James Galbraith Tells Us What Everyone Needs to Know About Inequality

By Polly Cleveland

Inequality has surged in the U.S. over the last forty years; many observers now blame the deregulation and tax cuts for the rich starting with the presidency of Ronald Reagan in 1980. In his new short book, Inequality: What Everyone Needs to Know, James Galbraith explains how this happened through the change in U.S industrial structure:

“In the early postwar period, the dominant American industrial corporation–such as General Motors, General Electric, American Telephone & Telegraph, International Business Machines–was an integrated behemoth that contained within itself not only production, but every phase of basic research, product design, and marketing that was relevant to its mission. Therefore incomes were distributed within the corporation by administrative decisions, governed by the bureaucratic imperatives and prerogatives of those in charge, and strongly responsive to the incentives of a highly progressive income tax structure. Top scientists and engineers, as well as top executives, were paid salaries, and salaries were regulated by the corporation. Tax structures also gave strong incentives for the corporation to retain profits, rather than pay them out as dividends, and to reinvest the proceeds–whether in factories or in the palatial towers that grew up in Manhattan, San Francisco, and Chicago in those years.

All of this changed with the tax “reform” movements of the 1970s and 1980s, which pushed for lower top marginal tax rates, fewer special exemptions from the tax, and for a “shareholder-value” model of corporate compensation. And a special feature of this change was that it created strong incentives to restructure the corporation itself.

“In particular, as the digital revolution came into view, the top technologists in the big corporations realized that they would be far better off if they set off on their own, incorporated themselves as independent technology firms, and then sold their output back to the companies for which they had formerly worked in salaried jobs.…

The effect of this structural transformation on the distribution of household incomes in the United States, as recorded in the tax records, is astonishing. For there were created, mainly in the 1990s, a handful of citadels of stratospheric incomes, previously unknown in the country and concentrated in the tiny handful of locations. One of these was Manhattan, the home of Wall Street and the source of finance. A second was Silicon Valley, a cluster of counties in Northern California. And the third was Seattle, Washington, and its near suburbs.”

Galbraith is describing the same phenomenon that Barry Lynn documented at length in his chilling 2010 exposé: Cornered: The New Monopoly Capitalism and the Economics of Destruction. That is, the transformation from vertically integrated firms to horizontally-integrated monopolistic trading companies, buying inputs from all over the world, squeezing both their suppliers and their customers. But Galbraith adds a new insight: not only did the postwar high-tax regime induce corporations to keep executive pay in check, it also induced them to retain profits and reinvest them in the corporation. With the 1980’s “greed is good” transformation, rates of reinvestment slowed as executives started taking more for themselves—surely helping slow the overall rate of growth.

Wait a moment! High taxes on income and profit produced more investment and growth? That’s the exact opposite of today’s Republican, and often Democratic, mantra that high taxes kill investment and growth. But the postwar taxes that tamed the corporate behemoths were in fact high marginal rates, top rates in a steeply progressive system. These were the very taxes imposed at the beginning of World War II to prevent war profiteering. These were taxes designed to capture the “unearned income” or “economic rent” of powerful corporations and wealthy individuals. It was perfectly logical for such corporations and individuals to “avoid” such taxes by investing money they would otherwise lose.

If high marginal income and profit taxes are so beneficial, is there any prospect—given the political will— of returning to such tax levels? Unfortunately, now that so many multinational corporations and wealthy individuals are registered or domiciled in tax haven countries, any simple effort to impose truly high marginal rates on profits or income will simply lead to more creative evasions, corruption (see Panama), and tax wars.

