In other words, globalization and the rise of the infotech industry, combined with the sticky economy, and no doubt with other important but perhaps more local changes, created a world of good and bad firms, which in turn contributed to an increase in inequality. In this view, what happened may have been unfortunate, but it probably could not have been stopped.
SOMETHING IS NOT ROTTEN IN THE STATE OF DENMARK
But the winner-take-all explanation for the rise in inequality cannot be the whole story either.
The reason is that, like skill-biased technological progress, the explanation ought to apply to Denmark just as much as the United States. But it does not. Denmark is a capitalist country where the share of income going to the top 1 percent was more than 20 percent in the 1920s, just like in the United States. But when it went down it stayed low, and now hovers around 5 percent.44 Denmark is a small country but it has a number of large and well-known companies, including the shipping giant Maersk; Bang & Olufsen, maker of beautiful consumer electronics products; and the Tuborg Brewery. But its top incomes never went sky high. The same is true of many very different countries in Western Europe and also of Japan.45 What’s different between these countries and the United States?
A part of the answer is finance. The US and UK dominate the “high end” of finance—the investment banks, junk bonds, hedge funds, mortgage-backed securities, private equity, quants, etc.—and this is where many of the astronomical earnings have shown up in recent years. Two finance professors at Harvard Business School (of all places) estimate that investors who use financial market intermediaries pay 1.3 percent of their total investment to their fund manager every year, which over the thirty-year horizon of an investor saving for retirement amounts to handing the manager a third of the assets initially invested.46 A chunk of change, but nothing compared to those who manage the hedge funds, private equity funds, and venture capital funds that epitomize high-end finance, where, at least until recently, you had to pay the managers between 3 percent and 5 percent of the amount invested every year. Given that the amount invested is growing steadily, it is no wonder some of these managers are becoming very, very rich.
Financial sector employees are now paid 50–60 percent more than other workers with comparable skills. This was not true in the 1950s, 1960s, or 1970s.47 This rise in earnings is a big piece of the overall shift in top incomes. In the UK, which is the most finance-dominated large economy, between 1998 and 2007, employees in the financial sector, who represented only about one-fifth of those in the top 1 percent, swallowed 60 percent of the rise in earnings in this group.48 In the United States, from 1979 to 2005, the share of top incomes going to finance professionals almost doubled.49 In France, where finance still mostly means banking and insurance, the change in inequality was much smaller in absolute terms. Between 1996 and 2007, the share of national income going to the richest one-tenth of one percent of the population went up from 1.2 percent to 2 percent (it then went down during the financial crisis, but had recovered partly by 201450), but about half of that increase, it is estimated, is due to increasing earnings in finance.51
The superstar narrative does not fit finance very well. Finance is not a team sport. It is an industry marked, supposedly, by individual geniuses, people who can spot the particular irrationalities currently infecting the markets or identify the next Google or Facebook before anybody else. But it is hard to see how that explains why an ordinary manager in the financial sector is nonetheless paid extraordinary fees, year after year. In fact, most years, actively managed funds do not do any better than “passive funds” that simply replicate the stock market index. In fact, the average US mutual funds underperform the US stock market52—they seem to have borrowed the language of individual talent but not the talent itself. A large part of the premiums paid to financial sector employees are almost surely pure rents; that is, rewards not for talent or hard work but for nothing more than having lucked out in landing that particular job.53
These rents, much like the rents from government jobs in poor countries discussed in chapter 5, distort the entire functioning of the labor market. As the 2008 global crisis unfolded, caused in large part by a combination of irresponsibility and incompetence on the part of the masters of finance, a study reported that 28 percent of Harvard college graduates of recent cohorts opted for jobs in finance.54 That ratio was 6 percent in 1969 and 1973.55 The reason to be concerned about this is that if some job pays a premium unrelated to its usefulness, like the fund managers earning a fat fee for doing nothing, or the many talented MIT engineers and scientists hired to write software that allows stock trading at millisecond frequencies, then talented people are lost to firms that might do something more socially useful. Faster trading may be profitable because it allows the trader to react more quickly to new information, but given that the reaction time is already seconds or less, it seems implausible that it improves the allocation of resources in the economy in any meaningful way. And hiring the brightest of the bright may be an effective tool for a financial firm to market itself, but if the firm does nothing useful those talents are lost to the world. Maybe in a saner world they would have been writing the next great symphony or curing pancreatic cancer.
There is another problem. The salaries and bonuses of CEOs of the larger corporations are set by board of directors compensation committees, and these committees use the salaries of CEOs at comparable firms as a benchmark. This creates a contagion; if one company (say, in finance) starts to pay its CEO more, others not necessarily in finance feel they have to as well, to keep getting the best. Their CEOs feel undervalued compared to CEOs they play golf with. Consultants who help the CEOs compile a list of what happens in “comparable” firms are very skilled at selecting a sample of particularly high salaries; the high finance salaries tend to infect the rest of the economy as well. The practice of using salary comparisons to negotiate increased compensation has spread far beyond the largest firms, and even beyond the for-profit sector.
