his tax rate was only 14.1 percent of his income. Financier Warren Buffett said that he was embarrassed to pay only a 15 percent tax on his income, a rate substantially lower than his secretary’s tax rate on her income.⁴⁴ Buffett has advocated for a higher tax rate on top income earners who benefit from paying taxes at a lower rate on capital investments than regular earnings. This loophole is estimated to have cost the U.S. Treasury $457 billion between 2011 and 2015.
      There is also an effort to end capital gains treatment for “carried interest.” Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds. This method of compensation seeks to motivate the general partner (i.e., fund manager) to work toward improving the fund’s performance. Traditionally, the amount of carried interest comes to around 20 percent of the fund’s annual profit. While all funds tend to have a small management fee, the fee is meant to only cover the costs of managing the fund, with the exception of compensating the fund manager. Carried interest is meant to serve as the primary source of income for the general partner.⁴⁵
      The criticism is that putting a capital gains tax of only 15 percent or 20 percent on carried interest is another example of a preferential treatment of income tax mostly going to the very rich. The general partner of a hedge fund should pay an ordinary tax on this income because it is a reward for his labor in managing the fund, not for his capital.
2. Home Mortgage Interest Deduction. Anyone buying a home with a mortgage is allowed to deduct the mortgage interest payment from his tax bill. The purpose of this deduction is to encourage more home ownership on the notion that people owning homes (instead of renting) will be more rooted in their communities and care more for their communities. (Note that most other industrialized nations do not offer this deduction and people still buy homes.) This loophole is estimated to have cost the U.S. Treasury $464 billion between 2011 and 2015. It amounts to non-homeowners (i.e., renters) subsidizing homeowners. A homeowner with an income exceeding $200,000 gets an annual tax benefit of more than $2,200. He gets another mortgage tax benefit if he owns a second home, which primarily benefits wealthy people, who are the most likely to own another home. Furthermore, most of these high-income homes are in California and the Northeast, thereby giving a benefit that is geographically disproportionate.
3. Tax on Foreign Earnings by U.S. Companies. Companies that operate globally are able to avoid a tax on foreign income as long as they do not bring the income into the United States. In 2013, the nation’s top 1,000 companies reported $2.1 trillion in such earnings.⁴⁶ Companies such as Apple, GE, Pfizer, Merck, and others keep their money in offshore tax havens. If they brought this money into the U.S., the effective tax rate would be 35 percent. By not bringing it into the U.S., their stockholders are receiving no benefit from this money in dividends, nor is the company able to use this income to buy back its stock. Apple, for example, is (ironically) even considering raising money by issuing bonds to get the cash to pay higher dividends to its stockholders or buy back Apple stock. Meanwhile, the U.S. Treasury forgoes taxes on Apple’s foreign income. One would think that the government should lower the tax rate on foreign-held corporate income to 10 or 20 percent if it would bring back much of this money to invest in the United States.
      The problem may be getting even worse. Some U.S. companies are thinking of reincorporating in another country where the corporate tax rate is lower. For example, Pfizer—the largest pharmaceutical firm in the United States—is considering buying AstraZeneca, another Big Pharma firm, and reincorporating the combined company in the United Kingdom. This move is called “inversion”: Fifty U.S. companies have used inversion to avoid paying U.S. taxes in the past thirty years, and twenty of them have done so in the past two years. The U.S. is acting to prevent this loophole, especially for U.S. companies whose revenue is more than 80 percent in the U.S.⁴⁷

Improve Transfer Payment Programs

Transfer payments represent money given by the government to its citizens. Examples include certain kinds of tax credits, Social Security, unemployment compensation, welfare, and disability payments. Here are two areas in which transfer payments could be made more equitable:

• Strengthen the earned income tax credit. The U.S. runs a large cash-transfer program to help the poor, which cost $61 billion in 2010. It provides up to $3,305 a year to low-income working families with one child and up to $6,143 for those with three or more children. The program has not been extended to help childless people who have very low incomes. Broadening the tax credit might make it possible to do away with food stamps and a miscellaneous set of other props aimed at providing a decent living for all.
• Apply a stronger “means test” before making transfer payments. I remember a wealthy person complaining about receiving a Social Security check for $3,500 each month. Although he is legally entitled to it because of his long history of putting money into the Social Security fund, he says that he shouldn’t be getting it. Federal transfer payments should not go to people who have a good income or substantial wealth. Too many people who are unemployed claim and receive disability benefits who are not actually disabled. Social Security payments should be subject to a means test.

POLICIES FOR REDUCING THE GREAT DIFFERENCES IN WEALTH

We need to address a separate problem—namely, the great differences in wealth distribution, not just income distribution. The top one percent of income earners take home 25 percent of the total income in a year. But the wealthiest one percent of households holds 40 percent of the nation’s wealth.⁴⁸ The wealthiest 10 percent of households holds 70 percent of the nation’s wealth. Forbes reported there were 1,211 billionaires in 2011, a 20 percent increase from 982 in 2010. By investing this wealth, the super-rich further increase the highly skewed distribution of wealth.

