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Why is the 'wealth gap' a bad thing?

The growing gap between rich and poor in the U.S. has  Michael in California wondering just why wealth inequality is a bad thing.  The Answer Desk, by John W. Schoen.
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With the holidays just around the corner, it's a good time of year to think about those who are less fortunate than you are. The growing gap between rich and poor is on Michael's mind in California. But he's wondering just why wealth inequality is a bad thing. David in Wisconsin, meanwhile, is wondering what he can do to increase the national savings rate.

There's a lot of press about the gap between rich and poor. It generally seems to be presented as a bad thing. Why is that? If the rich people earned (or inherited) their money honestly, where's the harm? I would think that a society without rich people would be in real trouble because it means no one is rising. Is the idea that the rich took the money from the poor? I can't see how that would hold today.
Michael, Davis, Calif.

It’s certainly true that without a profit motive, the rational thing to do would be to sit at home all day and play video games — or whatever other pursuit you might choose if you never had to worry about paying the bills. And history shows that government efforts to try to equalize wealth or manage economies usually backfire.

Inequality of wealth, by itself, isn’t new. In the past few decades, there’s evidence that the gap in some countries is widening – including the U.S. But super-rich folks like Forbes 400 billionaires and greedy corporate executives are hardly a recent phenomenon.

A hundred years ago, the wealth gap between the richest robber baron and the poorest farmer was wider than the current spread between a $100-million-a-year CEO and the worst-paid worker. And if you factor in modern health care, “conveniences” like cars, TVs and cellphones, the average American today probably enjoys a standard of living on a par with some of the richest Americans a century ago. So a widening income gap and wealth inequity doesn’t seem to have hurt progress.

The issue isn’t whether money is a potent incentive for keeping us all busy trying to buy or build a bigger house or inventing the next cool electronic device. The question is whether the playing field is level. Equality of opportunity isn’t just a matter of fairness. No society can expect to thrive if it doesn’t fully tap the talent and ability of its entire workforce — including those who happen to be born poor.

Economists talk about “human capital” like any other input to their economic models. In theory, free markets will allocate that human capital to the best use by rewarding best work that the market values the most highly.

But, like all other markets, the labor market is not truly free. For starters, much depends on where you happen to be born: Your chances of finding a high-paying job in Los Angeles are a lot better than they are in Lagos. That’s why so many people from other countries want to come to the U.S. And while it may have been possible to speak of self-contained, homogeneous “American society” a hundred years ago, a rapidly shrinking world is making that much harder to do.

Even for those of us lucky enough to be born into the wealthiest country in the world, the market for our labor isn’t truly free. Educational opportunity — one of the biggest determinants of future income — flows disproportionately to those born to families who can afford it. (Recent budget cuts draining $12 billion in federal financial aid haven’t helped change that.)  Wages for women remain lower, on average, than those for men who perform the same work. Tall people make more than short people. (You get the idea.)

We also live in a society where the wealthiest seem to have better luck tipping the playing field in their favor. Wealth generates access to those who make the rules; those rules can be written to further generate more wealth for the wealthy. (For examples of how this works, just open any page of the U.S. tax code.) Unless and until there are real changes in our current system of government — not just the party in power — anyone is free to lobby for (read: buy) laws that work to their advantage without doing anything “dishonest.”

But to take full advantage of the power of money to motivate, those who aspire to wealth need the encouragement of knowing that their honest efforts will be rewarded. If you’re convinced the game is rigged, you’re less likely to try out for the team.

It should also go without saying (but these days apparently it needs to be said) that there will always be a government role for some form of “wealth transfer” to help the most vulnerable in any society — especially those who, through no fault of their own, can’t maintain a decent standard of living. (For further reading, see the Book of Deuteronomy.) A partial list would include orphans, the elderly and infirmed and victims of natural disasters. It would be wonderful if this need could be filled entirely by private, voluntary acts of charity. But the job is just too big.  

As for the value to society of inherited wealth, that case is even harder to make. There are certainly family businesses that have thrived across generations; a few are occasionally derailed by inheritance taxes — or at least the failure to plan for them. For many, the desire to build a financial legacy is a potent incentive to amass wealth.

But for the recipient, unearned wealth is not a great work incentive. Billionaire Warren Buffett put it succinctly when asked why he opposes eliminating inheritance taxes. Doing so, he said, would be like "choosing the 2020 Olympic team by picking the eldest sons of the gold-medal winners in the 2000 Olympics."

I regularly read that the savings rate for Americans is zero or less. My question is,  when I make a mortgage payment, is the principle portion of my payment considered savings? What if I send in extra?
-- David, Delafield, Wis.

Ironically, paying off your mortgage faster than you're supposed to would probably lower the savings rate — at least the way it’s computed by the Bureau of Economic Analysis in their National Income and Product Accounts data, which is where the widely quoted “savings rate” comes from.

There's no question we could all use a little more savings — especially those nearing retirement who have waited way too long to get started. But the "official" saving rate doesn't tell you much about how much all of us are really saving.

That’s because these numbers simply take your income, subtract what you spend and then look at what’s left over. If there’s nothing left, you’ve got no savings. Spending on housing (whether rent or mortgage payments) is a considered a cost, so it shows up on the wrong side of the ledger.

And if you socked away a little money in a stock and it went up, that increase isn’t called savings either. Neither is the increased equity in your home — the biggest single “savings account” for most Americans.

Then there’s the thorny problem concerning the treatment of pension contributions by employers. Because these payments are are counted as income when the BEA calculates the "savings rate", your pension shows up in the savings numbers long before you can get your hands on it. More to the point, as defined-benefit pensions (the kind that pay a monthly check you get when you retire) go the way of the 30-year retirement gold watch, billions of dollars that were once counted as “savings” no longer show up in the statistics.

And you don't have to blow your weekly paycheck on a flat panel TV to shoot a hole in the "official" savings rate. College expenses — a form of spending that could better be defined as “investment” — is counted as spending, not saving. So the ongoing surge in the cost of higher education is also taking a bite out of the savings rate.

That’s why most economists don’t bother with the savings rate and look instead at changes in household net worth. That measure treats investments as savings and fully accounts for the impact of consumer debt. In the “official” savings rate, for example, only your monthly credit card payments are counted. So if you only make minimum payments, the statistics make you look richer than you are.

When you look at these broader measures of savings, the outlook is much more promising. A 2002 paper, using data from the BEA and the Federal Reserve, compared the narrow definition with a more comprehensive measure of personal savings that includes savings in pension accounts and capital gains on stocks. The narrow measure showed the rate declining to less than 5 percent in the 1990s. But the wider measure showed a savings rate of 25 percent for the decade.

For further reading, see “Spendthrift Nation” from the Federal Reserve Bank of San Francisco, published Nov. 10, 2005.