“Economics is about the question of the good life”
Michael Graff, Head of the Research Division "Macroeconomic Forecasting", explains why inequality should be a key topic in economics and why redistribution and efficiency do not necessarily have to be opposites.
Some observers see economics as being primarily about efficiency, while topics such as inequality and redistribution are better left to political science and political philosophy. Is this theory correct?
That is a rather truncated view of things. Economists such as Adam Smith, John Stuart Mill and, above all, Karl Marx, of course, dealt with the issue of social inequality a long time ago. The Stockholm School, which included Nobel Prize winners such as Gunnar Myrdal and Bertil Ohlin, also made valuable contributions to the foundation of neoclassicism but saw itself as a social science research discipline. They believed that economics also had an ethical component. The dominance of neoclassical economic theory more than a 100 years ago and the increasing mathematisation of economics have overshadowed this approach somewhat. The paradigm in economics that has increasingly prevailed is that, provided markets function and there are no market failures, market outcomes are always efficient. The ideology derived from this, often referred to as neoliberalism, in which the role of market failures and externalities was downplayed, was then put into political practice in the 1980s by Ronald Reagan in the US and Margaret Thatcher in the UK. Their economic policies, often referred to as Reaganomics and Thatcherism, emphasised a lean state, low taxes and minimum redistribution. It was assumed that everyone would gain when the economy grew, even if initially it was mainly the better-off who benefited. But this hope proved to be an illusion. The rich got richer and richer while the real wages of the poorer classes stagnated. By the time of the financial crisis, which originated in the United States, the heart of financial capitalism, this ideology had already begun to falter. More and more economists have reacted by revisiting the topic of inequality and redistribution over the last two decades. The most prominent example of this is the work of the French economist Thomas Piketty (‘Capital in the 21st Century’).
Is there always a tension between efficiency and equality?
Not necessarily. That is a constructed opposition. We can think about efficiency as well as equality. In the market-liberal paradigm, as it was in the days of Reagan and Thatcher, there are only individuals who selfishly maximise their utility. If you dilute incentives through redistribution, people will work less and earn less, which will harm everyone. As soon as this theoretical corset is removed and a good life for all is seen as the objective of economic activity, efficiency and equality are no longer opposites.
Is analysis of inequality a marginal or core issue within economics?
In my view, analysis of inequality has a central place in economics. Economics is not just about applying mathematical models and maximising under constraints but, at its core, addresses the question “What can the economy contribute to a good life?”.
Can you give an example to illustrate this with reference to analysis of inequality?
Inequality is often justified by merit because the argument here is that those who are better-off deserve to be better-off because they have earned it through achievement. But how much of this is actually deserved? If a top manager earns 10 million Swiss francs a year but an ordinary employee earns only 50,000 francs, does that really have anything to do with merit or productivity? External circumstances make more of a difference than we think. Someone who grows up in an academic household has better career opportunities than someone who grows up in a remote Alpine village – not to mention people born in sub-Saharan Africa, for example. As economists, we have to expose and question such correlations.
“Economists such as Adam Smith, John Stuart Mill and, above all, Karl Marx, of course, dealt with the issue of social inequality a long time ago.”Michael Graff, KOF Economist
What form of inequality should economists look at?
Inequality exists in many dimensions. We economists mainly look at income and wealth. Income is a flow variable. Wealth is a stock variable. These two variables are interrelated if wealth is formed as a stream of income according to the principle that those who work hard and are thrifty accumulate wealth. This is not the case, however, if wealth is created as a result of gifts, inheritance or random profits on the stock market.
What indicators can be used to measure inequality?
A widely used and practicable measure is the so-called Gini coefficient, where 0 denotes a perfectly equal distribution and 1 a perfectly unequal distribution, i.e. a situation in which one individual has all the income or all the wealth. We can also look at so-called percentiles, i.e. ask how much, for example, the top five or ten per cent of a society own compared with lower percentiles. But percentiles can be easily manipulated for political messaging purposes by cleverly choosing the percentiles without having to falsify data. This enables quite different messages to be derived from the same distribution. In general, inequality measures that reflect the entire distribution are more robust than those based on only parts of the distribution.
How much inequality is tolerable in a society?
Anthropologists believe that material equality prevailed in the Stone Age. There was a division of labour but no private ownership of productive goods. That only came with the advent of permanent settlements and with land as private property. There will never be complete equality because many important factors in life, such as partnership and health, depend on chance. However, inequality becomes dysfunctional when it is no longer accepted in a society. Then there is either a violent uprising or individual violence. The latter can be observed in many Latin American countries with high levels of inequality, such as Brazil and Mexico. The disadvantaged forcibly ensure redistribution from top to bottom through robbery or kidnapping. The rich have to live in gated communities and invest more and more money in their personal protection. This is, of course, completely inefficient in economic terms – quite apart from the ethical aspect.
How unequal is Switzerland?
In terms of inequality, Switzerland is a middle-ranking country compared with similar nations such as Germany and Austria. Consequently, there is no reason for alarmism in this respect. In contrast, wealth inequality is more pronounced in Switzerland than in most other countries. The creation of economic dynasties through inheritance – promoted by the almost total abolition of inheritance tax for close relatives – is crucial here. In addition, there is no capital-gains tax, and the very rich can minimise their tax liability by moving to a low-tax community.
“Someone who grows up in an academic household has better career opportunities than someone who grows up in a remote Alpine village.”Michael Graff, KOF Economist
What is the best way to combat inequality?
An inheritance tax is the most efficient tax from an economic point of view, as it reduces hardly any of the incentive to work. It should allow a personal exemption roughly equal to the market value of a family home but, beyond that, it should tax away the bulk of any inheritance. After all, large fortunes are created not in a vacuum but within a social context. Why should the heirs to such fortunes be entitled to them and not return such wealth to the general public? A progressive system of income tax also makes sense. Unfortunately, this system is often undermined in Switzerland by the fact that higher earners can move to cantons with lower taxes. High earners in low-tax cantons often pay less tax than normal earners in normal-tax cantons. We would therefore have to end all tax competition within Switzerland. In an ideal world it would, of course, be desirable if primary incomes were distributed more equally – especially through equal access to education – before considering corrective measures via the tax system.
Would it also be an option to give people on low incomes a greater share of corporate profits through the stock market? After all, super-rich individuals such as Elon Musk, Bill Gates and Warren Buffett have also become rich thanks to their shareholdings.
The problem is that most low-income earners have no assets at all to invest in the stock market. Moreover, you have to be careful if you live near the subsistence level. Those who have more money can take greater risks when investing in the stock market. Those who have little money and rely on their capital at an unfortunate time cannot simply sit out a crisis in the financial markets. Also, I don’t know whether every Swiss person should become a financial market expert or whether this would place a burden on people, which is not necessarily part of the good life. In my spare time, for example, I prefer to read a good novel rather than share prices or research papers on risk-return profiles.
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