This is not helped by the fact that CEOs, everywhere and not just in finance, try very hard to pack boards of directors with people they feel they can control (or people who are only interested in getting paid their director’s fees). The result is that CEOs are often rewarded for pure luck; when the stock market valuation of the firm goes up, even if it is due to pure chance (e.g., world crude oil prices went up, the exchange rate moved in the firm’s favor), their salary increases. The one exception, which in some ways proves the rule, is that CEOs of companies where there is a single large shareholder who sits on the board (and is vigilant because it is his own money on the line) get paid significantly less for luck than for genuinely productive management.56
Stock options probably contributed to the skyrocketing CEO salaries, by normalizing the idea that CEO pay was directly linked to shareholder value and nothing else. In addition, linking managerial pay to the stock market meant that managers’ pay was no longer linked to a salary scale within the enterprise. When everyone was on the same scale, CEOs had to grow salaries at the bottom to increase their own. With stock options, they had no reason to increase wages at the bottom, and in fact every reason to squeeze costs. Paternalism, once a feature of the large corporations that demanded loyalty but took care of their own, is now restricted to elite workers in software companies, and is expressed in the form of free food and dry cleaning in exchange for long hours.
One solution to the puzzle posed by Denmark might be that finance is much more dominant in the UK and the US than in continental Europe,57 and perhaps a more attractive option for those countries’ elite graduates. Relatedly, stock options (and stock market–linked compensation more generally) are much more likely to get used in the Anglo-Saxon world, where more people are familiar with the stock market and where most reasonable-sized companies are traded.
TOP TAX RATES AND CULTURAL CHANGE
Low taxes probably played a role as well, as argued by Thomas Piketty. When tax rates on the very top income are 70 per
cent or more, firms are more likely to decide that paying stratospheric wages is a waste of their money and cut back the top salaries. With these tax rates, the board faces a stark trade-off: at a 70 percent marginal tax rate, a dollar in salary is only thirty cents in the pocket for the manager, versus a whole dollar for the firm. It makes salary less valuable for the CEO, and it becomes cheaper for the board to pay the CEO in other “currencies,” such as allowing him to pursue his dream projects. This might not always be what the shareholders want (they want higher profits, not size per se)—economists in the 1960s and 1970s were concerned with empire-building by managers—but could be better for the workers, or the world. For example, the CEO could prioritize growing the firm, being popular with the workers, or pursuing some new product because it is good for the world, even if it is not the best for share value. The shareholders may tolerate this to keep their CEO happy. It might even be part of the reason why workers’ salaries were rising when top tax rates were high.
So the point of the very high top tax rates of the 1950s and 1960s, which applied only to extremely high incomes, was not so much to “soak the rich” as to eliminate them. Almost nobody ended up paying the top rates, because those very high incomes had all but disappeared.58 When the top tax rates went down to 30 percent, ultra-high salaries became attractive again.
In other words, high top tax rates may actually lead to a reduction not just in inequality after taxes, but also in inequality before taxes. This is important because, as already discussed, a large part of the reason for the divergence in inequality between Europe and the United States in recent decades comes from pre-tax inequality. And some evidence hints at the possibility that the decline in top tax rates may have something to do with it: at the country level, there is a strong correlation between the size in the cuts in top tax rates between 1970 and today, and the increase in inequality. Germany, Sweden, Spain, Denmark, and Switzerland, where top marginal tax rates stayed high, did not experience sharp increases in top income shares. In contrast, the United States, Ireland, Canada, the UK, Norway, and Portugal cut the top tax rates significantly and experienced large increases in top income shares.59
However, beyond tax rates, in the United States it is also likely there was a cultural change that created a social environment in which high salaries were acceptable. After all, how did people in finance manage to convince their shareholders and the world they could be paid that much for their services, if we are correct that they are mostly earning rents?
In our view, beyond the tax cuts, the narrative of incentives that underpinned the Reagan-Thatcher revolution convinced a substantial fraction of the non-rich (and most of the rich who had any doubts about it) that those sky-high salaries were legitimate. Low taxes were a symptom of it, but the ideological shift was even deeper. The rich could go ahead and pay themselves more money than they could ever spend, without raising any hackles, as long as they had “earned” this money. Many economists, with their unconditional love for incentives, played a key role in spreading and legitimizing this narrative. As we saw, many economists remain in favor of high CEO pay today even though they are not opposed to higher taxation across the board. The narrative has spread: even today, while many in the US and the UK clearly resent their own economic situation, they tend to blame immigration and trade liberalization rather than the increasing vacuuming of resources toward the very rich.
Was the basic presumption, that high take-home salaries were essential to encourage the most productive people to do their best and create prosperity for the rest of us, correct? What do we know about the effect of taxes on the effort of the rich?