According to the 2014 report of the Russell Sage Foundation, the median household wealth in America has substantially fallen in recent years.⁴⁹ Household wealth consists of the value of one’s home, savings, and stocks and bonds, less debt of the median household in the U.S. The wealth of the median household in 2003 was $87,992, then rose in 2007 to $98,872, then fell in 2009 to $70,801, and in 2013 fell to $56,335. One can see how a major illness can easily wipe out the $56,335 wealth of a median American household.

Why is the high concentration of wealth a problem? Essentially it goes against the grain of a democratic society. In a democratic society, each qualified person should have one vote. But today, wealthy families have a disproportionate influence on the voting outcome. The super-rich behave more like oligarchs because of their ability to influence public policy. Are we living in a democracy or are we living in a plutocracy?

Recognize further that most of today’s wealthiest people are wealthy by inheritance, not by contribution. Yet they are able to supply conservative candidates with a great amount of money for their election campaigns. The Huffington Post reported that billionaire Charles Koch pledged to give $40 million to unseat Barack Obama in the 2012 presidential election, while his brother David Koch pledged $20 million.⁵⁰

The Supreme Court decided in the Citizens United case that a corporation could be called a “person” and, under “free speech” protection, create or give substantial sums of money to new nonprofit organizations to spread conservative views. Wealthy families and wealthy corporations, by giving heavy donations to conservative candidates, have a much greater voice in influencing who become our legislators and how they will vote. Working-class families lack the money to personally influence elections and can rely only on their shrinking unions to exercise some counter influence. The bottom line is that great extremes of income and wealth can diminish or destroy the power of the people to vote for the best candidates.

What can be done to reduce the great concentration of wealth? First, we have to put heavier taxes on the passage of estates to their heirs. Today, the estate of a super-rich person is exempt from a tax on the first $5 million given to each heir. The tax rate on the rest of the estate is 55 percent. This rate can be raised even higher to reduce the concentration of wealth. Warren Buffett sagely observed that “a very rich person should be able to leave his kids enough to do anything but not enough to do nothing.” This captures the spirit of what amount of money should be passed on to one’s heirs.

The excessive compensation plans set up by companies for their senior executives is another area for reform. Buffett has been on the right side of this issue, but he flip-flopped when it came to Coca-Cola’s executive compensation plan. Buffett owns over 9 percent of Coca-Cola’s shares and is the largest investor. Another Coca-Cola shareholder charged that “the company expects that the 2014 plan will award a mix of 60 percent options, 40 percent full value shares, resulting in the issuance of 340 million Coca-Cola shares” that would transfer around $13 billion from shareholders to management. This shareholder saw this as an “outrageous grab.”⁵¹

In the past, Buffett has come out against excessive executive compensation. At a 2009 meeting, for example, Buffett stated that he hoped institutional investors would “speak out on the most egregious cases.”⁵² However, in this case, Buffet decided to abstain from voting against Coca-Cola’s new compensation plan because he didn’t want to discourage the company’s senior management, for whom he had great respect. This in spite of the fact that Buffett once said that stock options amount to giving away “free lottery tickets” and should be minimized.⁵³ Many people were disappointed that Buffett didn’t have the courage to carry out his convictions.

Huge bonuses paid to top executives also skew the unequal concentration of wealth. These bonuses are often wildly out of balance with the actual contribution of the top executives to the company’s profits. However, a few CEOs have declined the bonuses that they were entitled to. Virginia Rometty, CEO of IBM, was to collect a bonus of $8 million based on the company’s performance and decided to turn it down. Barclays CEO, Antony Jenkins, turned down his bonus of $2.8 million for the second year in a row, saying, “It would not be right” to accept it. Similarly, Stephen Hester of the Royal Bank of Scotland turned down his annual performance bonuses.⁵⁴ These people could be said to have a reasonable sense of what’s fair and proportionate.

Despite having so much in the way of advantages to help them boost their fortunes, many of the wealthy are bitter about proposals for higher taxes. Billionaire investor Tom Perkins of the venture capital firm Kleiner Perkins Caufield & Byers lamented public criticism of the “one percent” and compared it to the Nazi attacks on the Jews. Stephen Schwarzman of the Blackstone Group said that eliminating tax loopholes was “like when Hitler invaded Poland in 1939.” These plutocrats react with a mix of paranoia and megalomania rather than thinking deeply about the problem that excessive wealth poses for the overall economy.⁵⁵ They are also outrageously out of line in their metaphors.

There is a whole industry involved in helping the super-wealthy hold on to their wealth beyond the last living member and even down to their grandchildren’s grandchildren. South Dakota has pioneered “dynasty trusts” to help rich families escape estate taxes forever. In January 2013, Congress allowed families to set up a trust of $5 million that would have iron-clad secrecy. Lawyers have invented more complicated strategies to protect much larger fortunes.⁵⁶

This again raises the question of whether higher estate taxes will lead to more avoidance and also cause talented people to work less hard or threaten to leave the country. I would argue that there are a great many talented civic-minded people waiting to move up the wealth ladder and take their place. The major issue, of course, is who would receive the redistributed wealth? Will it ultimately be used by government to increase wages and jobs? Or will it go into more defense spending and more bureaucracies?

