TCS Daily

Never Mind the Gap

By Christopher Lingle - March 2, 2006 12:00 AM

Bali, INDONESIA - South Korea's President Roh Moo-hyun has expressed serious concern about income "bipolarization" whereby a gap between upper- and lower-income brackets widened. His anguish was not over the fate of the starving masses under the boot heel of a Stalinist North Korean regime. Instead, he has embarked on a campaign to pollute South Korea with more populist rhetoric that supports coercive redistribution of incomes or wealth.

The National Statistical Office (NSO) offers data that seem to justify this disquiet. A gap in Korean household income between top and bottom brackets has been widening. And the average rate of increase of income earned in 2005 by urban households was the lowest on record since 1997.

But none of this is surprising since income inequalities tend to harden and broaden when an economy is stagnant like Korea's has been since President Roh took office. His focus on using redistributive policies to try to reduce social or economic disparities has been counter-productive.

Instead of narrowing the gap in incomes between high and low-income brackets, it has widened while the number of middle-class households has decreased. The US also experienced a growing income gap between rich and poor despite higher worker productivity during the Clinton years. It is no accident that both Korea's Uri Party and America's Democratic Party use populist rhetoric to promote policies to redistribute income.

The interpretation of what is behind widening income gaps and what to do in response is far more complicated that meets the eye. Assuming that social injustices are at work, the Roh government is considering increasing taxes to expand the tax base and raise revenues. This would be a wrong response to a misguided interpretation of reality.

It turns out that policies that would close the gap by altering income earned in a market context can actually increase the polarization of incomes. This is because social security schemes, higher taxation or expanded welfare benefits to redistribute income create disincentives that thwart job creation and investments.

While the rich may be getting richer faster than the poor are getting less poor, there are some good reasons for this to occur and well as some bad ones. It turns out that the truth about the villains in this tale may be a surprise.

While the spread of free markets can lead to rising inequality, the universal cause of persistent poverty is failed domestic public policies and corruption. In turn, most rigidities in income distribution are caused by government interventions that decrease competition and market flexibility.

As it is, an economic system that allows income mobility compensates for income inequality. Depicting the distribution of income as an escalator rather than a pie shows that people at the bottom of the income pyramid can and do move up over time.

This movement also works in the reverse where those at the top can lose their position. This process may be preferable to a system with little income inequality but limited economic growth and little change in the positions of people at the bottom or top.

One element of the larger income disparities can be explained by a rapid rise in the demand for highly-quality skilled workers or managers relative to a small talent pool. For example, a more limited supply of good managers combined with rising demand for them pushes up executive pay faster than earnings for most other occupations.

The goal should not be the imposition of greater income equality. Instead, the aim should be to boost GDP growth while increasing income mobility to make it easier to move upward in income distribution.

Income mobility is best achieved with flexible labor markets with fewer obstacles for employers to create new jobs and facilitate job changes. Workers moving between jobs are more likely to find positions that best match their skills and preferences.

Flexible labor markets also lead to the fixed costs of hiring workers being low. These costs include restrictions on redundancies, minimum wages, legally-imposed obligation for special benefits to workers, and taxes on wages for social insurance contributions.

When it is simple to fire workers, employers are more likely to hire them. When firms face large penalties or are required to negotiate with government bureaucrats or trade unions to lay off workers, there will be a greater reluctance to take on new workers.

The way for living standards and real wages to rise is for there to be more economic growth supported by increased capital accumulation. Therefore, a better plan for easing income "bipolarization" is to create an environment whereby the private sector creates more jobs so that employment is stabilized.

By itself, a widening income or wealth gap is not an economic problem nor is it evidence of social injustice. But using the existence of widening economic differentials to expand political control over resources is a cynical populist ploy that does more harm than good.

When a less-well-off democratic majority pushes for increased state control, it tends to harm future economic prospects. Increased government intervention allows individuals to earn higher incomes by being skillful at manipulating political mechanisms rather than being socially useful.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala.


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