Solicitous investing will help close rich/poor gap

Peter Lyons asks if income inequality is actually an economic problem.

The fabled 1%ers are gaining notoriety for much that is wrong with our economic system. 

It is suggested their gains in wealth and income in recent decades have been at the expense of their fellow citizens. They defend themselves as wealth creators, unfairly attacked in difficult times due to the politics of envy.

Economics as a social science should seek to answer two fundamental questions about the rising income inequalities in developed economies over the past few decades. The questions are, why has this occurred, and are these inequalities beneficial or harmful to societies?

Economic theory states that in a competitive market a person's pay should be closely linked to the value of their output. If a CEO is paid $5 million per annum, then his or her decisions should be generating at least this return for the business. The same theory applies to all workers. A rational employer in a competitive market would be foolish to employ an additional worker unless their contribution exceeded their wage.

Keeping this theory in mind, it is worth examining the multitude of reasons for rising income inequalities. A key factor has been the effects of globalisation.

The removal of many trade barriers for goods and services has tended to push down the wages of less skilled workers forced to compete with massive cheap labour pools in countries such as China and India. This is particularly obvious in large-scale manufacturing industries.

The net result of this process is that workers with unique skills or qualifications are able to command increased income premiums compared with those in low-skill occupations.

There have also been specific factors that have benefited those at the very top of the income tree.

Top executives' salaries have been supplemented with stock options and bonuses in attempts to align their interests with those of shareholders. The outcomes have been dubious and mixed to say the least. Some executives have played this system by manipulating share prices though dodgy accounting practices and netting themselves huge sums on their options in the process. There is also widespread suspicion that top-tier executives and directors have created a self-perpetuating and reinforcing system of spiralling rewards. The interests of top management are not always those of shareholders, yet the power of shareholders to do anything about this is sometimes too widely dispersed to restrain management greed.

More importantly, there has been the deregulation and globalisation of financial markets. The incomes of the winners in this brave new world have become turbo-charged. The waves of mergers, acquisitions, privatisations, leveraged buy-outs and private equity deals have all been made possible by financial deregulation. The incomes generated by these activities are enormous. Annual rich lists provide concrete evidence that the fastest road to extreme riches is through finance rather than the production of actual goods and services. Western societies seem to have forgotten the teachings of Adam Smith, that it is the production of actual goods and services which is the driver of economic prosperity for a nation.

The 1%ers have also pulled away from the rest because their incomes are largely based on capital returns rather than labour. They are owners of property, shares and securities which generate capital gains, which allows further investments to generate further gains. New Zealand does not tax incomes generated by capital gains.

Compounding the trend has been the reduction in progressive income-tax rates in many countries. The rationale behind this has been that higher tax rates act as a disincentive for top-income earners to work, save and invest, leading to a loss of efficiency.

So do income inequalities matter for a society's overall welfare?

Former prime minister Jim Bolger once famously said rising income inequality was a good thing because it showed our capitalist system was working. In a capitalist system, people respond to incentives in the form of higher pay or more profits leading to more output and higher living standards.

Historical evidence shows that countries which have adopted versions of capitalism based on property rights and free markets have generally achieved far higher living standards than traditional agrarian or socialist economies.

But large income inequalities can also act as a drag on economic progress. The current economic malaise is symptomatic of this. It is caused by a lack of effective demand in many Western economies. According to economic theory, income that is not spent is saved and used for investment in productive capacity to grow the economy.

But when large income inequalities occur, this process can become distorted because the demand for goods and services is so unevenly spread in a society. It was mass consumer demand that unleashed the golden years of capitalism in the 19th and 20th centuries. When high-income earners seek to put their savings into assets rather financing new production, asset prices such as shares and property become distorted, leading to periodic asset bubbles and crashes. These episodes have multiplied over the past 20 years from the 1997 Asian crisis to the tech wreck of the late 1990s to the recent global financial meltdown.

Income inequalities are a necessary prerequisite and outcome of a free-market economy. When these inequalities become excessive, this creates social disharmony and tensions. Large income inequalities can also create economic damage by distorting demand and investment patterns in an economy.

• Peter Lyons teaches economics at St Peter's College in Epsom and has written several economics texts.