Where's the hand up to replace the handout? Photographer: Justin Sullivan/Getty Images
Where's the hand up to replace the handout? Photographer: Justin Sullivan/Getty Images

Our political discourse today is riven by the issue of inequality. Some commentators embrace inequality as an inevitable byproduct of free markets. Others say inequality is greatly overstated. Both claims are harmful and deceptive.

Defenders of inequality begin with an incontrovertible fact: Free markets rely on inequality. It inspires those who have less to work harder. But this doesn't explain why inequality was much lower a generation ago. In 1979, chief executive officer pay was 29 times higher than the typical worker's; in 2011, it was 231 times higher. Nor does it tell us how much inequality is enough.

As measured by two leading researchers, Thomas Piketty and Emmanuel Saez, inequality has grown when examining tax-return data. Tax returns are useful when looking at changes at the highest-income levels because the Census Bureau, the only other good data source, treats everyone over a certain figure (currently $250,000) as earning the threshold amount.

Piketty and Saez tell us that average incomes (in constant dollar terms) increased 15 percent over the 33 years to 2011. The minimum income required to join the 1-percent club increased 62 percent over that period. And the average income of the 1-percent club increased 129 percent.

“The market made me do it” isn't a complete response to these facts. So the question really is: What defense can be mounted, not to inequality in general, but to current levels of inequality?

N. Gregory Mankiw, a well-known economist and the author of popular economics textbooks, took on this challenge. In his paper, "Defending the One Percent," Mankiw doesn't dispute the surge in inequality. Instead, he explains it as a consequence of globalization and rising demand for highly educated and exceptionally talented individuals in the digital economy.

Mankiw offers the example of the late Steve Jobs of Apple Inc., who created tremendous value for customers and shareholders -- and became very rich in the process. There is certainly a grain of truth in this. The trouble is that there are more than 1.5 million Americans in the top 1 percent -- too many for this explanation to be convincing. Most are finance types, lawyers, doctors, and second- and third-tier business executives, not Steve Jobs clones. By definition, all the CEOs of the Fortune 500 put together are only 500 strong. What are the other 1.4995 million doing?

If technology and globalization explain the surge in U.S. inequality, one would expect to see similar rates of inequality growth elsewhere. Instead, one sees much more modulated growth.

A more complete explanation would include “rent seeking” -- a topic Mankiw dismisses too quickly. The idea is that people look for shortcuts to wealth or power by advancing their interests through whatever levers are available to them, but without creating new economic value.

Imagine you are the CEO of a company seeking a new tax benefit for your kiwi farm, on the theory (or pretext, take your pick) that such an incentive will stimulate U.S. kiwi farmers to employ more workers. You hire a tax lobbyist and head for meetings with members of Congress. Money is never discussed when you plead your case, but the lobbyist explains what is expected from you and your company's political action committee.

Finally the lobbyist calls you to announce with great fanfare that he has secured your tax break -- but only for two years. After all, the lobbyist explains, the tax break is expensive, and people want to see if your promises about job creation come to fruition. Two years later, you must start the process again, this time seeking an “extender” -- the periodic rollover of “temporary” tax breaks that in fact are never expected to die.

Everyone in this story is engaging in rent seeking, but at least you were a transparent and faithful agent of shareholders. The lobbyist and lawmakers who became your champions are the real masters of rent-seeking, and you will have to pay them both, not once but every couple years as your tax break comes up for renewal. They have created annuities for themselves out of your single tax break. Perhaps this sheds some light on how the tax code came to be littered with more than 100 such business tax “extenders.”

In reality, almost everyone engages in rent seeking. Joseph Stiglitz’s book, "The Price of Inequality," argues that rent seeking explains the surge of top incomes in the U.S. Much of what went on in the finance industry in the early 2000s was rent seeking, and even Mankiw acknowledges some of this. But Mankiw rejects rent seeking more generally as an explanation. He does so by defining it very narrowly, as political lobbying for monopoly rights and the like.

Inequality defenders like Mankiw also ignore the role of sheer luck in market outcomes, and of family money in determining success. However obtained, wealth can profitably be plowed into investments in one’s children. A moderately able child can be coached, prodded, cajoled and bribed all the way into a top tier university, then introduced to her affluent parents’ circle of friends in order to find a first job.

It is now apparent that vast fortunes can also buy special relationships and privileges with government, which further act to turn today’s great fortunes into dynasties.

By the same token, Mankiw also overlooks the magnitude of the handicaps that poverty imposes. The poor are not just like us, only with less stuff. At every turn, poverty erodes cognitive ability, the physical and mental development that comes from adequate nutrition, and equality of educational opportunity.

Defenders of the status quo have no answer to why the U.S. is an outlier in the rate at which income inequality has grown. There is something about the U.S. that is unique, and it's not its markets, which are largely indistinguishable from those of other countries. No, it's the comparatively parsimonious investments the U.S. makes in its citizens.

Americans simply do not have equal opportunities. This is more than an ethical or social issue: Underinvestment in human capital leads to lower productivity, which is to say, lower national income. Comparative data show that the U.S. offers less social and economic mobility than do many of its peer countries -- a startling rebuke to the mythology of America as the land of opportunity.

(This is the first of two excerpts from "We Are Better Than This: How Government Should Spend Our Money," which will be published Oct. 1 by Oxford University Press.)

To contact the writer of this article: Edward D. Kleinbard at ekleinbard@law.usc.edu.

To contact the editor responsible for this article: Paula Dwyer at pdwyer11@bloomberg.net