American democracy is under strain.
Public disenchantment with democracy as a system of government has grown consistently in recent decades, with Gallup surveys showing a large decline of confidence in democratic institutions. The number of Americans having confidence in citizens to make good judgments “under our democratic system” is at a historic low of 56 percent. An alarming 40 percent of the population has “lost faith” in U.S. democracy, according to a poll published in the Washington Post last year. The levels of frustration reflected in these surveys — all pre-Trump administration — reveal the preconditions for dark political developments. The imperative to understand their causes could not be greater.
Two economic phenomena deserve particular attention for anyone considering the sources of this discontent with democracy. One of them is generating unhappiness among middle- and lower-income citizens, while the other contributes to grievances at the top end. The misconceptions of economists have played a key role in each of these phenomena, and a continuation of these flawed assumptions driving public policy is set to lead to further strain on the political system. Let me explain.
The first misconception relates to the blind spot that economists have regarding competition. That blind spot is itself the result of one of the foundational assumptions of modern economics, the Pareto principle, which holds that if a government policy improves the spending power of one group, we should assume zero impairment to other groups providing their absolute position does not go backward.
Economists accept the zero-impairment assumption because they think in terms of goods and services such as furniture, food, and haircuts: If the spending power of one group is increased, this doesn’t impair the ability of others to compete for these goods — producers can simply increase supply. (Indeed, economists sometimes cite the consumption of these assets to argue that concerns about rising inequality are irrational.)
The logical flaw in this theory is that there is a range of other critically important assets, ignored by economists, of which the supply is limited. For these assets in limited supply, spending power is bidding power, meaning that higher inequality diminishes the ability of less wealthy people to compete for them.
Some Critical Assets Are in Limited Supply and out of Reach
The first of these assets is a simple but critical one: marriage partners. In our Darwinian world, there is intense competition to find the best biological mate, and financial resources are a key means of winning that competition. If we increase the spending power of higher earners and their children, this diminishes the ability of those with less wealth to secure the most desirable marriage partners. Matt Ridley, a noted author of several books on evolutionary biology, puts it neatly:
Among hunter-gatherers, even the tiniest inequality translated into more babies on average. The man who killed the most game, or killed the most enemies, got the most sexual opportunities. That’s the startlingly simple calculus that we still walk around with in the back of our heads. . . . And it is still true today: even in an age of working women, sexual continence, and gender equality, the man with the most money still gets more sexual opportunities than the man with the least money. Ask them. So no wonder we dislike inequality.
Inequality has increased in most developed countries during recent decades, and it is notable that over the same time people have been increasingly marrying partners from similar economic backgrounds. The Organization for Economic Co-operation and Development’s examination of marriage trends over recent decades has found a declining number of people mating outside their economic strata in almost every developed country, including the United States. “Increasingly,” the OECD says, “people are married to spouses with similar earnings levels, a process known as assortative mating.”
Another critical asset with limited supply is real estate. The disproportionate increase in the spending power of higher-wealth people over recent decades has enhanced the ability of those people and their offspring to compete for the most desirable real estate, while the ability of those below them to bid for that real estate has been diminished. Princeton University researchers have found that in recent decades the concentration of high-income families in affluent areas has risen significantly, alongside an increasing concentration of poor families in low-income areas. “Rising inequality in the economic sphere,” the researchers concluded, “was accompanied by growing separation in the spatial realm, as households increasingly sorted themselves by income and wealth within America’s urban geography.”
Over a period of decades, the cumulative effect of the widening gap in bidding power has been an increased social rigidity.
A third such asset is occupation ranking. Having extra spending power increases the chances that high earners and their children will secure the top positions in virtually every occupation, from property developer to restaurateur. Policies may expand the number of desirable positions, of course, but in securing the most desirable of those positions it remains the case that a greater spending power means an enhanced competitiveness against others. Research from economists at the United States Federal Reserve and the Department of the Treasury found that positional stagnation has significantly increased over recent decades, with high earners occupying the best jobs for longer, while those below remain longer in less desirable positions.
The combined effects of these assets obviously have profound impacts on people’s life opportunities, impacts that are in turn passed down to subsequent generations. Economists have long been baffled by concerns about rising inequality — “they have more TVs than ever!” — but as we consider the loss of bidding power for such elemental assets as mates, territory, and occupations, this frustration is entirely predictable. People with relatively less wealth have lost the ability to compete for things that matter.
It is clear that one of the unintended consequences of government policies that disproportionately lifted the spending power of higher-income citizens has been to enhance their ability to shield themselves and their children from competition for these critical assets. Over a period of decades, the cumulative effect of the widening gap in bidding power has been an increased social rigidity. The eminent political scientist Charles Murray has found in America today “the formation of classes that are different in kind and in their degree of separation from anything that the nation has ever known.” With a diminished bidding power, it is unsurprising that many of those on lower incomes feel that “the system is rigged” and that “the American dream is dead.”
If American economic policymakers continue to introduce policies that move the United States toward hyper-inequality, the consequences of the continued loss of bidding power for non-wealthy families will be predictable and increasingly severe. Step by step, we will see a further impairment of competitiveness, greater social stratification, and an even deeper frustration with the political system. Economists in this situation, wedded to the Pareto assumption of zero-impairment, might ultimately find themselves the unwitting drivers of democratic disorder.
