Eric Palmieri: Income Inequality, a Red Herring


In a free market capitalist system, growing inequality of individual incomes is to be expected.  It is a natural result of a growth.  It only makes sense that, as the size of a company grows, so too will its profits and the need to hire more workers.  Think of a company as a pyramid.  It is reasonable to assume that as the pyramid gets bigger, the number of bricks at the bottom (workers) will grow faster than the number of bricks in the middle (managers), which will in turn grow faster than the number of bricks at the top (chief officers).

This leads to greater income inequality, as the increase in profits is spread out over a larger number of workers than managers, and a greater number of managers than chief officers.  This means, that the salary of any given worker will grow more slowly than the salary of any given manager, which will grow more slowly than the salary of any given chief officer. But on the whole, the total number of workers will usually make more than the total number of managers, and the total number of managers will usually make more than the total number of chief officers.

Perhaps the most important thing to keep in mind regarding the pyramid model is that all salaries continue to grow, albeit at different rates. Critics of the free market, in neglecting to focus on the overall increase in salaries, have succeeded in misleading a large portion of the public on the issue of income inequality.  To use another, more popular metaphor, let’s imagine for a moment that a company is like a cake.  As the quantity of profits and capital investments grow (the cake getting bigger) so do individual compensations (the slices).

For example, let’s say there is a computer technician named Tim who works for a small IT company in Maryland.  He is one of 10 technicians and makes roughly $50,000 per year.  The CEO makes $250,000 per year.  The company as a whole makes about $1 million per year.  Fast forward to 10 years later.  Tim has since been promoted multiple times, but Pete, who performs Tim’s old job, is making $100,000 per year.  The CEO now makes $3.5 million per year.  The company has grown exponentially, employing 40 technicians and making about $10 million per year.  Tim earned 5% of the whole cake when he was the computer technician, and the CEO earned 25%.  Ten years later, Pete (although making twice as much money as Tim did) earned 1% of the cake and the CEO earned 35%.  Although the gap in the percentage of income grew over time, the size of the slice earned by the computer technician position doubled in size.  So the question is, would you rather make 5% of a $1 million cake ($50,000) or would you rather make 1% of a $10 million cake ($100,000)?

Of course, increasing salaries ultimately depend on the reinvestment of profits back into the company.  In its first year, the company reinvested 25% of its profits ($250,000) back into the company.  In its last year, the company once again reinvested 25% of its profits back into the company, but just ten years later the amount of money that has been reinvested has grown to $2.5 million.  In addition to creating higher compensation, capital reinvestment also leads to lower prices and thus, a lower cost of living for the consumer.  This is how capitalism not only grows the profits of a company, but how it grows wages, jobs, and the overall standard of living.

Economists who reject the free market in favor of a state-managed economy often argue that the acts of saving and reinvestment by private property owners hurt the general public more than they help, and thus, those acts should be discouraged by a government that actively manages fiscal and monetary matters.  In his book The Conquest of Poverty, Henry Hazlitt quotes from Economic Consequences of the Peace by John Maynard Keynes, perhaps the most well-known critic of the free market, who wrote:

On the one hand the laboring classes accepted from ignorance or powerlessness, or were compelled, persuaded, or cajoled by custom, convention, authority and the well-established order of Society into accepting, a situation in which they could call their own very little of the cake that they and Nature and the capitalists were cooperating to produce. And on the other hand the capitalist classes were allowed to call the best part of the cake theirs and were theoretically free to consume it, on the tacit underlying condition that they consumed very little of it in practice. The duty of ‘saving’ became nine-tenths of virtue and the growth of the cake the object of true religion.

Keynes’ whole argument here completely ignores the fact that the “capitalist classes” (or, property owners) are not consuming the entirety of their piece of the cake.  In addition, they aren’t simply hoarding their profits by throwing them into a giant safe for the next several decades.  They are reinvesting a sizable portion of their profits each year into their property in order to better serve the demands of their customers.  Furthermore, he seems to hold the average worker in pretty low esteem, to think that they are either ignorant or powerless and therefore easily cajoled into a situation that has, quite clearly, been proven to be mutually beneficial.  Remember, the workers are also consumers, and as consumers they hold ultimate authority over the actions of the owners.  Also, in a highly competitive marketplace, workers have the opportunity to go wherever the wages and working conditions are most suitable.

You see, the owners may be taking larger portions of the cake than the workers, but instead of eating all of it, the owners recycle the leftovers back into the mixer in order to make a larger cake.  As the cake gets bigger and bigger, so does the size of each slice awarded to both the owner and the worker.  Sure, an owner could eat their entire piece of cake, but in doing so, the company would lack the capital investment necessary to compete in the marketplace.  Eventually, the owner will be forced to sell all the baking equipment, recipes, and the property itself to another capitalist that has a more sustainable appetite.  So as you can see, selfish and greedy behavior on the part of an owner will ultimately lead to his or her own financial ruin. (Although, in today’s economy, some are able to survive as they are often propped up by government subsidies that allow them to keep eating and eating and eating, without suffering the aforementioned consequences.)