But, assuming the political will, are there other approaches? Galbraith proposes:

A much older and yet, to this day, still more promising alternative to taxing financial wealth is to tax land value, including the value of mineral and energy resources in the ground. The economic concept behind this idea is that of Ricardian rent–the argument that rents (which are inherently unproductive) flow to the owners of the fixed and non-reproducible asset, namely land. By taxing land and minerals, one reaches the least defensible forms of accumulated wealth, while at the same time doing the least to distort market decisions as between capital investment and hiring of labor. And there is another advantage: unlike financial wealth, land stays put. It exists in fixed jurisdictions with registered ownership; all the taxing authorities need to do is to send an appraiser, and then a bill. Local property taxes already work this way; however, in the United States landowner opposition to land taxes has been fierce, and many states are barred by their constitutions from levying property tax on a statewide basis. In California, notoriously, even local property taxes were capped in the late 1970s by a ballot measure strongly supported by wealthy landholding interests.

Land taxation has been for a century the program of the followers of the 19th century American economist Henry George, whose influence was vast around the world a century ago. One of his followers was the Chinese revolutionary Sun Yat-Sen, founder of the Republic of China in 1911. And Maoist China, by conducting an early war against landlords, ended up having the world economy most like the Georgist program in the modern age. But instead of taxing land value, the Chinese state actually owns it, and collects the land rent for itself. By doing this, Chinese municipalities and provinces have enjoyed ample revenue from which to make capital improvements, which is why Chinese cities have been able to grow like weeds in the reform era…

To this I would add that land taxes weren’t new in China: they financed Chinese empires as early as 2000 BC. Stiff land taxes of four shillings to the pound of assessed value financed the transformation of British finance in 1688; Adam Smith deemed them “the most equitable of all taxes.” Taxes on high profits and incomes and on land values all capture unearned income, or rents, forcing taxpayers to invest productively to pay the tax.

Piketty’s Model of Inequality and Growth in Historical Context, Pt 1

The first economic model: François Quesnay’s Tableau Économique

In Thomas Piketty’s doomsday model, slowing of growth in the twenty-first century will cause an inexorable increase in inequality. Piketty is not the first to propose a grand model of inequality and growth. To get some perspective on his model, let’s see what the “classical” economists had to say (Part I), and how the “neoclassical” economists responded (Part II).

Part 1. The Classical Economists on Inequality and Growth

The first generation of “classical” economists, notably Francois Quesnay (1694-1774) in France and Adam Smith (1723-1790) in England, knew perfectly well where inequality came from. It was simply a fact of life that most land and other natural resources belonged to a small hereditary nobility. In England, some 2% of the population owned most of the land. This nobility, or their ancestors, gained their estates by force, favoritism, or fraud: that is, conquest, gifts from the king, or bribes to magistrates.

The classical economists recognized that landowners, large and small, received unearned income for the mere fact of holding titles protected by the state. They called this unearned income “rent”. Besides the landowners, these economists identified two other social classes: capitalists who received profit by investing or interest by lending, and workers who received wages. (Of course they recognized that the classes overlapped; successful capitalists soon bought land or married their daughters to landowners.)

Smith, witness to the English industrial revolution, proposed the first coherent theory of economic growth. At the start of his Wealth of Nations (1776), he explains how production increases dramatically when workers cooperate and specialize. This can happen both within an enterprise—he gives an example of a “pin factory”—and through market exchange. Hence both increase in population density and improved trade—greater “extent of the market” as Smith puts it—will generate economic growth. That’s why Smith, like Quesnay, advocated free trade, both domestic and international. They opposed government-granted monopolies, such as exclusive trading privileges given to the British East India Company. They also advocated shifting taxes off of activities such as transport and sale of merchandise and onto rent, by taxing land values—what Smith termed the “most equitable” of taxes.

Smith observed that growth was already improving workers’ living standards, as well as undermining the elite landholders. So in his view, growth reduced inequality.

The next generation of classical economists brought new and more dramatic perspectives to growth and inequality.

Thomas Malthus (1776-1834) claimed that workers’ wages would forever remain at “subsistence” due to their alleged propensity to breed faster than food production could increase. Any efforts to feed or otherwise assist the poor were actually counter-productive; the poor would just breed faster. By this logic, growth increased inequality, because the bottom remained stuck. This view, while pleasing to the elite, would have horrified the humane Adam Smith.

