Introduction: Distribution versus Accumulation
The present distribution of wealth cannot be labeled de facto bad. However, some current market mechanics that support the process by which it is accumulated are perversely distorted and need reform.
First, I admit I accept as a fundamental assumption that free markets serve democratic societies better and more effectively than central planning, as seen in various communist and fascist regimes. If the last hundred years of human history do not provide sufficient evidence of this assumption then you will find the whole of my argument unsatisfactory. There are some who have a deep-seated belief that the whole of mankind should earn the same income and be “entitled” to the same resources. Such is the socialist theory which I as an entrepreneur must reject on the grounds that the ensuing economic distribution is woefully inefficient and the violation of freedom is intolerable.
With that in mind, understanding the present distribution of wealth requires an examination of how wealth is accumulated and whether such methods are broadly acceptable in a free society with competitive economics. The fact I have X dollars and my neighbor has Y dollars says nothing to a liberal (used in the classical laissez-faire economic sense, not in the modern progressive political sense) about the market mechanics. If income and wealth are duly earned under the agreed market rules, then the present status must be accepted. However, if the rules serve to favor one group over another or distort the underlying market, then we must accept that the distribution is bad insofar as it is evidence of a broken market.
In many ways, the debate about whether this market is broken can be reduced to arguments between two schools of economics: the standard rational school and the behavioral school. In fact, empirical evidence is decidedly mixed1. While a rational economist would argue that the individual will always evaluate a market decision by comparing price to perceived value, a behavior economist will argue that psychological forces will also impact the decision: learned helplessness (if you are conditioned to feel you will fail, you will simply stop acting in your best interest to avoid future failure), anchoring effects (when given the choice of three wines—high, medium, low—people tend to pick medium regardless of the price of the three), relative comparison effects (CEO pay escalates when made publicly available because of peer-comparison rather than through assessed value), and simple “heated” irrationality (angry decisions are routinely suboptimal compared to decisions made in a cool, calm state). Concepts from both of these schools are useful when evaluating how wealth is accumulated.
The Essence of Profit and Income
In broad terms, profit from an enterprise can be reduced to one of three factors (or some mixture): arbitrage of endowed resources, arbitrage of information, and arbitrage of scale.
The arbitrage of endowed resources is generally observed at the state or nation level and arises from defined political boundaries. Some countries have extensive access to oil, others to timber. However, there is no absolute reason why the profit from those resources should accumulate to a single individual or firm unless an explicit monopoly has been sanctioned by the state. The arbitrage of information suggests that if I know something you want to know, I can extract compensation from you. Or, if I know how to build something you want and you are unable or unwilling to do so yourself, I can extract compensation. Arbitrage of scale arises when a large entity can do something more efficiently than a combination of smaller entities. At the extreme, you find technical monopolies like national defense and, perhaps, certain utilities.
An important qualification arises with tooling and equipment. In the Marxist doctrine, equipment is a product of labor and hence the profits should accrue to the laborers. In the standard liberal economics view, tooling and equipment represent investment of capital and past labor—not necessarily present labor. In either case, equipment remains a medium between knowledge and output and information arbitrage arises indirectly through its application in production.
The competitive market exists to set a price for the transfer of this knowledge and its expression as products and services. Prices should (and this is an important qualification which may not always hold true) reflect the nature of supply and demand for such output. Income should be distributed according to the productive value created. An entrepreneur can, therefore, identify an opportunity, develop and deploy requisite knowledge, and accrue the resulting profit—facing down the ever-present risk of outright failure or defeat from a superior firm. In doing so, the entrepreneur rightly earns the wealth associated with the value contributed to society.
The Role of the State
Even a fervent liberal economist admits there is a role for the state. Above all else, the state safeguards the universal Rule of Law without which a free, competitive economy could not exist. The state also protects open markets, administers a common currency, and provides critical national initiatives which would not emerge from a market due to the structure of either positive or negative externalities (where the pricing system is impractical because property rights cannot adequately assign the true benefit/cost of the underlying asset)—building the first interstate highway, for example.
More complicated examples arise when considering old age insurance and health insurance. In the interest of brevity and focus, I will ignore the supreme importance of these two issues, though it is important to consider that in light of evidence from behavioral economists and because free market mechanics require the ability to discharge unwanted items, both of these warrant some level of state involvement.
What remains is a critical feature of competitive markets and also a point at which the debate of improperly assigned wealth turns: the state must afford equal opportunity to market participants. That is to say, an educated populace is central to the protection of democracy and to the ability of the labor force to respond to market shifts in demand for talent, knowledge, and skill.
Given the ability to arbitrage information, it reasons that if the provision of basic knowledge is unequal then profit subsequently derived is improperly earned. For at each step of development, the arbitrarily more educated and better prepared individual can reap substantially greater profits. The fact that many parents move to ensure their student attend a “good” school is alone a damning symptom of unequal public education and evidence of our failure to produce equality of opportunity. In a similar vein, the rags-to-riches fable is both deeply entrenched in the American psyche and arguably the most misunderstood evidence of our time2. In any case, economic success is derived, at least in part, from some predictable advantage or state initiative.
The lack of equal opportunity does not stop with basic education (though many problems can be traced to this early failure). For instance, the current tax code compounds lifetime gains by applying very different marginal rates to different sources of income. A rational economist of any ilk would find it hard to argue that corporate perks should be treated more favorably than salary or that capital gains should be given special treatment from ordinary income. Moreover, the existing tax code encourages high-income individuals to invest in elaborate schemes to minimize tax effects. While the outcome of these strategies is often economic gain, the existence of such opportunities lacks a rational explanation other than failed tax policy.