We also need to look at other wealth sources and whether they need some trimming. For example, the country may be too generous in its subsidies to those who search for oil. Exxon Mobil took home a net income of $30 billion in 2012. Boards of directors might be too generous in the compensation packages that they set up for CEOs for take-home pay. Not long ago, the average CEO’s take-home pay was twenty to forty times that of the average worker’s income. Today, the average CEO may take home 300 times the pay of the average worker in his/her company. If the top guy gets that much, consider then what has to be paid to the company’s vice presidents? This means that the expense of managing a major American company is top heavy in relation to its foreign competitors. For example, a Japanese CEO’s take-home pay is more on the order 100 times the average worker’s, rather than 300 times as in the United States.

Is there any realistic way to cap wealth accumulation? French economist Thomas Piketty holds that wealth inequity keeps growing because in this period “the rate of return on capital . . . is higher than the economy’s growth rate.”⁵⁷ He sees income from capital continuing to exceed income from wages and salaries as a worldwide phenomena. His preferred solution is “a global tax on wealth combined with higher rates of tax on the largest incomes.” Wealth or capital would include real assets: land, houses, natural resources, office buildings, factories, machines, software, patents, stocks, and bonds. Households would have to declare their net worth to the tax authorities and pay a levy of one percent (for households with a net worth of between $1 million and $5 million) and 2 percent (for those worth more than $5 million). Piketty adds that even a steeper progressive tax of 5 percent to 10 percent on wealth above one billion euros would help break up such fortunes. In the United States, this would mean that the 16,000 people (the top hundredth of one percent) who have a combined net worth of $6 trillion would pay substantial taxes, and the money would hopefully be used to improve the education and health of the U.S. population.

Piketty recognizes problems with his intriguing proposal. First, the wealthy would scream that it would reduce incentives and innovation. (Piketty doesn’t believe that innovation will be hurt.) Second, this proposal would never be proposed, nor passed, because politicians are too dependent on the wealthy for their reelection. Third, the wealthy would transfer their wealth to other countries where this wealth tax did not exist. (They wouldn’t transfer it to Spain, which has a wealth tax of 2.5 percent of assets.) All countries would have to pass such a wealth tax, which is clearly a utopian idea. Piketty is realistic, but offers his proposal as a standard against which to judge other proposals for curbing the growth of wealth inequity.

World Bank economist Branko Milanovic said of Piketty’s Capital in the Twenty-First Century: “We are in the presence of one of the watershed books in economic thinking.” Paul Krugman has said that it “will be the most important economics book of the year—and maybe of the decade.”⁵⁸ Krugman thinks that Piketty’s book has the potential of creating a monumental change in public attitudes toward growing income inequality.⁵⁹ The publicity that the book is receiving is making people aware that all great wealth is not the result of meritocracy, where great wealth is earned and deserved. Much of the income of the wealthy is not coming to them on the claim that they are “job creators.” Much of their income is coming from the assets they own or their inheritance.

Piketty’s book is now worrying the rich because they have not been able to tear down its premises. They rely on name-calling by claiming it is “Marxist” or “collectivist” or “Stalinistic.” The rich are on the run politically and will use their money to confuse the public as much as possible regarding the real issues. One unsolved mystery is how it can be that so many Americans who are poor, working class, or even middle class identify their interests with the political party whose whole basis is to defend the interests of the super-rich.

The real challenge is to convince the super-rich that paying higher taxes would benefit them as well as the general public. Arguments can be used that roads and infrastructure will be improved, workers will have more money to spend on the businesses owned by the rich, and the public will think that the tax system is fairer and be willing to comply more readily. If the government can demonstrate that its operations are efficient and that their tax money is going to the right causes, people will be more willing to pay their fair share of taxes. In the end, is it better to move toward a budget calling for preserving tax loopholes, cutting taxes, and reducing investments in education, health, and infrastructure or to develop a system that raises more money through a fair and efficient tax system and uses the money to improve the lives of people?

*   *   *

Clearly, a whole set of interesting solutions exists to reduce the sharp differences between the earnings of the super-rich and the other groups—solutions that are not likely to damage incentives or productivity. The problem is not one of sound economics. It is the way politics interferes with economics and allows the rich and their publicists to confuse average citizens as to what lies in their true interests and in the country’s long-term interest.

Let’s return to our initial question about whether capitalism is intrinsically destined to produce little for the poor and extreme incomes and wealth for the few. This may well be the tendency of free market or unregulated capitalism. But if so, capitalism could contain the seeds of its own destruction. Why? Capitalism depends on consumers having enough money to buy the goods and services that the capitalist economic machine produces. Without rising real income in the pockets of the majority of the citizens, the result is overstocks of goods, slowdowns in investment and production, and a rising unemployment rate. The amount of joblessness may reach a point of inspiring an uprising and attack on not only the wealthy, but on capitalism itself.

Ultimately, capitalism will be judged on the degree to which it improves the lives of all its citizens. A good place to start would be with a fairer tax regime on wealth.