A TALE OF TWO FOOTBALLS
Europe is a more equal society than the United States, with much lower inequality in pre-tax income, a higher tax burden, and highly progressive taxation. There is one interesting exception to that: payments to top athletes. Major League Baseball in the United States implements a luxury tax, wherein teams are fined if their combined payroll exceeds some amount. A team that goes over the luxury tax threshold for the first time in a five-year period pays a penalty of 22.5 percent of the amount they were over the threshold, and the maximum fine for repeat offenders is 50 percent of the excess. Most other major sports leagues in the United States (the NFL, the NBA, Major League Soccer, etc.) have salary caps. The maximum that could be paid in total for a team in the NBA in 2018 was $177 million. Not a trifle, but in 2018 the Argentine soccer player Lionel Messi was paid a yearly total of $84 million by his club, Barcelona, way above what would be possible in the US.
Salary caps in professional sports are hardly the product of some Nordic idealism. Clearly, the main rationale of the salary caps is to control costs. It is what a cartel of team owners does to limit how much of the proceeds go to players and, by implication, increase the amount that goes to them. But it has the virtue, and this is the stated reason for the caps, that it ensures some degree of equity between the teams, making the season much more interesting to watch. Unlimited money creates too much inequality, with the result that within a league only a few teams ever have a real chance of winning. In Europe, where Major League Soccer does not have salary caps, some teams (such as Manchester City, Manchester United, Liverpool, Arsenal, and Chelsea in England) spend vastly more than others and enjoy an uncontested domination. So much so that in 2016 the odds against the team of Leicester winning the Premier League championship was five thousand to one, lower than the probability of spotting Elvis alive. Bookmakers lost a combined 25 million pounds when the team, to everyone’s surprise, actually won.
There is plenty of opposition to the salary cap in the United States. A Forbes article described it as “Un-American,” arguing that “based on the capitalist system, spending money on employees (and that’s what athletes are in professional sports) should be based on performance and not encumbered by system.”60 Players naturally hate it, resent it as deeply unfair, and have staged multiple strikes to oppose it. Interestingly, the one argument no one makes is that players would play harder if only they were paid a little (or a lot) more. Everybody agrees that the drive to be the best is sufficient.
WINNING ISN’T EVERYTHING61
What is true of professional athletes seems to be true of rich people in general.
The question of taxes on rich people took center stage in the political discourse in the United States at the end of 2018. With Alexandria Ocasio-Cortez’s proposal of a top marginal income tax above 70 percent and Elizabeth Warren’s call to establish a progressive wealth tax, tax policy became one of the core issues at stake for the 2020 presidential election.
Given the longstanding importance of income taxation as a policy issue, it is no surprise there are many studies that look at whether people stop working when their income taxes increase. The authoritative review of the literature by Emmanuel Saez and his colleagues concludes that real work effort does not respond to top tax rates, although effort to evade or avoid taxes does.62 For example, the Reagan tax cut of 1986 led to a large onetime increase in personal taxable income, which faded quickly. This suggests the increase in taxable income was mainly people bringing their previously hidden incomes into the (now friendlier) tax net rather than an increase in earnings and hence effort. In countries where there are no easy loopholes because taxes apply to all income (with no differential treatment for investment income, labor income, or “fees for being a real estate agent”), taxable income (and therefore the underlying real effort) is insensitive to taxation.
This should make sense. For top athletes, as Vince Lombardi is reputed to have said, “Winning isn’t everything, it’s the only thing.” They are not going to do less than their best because the tax rate just went up. The same probably goes for top CEOs and aspiring top CEOs.
What about the idea that the best firms want the best managers and are willing to pay top dollar for them? Would they be able to do that if taxes were high? The answer is yes. The argument that the best CEO will go wherever he makes the most money works no
differently when the government takes 70 percent of the money. The highest-paid job is still the highest-paid job, as long as the tax rate is the same in all firms.
However, high top marginal tax rates may also reduce the lure of the most lucrative, but not necessarily the most socially useful, professions, such as finance. Without the attraction of huge take-home pay, aspiring top managers may prefer to go where they will be the most productive, not where they will make the most money. A silver lining of the 2008 crisis is that it reduced the appeal of the financial sector for the brightest minds; a study of career choices of MIT graduates found those who graduated in 2009 were 45 percent less likely to choose finance than those who graduated between 2006 and 2008.63 This may lead to a better allocation of talent, and to the extent finance’s salary levels infect every other sector, it could further reduce income inequality.
All in all, therefore, it seems to us that high marginal income tax rates, applied only to very high incomes, are a perfectly sensible way to limit the explosion of top income inequality. They would not be extortionary, since very few people will end up paying them; top managers will simply not get these kinds of income anymore. And from all we see, they won’t discourage anybody to work as hard as they can. To the extent they affect people’s choice of career, it will likely be in a positive direction. This is not to deny the importance of structural economic changes, which have made it increasingly difficult for those with low education to succeed, generating an increase in inequality even within the remaining 99 percent.64 Addressing this issue will call for other complementary approaches. But we might as well begin by eliminating the ur-super-rich (which really means, in case you feel sorry for them, turning them to merely super rich).
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