Or, take two recent examples of high-end malfeasance: (1) Enron and the spate of improper earnings management and (2) the Great Recession, specifically the subprime mortgage crisis. In both cases, privileged individuals manipulated a market in their favor—sometimes within the letter but certainly not the spirit of the law3. For an entrepreneur, both incidents seem to present subjective evidence that arbitrarily positioned actors are often found plying a trade hardly distinguishable from gambling with little actual value contributed to the market. Additionally, these failures demonstrate the perverse tendencies of an unregulated market operated by self-interested actors who, in pursuit of short-term optimums neglect large negative public externalities as well as the failure of the state to anticipate such actions and deploy policy to avert destabilization4.
Thus, the redistribution of income through taxation is a mechanism by which the nation can be made better off—reducing inequality in opportunity and eliciting full and complete competitiveness in the market. We as a free capitalist society should be providing actual equality of opportunity, not simply lip service to the ideals of competition. Indeed, allowing for the accumulation of wealth arbitrarily via inconsistencies in market rules and limited entry opportunity is fundamentally no better than arbitrary transfer dictated by bureaucracy. Without equality of opportunity, we are not the competitive market we wish to be. Instead, we are akin to an aristocratic system with market-like properties, not as far removed as we ought to be from a communist state with market-like properties.
Prescriptions for Improved Competitiveness and Stronger Entrepreneurship
As an entrepreneur myself and acquainted with many other entrepreneurs in Silicon Valley, Chicago, and Boston, I can speak confidently that few, if any, of us wish to retreat from commercial freedom to a planned economy. As a founder, I am categorically opposed to the notion of barons and aristocracy over merit and competition. Or, said another way, I demand fair and free competition as the mechanism for distributing income rather than birthright and status.
Government’s role in the distribution of wealth should be a strictly limited affair and only apparent in necessary facets, such as enforcing property rights. But that is an orthogonal concern to the process of accumulating wealth in the first place. As a student of economics I must insist that a competitive system be allowed to produce unequal results. However, as a matter of policy, I would also require that the same system provide equality of opportunity to guarantee the most competitive market possible. To do anything else would be in pursuit of some aristocratic, caste-based society that grinds against the American spirit.
Therefore, a few changes to the process of wealth accumulation would greatly enhance competitiveness going forward (though in adherence to the Rule of Law, there is little argument for “clawing back” distorted but legally-earned past income):
I. Adjust the effective tax rate of every individual or family unit so that (1) all forms of income are treated the same, (2) high-income earners never pay a lower effective marginal rate than low-income earners, (3) a graduated effective tax rate delivers consistent marginal economic disutility (in effect, the perceived “harm” from having income withheld by the state is the same5) across income brackets with some minimum threshold for impoverished families.
II. Invest far more tax revenue in programs that engender labor market competitiveness and enhance fluid movement in the labor availability. For most citizens, the primary source of wealth is derived from their occupation and, therefore, state-services should provide the opportunity to develop new skills and relocate to areas of the country where such skills are in demand. F. A. Hayek, the noted classically liberal economist even remarks, “…the state could do a great deal to help the spreading of knowledge and information and to assist mobility”6.
III. Provide more capital to accelerate innovation in the market through bank assistance, loan programs, and direct technology grants. Admittedly, this is the weakest and least well defined of my proposals but if as a democratic society we agree that a central component of protracted prosperity involves product and service innovation (for there is no guarantee of perfect market mechanics in the international market with limited applicability of the Rule of Law and exposed dangers of limited enforceability of what little laws there are), we must continue to be the world leader in advancing technology.
Accumulation of wealth is, in and of itself, a natural outcome of a healthy market and strong economy. However, we have a significant amount of work ahead of us if we want to deliver the competitive market we idealize. In working to deliver a better process, it is helpful to consider the modus operandi of my fellow technology entrepreneurs: the lack of a perfectly optimal solution to current problems should not stop us from implementing a minimum viable solution and iterating quickly in pursuit of measurable improvements. And, in indentifying the logical next step, we must be willing to adapt our system and press forward rather than fearing change and allowing growth to stall.
1 For comparison, see Gary Becker and Kevin Murphy’s work into rational addiction versus Dan Ariely’s work into behavior biases. 2 Much of Malcolm Gladwell’s work focuses on unwinding the rags-to-riches story and instead offers support for the idea that such success is a mixture of timing and circumstance - much of which is due to systematic and often state-conferred advantages. 3 For an interesting exploration of the events from an insider’s perspective of each see The Smartest Guys in the Room by Bethany McLean and Peter Elkind and A Colossal Failure of Common Sense by Lawrence McDonald. 4 Ironically, those who demanded that financial firms be allowed to declare bankruptcy are also often the same people demanding fully privatized old-age and health insurance despite the fact the risk of such structural failure is a central motivation for state-sponsored services in the first place. 5 For a discussion of various economic tax effects see Basic Economics by Thomas Sowell and Price Theory by Milton Friedman. 6 F. A. Hayek wrote The Road to Serfdom as a defense of economic freedom in a time where totalitarianism, specifically National Socialism led by Adolph Hitler, was gaining physical and philosophical ground.