David Ricardo (1772-1823), Malthus’s contemporary and friend, proposed a “marginal” theory to explain the magnitude of land rent. The rent of a given parcel of land depends, he said, on its superiority to land barely worth using, that is, “marginal” land. Imagine you are a farm operator. How much more would you be willing to pay the owner of a fine flat parcel down in the valley over a remote, steep parcel you could use for next to nothing? That extra payment is your rent—income to the landowner for the mere fact of holding legal title to land. (Note that location is usually the most important component of land quality.)

Ricardo’s rent theory led him to propose a doomsday model even more frightening than Piketty’s. As population grows, he said, the economy must expand onto lower and lower quality land. Since rent depends on the difference between the best and the poorest land in use, more and more of the economy’s production will go to landowners as rent. Eventually the landowners will take so much that there won’t be enough to provide even starvation wages to workers or minimal profits to capitalists. Only improved technology and gains from trade can stave off collapse. Hence, Ricardo vigorously advocated free trade.

In the final generation of classical economists, two—Karl Marx (1818-1883) and Henry George (1839-1893)—attacked inequality with such force as to provoke a powerful backlash.

Karl Marx, a German revolutionary exiled to England, rejected Malthus’s wage theory. He focused on exploitation of workers by capitalists, among whom he now included landlords. However, like Ricardo, he predicted that growing inequality would lead eventually to a collapse of the capitalist system, and its replacement by a new socialist society. In effect, Marx said growth increases inequality, leading to revolution followed by equality.

Henry George’s bestseller Progress and Poverty (1879) threw a searchlight on the inequities of the late nineteenth century. With Marx, George rejected Malthus’s wage theory. He added his own twist to Ricardo’s theory of land rent. Just as marginal land determines rent, he said, it also determines wages—because a worker will not accept wages lower than what he could earn for himself on marginal land. But the greater the inequality of ownership of land (and other natural resources) the lower will be the quality of marginal land—and hence the lower the wages.

George also added a twist to Adam Smith’s theory of growth. Yes, growth results from cooperation and specialization, and the larger the population and the greater the “extent of the market” the greater the potential for growth. But also, the more equal the people, the greater their ability to cooperate. In George’s words: “association in equality is the law of progress.”

Marx saw history as progressing by action and reaction toward the inevitable overthrow of capitalism. By contrast, George combined his modified growth theory with Ricardo’s inequality theory to argue that progress carries the seeds of its own destruction: A fortunately-situated, relatively egalitarian society may begin to grow and prosper, expanding and attracting population. However this growth primarily benefits the holders of key parcels of land—such as parcels on the waterfront of port cities. As the economy grows, so does inequality. Wages fall, relatively if not absolutely. A wealthy, corrupt elite increasingly controls government. Eventually, the society collapses, or becomes so weak as to fall to invaders—as for example did the Western Roman Empire.

George feared this fate would soon befall the United States. Like his classical predecessors, he opposed government-granted monopolies, notably vast tracts of land handed to railroad companies like Southern Pacific. Also like his predecessors, he proposed shifting taxes onto the unearned income of land and other natural resources. But unlike his predecessors, George turned land taxation into a major and partially successful political crusade, not only in the United States, but in other countries, notably England and its colonies in Canada, Australia, New Zealand, South Africa and Hong Kong. In practice this meant increasing the land component of ordinary property taxes and removing the component on buildings and other improvements, a proposal easy to understand and implement back when property taxes were the primary taxes.

Marx and George—and the huge political movements they inspired—scared the pants off the elites of Europe and the United States. They had to be stopped, and not just physically. The classical focus on inequality and unearned income had to be disappeared from economics. As we will see in part II, that was the purpose of “neoclassical” economics.

–Polly Cleveland