Growing Inequality Makes the Wealthy Feel Aggrieved, Too
Now that we have explained a key source of the political malaise afflicting non-wealthy people, let us turn to the frustrations of higher-wealth people, because they constitute the other side of the vise squeezing the institutions of democracy.
One of the under-appreciated aspects of public disenchantment with democracy globally over recent decades has been the rise of support for authoritarianism among higher-wealth people. The most recent World Values Survey shows that for the first time higher-earning people in almost every region are now more likely to support authoritarianism than are low- and middle-income earners, including in the United States, where support has nearly doubled since 1995 to 34 percent.
The key source of the growing frustration of wealthy people is obviously not their financial standing, which is higher than it’s ever been. It is their sense that they are carrying more than their share of the tax burden. Underpinning this complaint is a “tax-share argument” constructed by economists, which relies on income-tax statistics showing an increasingly large proportion of tax being drawn from high earners and a correspondingly lower proportion from those below.
Some wealthy Americans have come to feel that they are the only real contributors to society while others are effectively parasites on the system.
Harvard professor Gregory Mankiw, author of the most popular economics textbooks in the United States, has used tax and expenditure statistics to claim that a majority of Americans are now net “takers” because they receive more from the government than they give. “The middle class,” writes Mankiw, “having long been a net contributor to the funding of government, is now a net recipient of government largess.” Mitt Romney, who employed Mankiw as an economic adviser, drew on tax-share statistics when he made his dismissive remark that almost half of Americans — 47 percent — lacked a sense of personal responsibility.
There are numerous flaws in such analyses, but the chief logical error in using tax shares to demonstrate “unfairness” is that they ignore underlying structural trends in inequality. What has happened is that over recent decades across the globe high earners have enjoyed a disproportionate lift in incomes, and as a result the proportion of the total tax burden paid by high earners has also risen. The greater tax share doesn’t demonstrate a greater virtue of high earners compared with their parents’ generation; it’s just a reflection of much higher gross incomes. The pertinent point is that the after-tax incomes of higher earners are higher than ever before, making their claims of victimhood illogical.
Notwithstanding the flaws in using the share of income taxes paid as a measure of relative virtue, the sense of grievance among higher-income earners is real and widespread. An unsavory rhetoric has emerged from the tax-share argument, dividing society into makers and takers, and many high earners have used that rhetoric to argue for higher taxes on low and middle earners. Some high earners, from venture capitalists to political figures, have gone further and suggested that the voting rights of lower-wealth people be diminished in some way.
The consequence of economists’ providing legitimacy to these grievances among higher-wealth people is serious: Some wealthy Americans have come to feel that they are the only real contributors to society while others are effectively parasites on the system. We know from history that labeling groups as lesser citizens can develop into policies that treat them as such. Where a country’s elite feels cheated and unhappy, the pressure will build to move to a system that better protects their interests.
Less Inequality Means Enduring Prosperity
Once we understand the causes of increasing frustration at both the top and bottom of the economic ladder, the deeply destabilizing political consequences of widening economic gaps become clearer. Where underlying inequality expands we can see the development of increasingly intense grievances at both ends of the spectrum: Those at the bottom feeling less and less competitive in important areas, while those at the top feel increasingly resentful about the proportion of tax coming from them and insist that those below start paying more. If the bidding-power gap grows wide enough it is possible to imagine the system crumbling through a combination of frustration, illiberal measures, populist demagoguery, repression, and stagnation — the sorts of cycles that Latin American countries, with the highest inequality levels in the world, go through regularly.
So what should policymakers do?
The good news is that the orthodox formula for economic success — smaller government, conservative budgeting, competitive markets, reduced regulation, flexible labor markets — remains intact. We simply need to correct the two erroneous assumptions identified above: Renounce the Pareto principle of zero-impairment, and end the assumption that an increased tax share demonstrates that people are worse off.
Repairing these two errors allows for a more sensible evaluation of policy that avoids the extremes of obsessing about inequality and believing that it can never be of legitimate interest. It remains a simple fact that governments will sometimes need to introduce policies that entail greater inequality. What’s most important is that prior to pronouncing policy proposals that widen inequality “efficient,” lawmakers and economists need to take into account the pros and cons of those proposals.
American policymakers might take note of the common-sense philosophy of former Australian prime minister John Howard. Howard was a great supporter of free enterprise, but he regularly noted the deep benefits of a lesser level of inequality in fostering enduring prosperity. “Our social cohesion . . . is arguably the crowning achievement of the Australian experience over the past century,” he once said in a major speech. “Yet this cohesion will be tested if wealth and opportunity can’t be fairly and broadly distributed across society as in the past.” With American politics fraying at the seams, it is not unreasonable to ask policymakers and economists to reexamine some of their foundational assumptions. It would be a shame, after all, to lose democracy for a couple of intellectual misconceptions.
— David Alexander is the federal managing director at Barton Deakin. He previously served as a senior adviser in the government of Australian prime minister John Howard.