Capitalism’s detractors are not wrong in pointing out the growing income inequality amongst members of society.  However, they are wrong to focus on the percentages as opposed to the numbers.  They fail to look at the slices of an economic cake in terms of size as opposed to fraction.  When government takes money out of a company’s profits for the purpose of redistribution, the company is unable to adequately reinvest in its operations, and as a result, production slows.  As government continues to take more and more money out of a company’s profits, production begins to decline, leading to higher prices and lower salaries.

While government redistribution may lead to greater economic equality, it also leads to a higher cost of living and an equally lower standard of living for the general public.  Ironically, the results of redistribution more adversely affect the poor and working classes than they do the wealthier members of society, who can more easily adapt to changing economic conditions.  When it comes to increasing the standard of living for poor and working people, there is simply no substitute for free market capitalism.

  • Joe Smith

    Tim has since been promoted multiple times, but Pete, who performs Tim’s old job, is making $100,000 per year.

    So, that’s an annual salary growth (CAGR) of 7.2% – please tell me middle class jobs that have sustained (other than the public sector – :) ) 7.2% CAGR for wages. Also, your example implies a 25% CAGR for the company – true in some companies, but *far* from the norm.

    Also, in a highly competitive marketplace, workers have the opportunity to go wherever the wages and working conditions are most suitable.

    Okay, but in the real world where things like health insurance lock, relocation costs, spousal job and preference (are we to assume there’s perfect spousal skill/job transfer?), housing market conditions, etc.. come into play, your theoretical underpinnings get seriously eroded.

    In addition to creating higher compensation, capital reinvestment also leads to lower prices and thus, a lower cost of living for the consumer. just had an example with workers getting a 7% wage bump annually and you want to tell me capital reinvestment will cause deflation? Maybe if there is corresponding factor productivity increases; otherwise prices (marginal revenue) would have to rise for the wage to rise.

    Plus, deflationary conditions are not ideal for the long-term of an economy – if we are playing the perfectly competitive, perfectly rational game of theoretical economics, falling prices would cause the rational worker to save (because prices will be lower in the future so it is better to defer consumption), causing a fall in propensity to consume, which in turn leads to recessionary gaps. One need only look at Japan to see a real world example.

    No fan of Keynes on the whole, but let’s remember that book was written as a protest to the severe (using your point – massive redistribution of Germany’s wealth to the allies) terms (economically) being imposed on post-WW1 Germany – and rightly predicting the consequences (as you point out, redistribution leading to massive inflation and reduced standard of living) for Germany in the 1920s…and one might argue the rise of National Socialism.

    Also, it’s a bit out of context to use the market conditions of the early 20th century as if the same situations between labor and management, between consumer and producer, and between public and private sectors exist today. I agree with your points in general, but let’s start with the reality we have a quasi-free market – partly because some markets do fail -even if competitive – to achieve the most efficient outcome and partly because of societal values that put equity (or other outcomes) ahead of efficiency and processes that give rise to rent-seeking manipulation.

    And if we’re going to talk income inequality – it’s not really a red herring to point out your example, which has held true (although maybe not so great in real income terms) for generations (young generation comes up and makes more in real terms than the generation before *at the same* age level), is no longer the norm,

    “Throughout most of our history, inequality between generations was large and usually increasing, to be sure, but for the happy reason that most members of each new generation far surpassed their parents’ material standard of living. Today, inequality between generations is increasing for the opposite reason. Though much more productive and generally better educated, most of today’s workers are falling farther and farther behind their parents’ generation in most measures of economic well-being.”


    “Until the present era, despite vast disparities and inequalities across different racial, ethnic, and other demographic groups, most American families realized a rising net worth, not just within the life course of each generation but from one generation to the next. Today’s older Americans still exemplify this historical pattern. For example, according to work done by the Urban Institute, Americans who were seventy-four or older in 2010 had an average net worth that was 149 percent higher than that enjoyed by Americans who were the same age in 1983 (after adjusting for inflation).

    This pattern has disappeared, however, among all subsequent birth cohorts. The tipping point came among people born in precisely 1952, who, by 2010, became perhaps the first birth cohort in American history to have less real net worth on the threshold of retirement than people born ten years earlier had at the same age.”

    You’re right in the red herring comment in terms of expecting income inequality, but off the mark in terms of saying “government redistribution may lead to greater economic equality, ”

    The data suggests government redistribution and those who use power and influence to intervene in “free” markets have contributed, not restrained, to the fundamental change in income inequality.