Why Small Government Reduces Income Inequality

By Julian Adorney

Monday, March 17, 2014

As President Obama struggles to rejuvenate his flagging second term, he’s returning to a theme that struck a chord in 2009: Income inequality. The top 1 percent of income-earners in the United States bring in 22.3 percent of all pre-tax income, which many feel is inherently unfair. But if Mr. Obama is serious about reining in income inequality, he should promote less government, not more.

The market gives its benefits to the poor more than the wealthy. At the same time, crony capitalism increases the income gap by favoring the rich.

In “A Dynamic Analysis of Economic Freedom and Income Inequality in the 50 States: Empirical Evidence of a Parabolic Relationship,” Daniel L. Bennett and Richard K. Vedder argue that, past a tipping point, economic freedom decreases inequality. Increasing economic freedom benefits the poor and middle class more than it helps the wealthy. The pair analyzed all 50 states over a 25-year period.

By 2004, 21 states had already reached the tipping point proposed by Bennett and Vedder; for the country at large, it is just around the corner. On the Fraser Institute’s scale of economic freedom, rated from 1 to 10, the tipping point is about 7.0. The Institute measures economic freedom as a combination of size of government, taxation, and levels of regulation. New York, least economically free state in the union, was at 5.4 in 2011; at the other end of the spectrum, Delaware ranks at 7.8Why is this the case? Bennett and Vedder argue that, at first, states that pursue economic freedom see increases in income inequality, as the gains from capitalism begin at the top. But past the tipping point, the gains spread more quickly to the poor and middle-class, and income inequality declines.

The emerging technology of tablets provides a good example. In 2011, when tablets were still new to the market, only 8 percent of families with young children owned one. Most of these families were wealthy. But by 2013, that number had quintupled to 40 percent. The economic gain of iPad ownership began among the wealthy, but spread rapidly to the poor and middle-class. In fact, the poor gain more from the new technology than the rich. In 2011, the iPad 2 sold for $499. Two years later, the iPad 2 cost only $399. Both wealthy early adopters and lower-class later adopters got the same product, but the latter purchased it at a significant discount. This meant a net gain for lower-class buyers compared to upper-class buyers.

This same trend occurring across a dozen industries, providing marginally more gains to the poor than to the wealthy, helps explain why economic freedom reduces inequality. If we unleash the engine of economic growth, it will primarily benefit the lower-class. The well-connected have always lived in luxury. Capitalism, by enabling cheap mass production, is the first system in history that has brought luxury to the masses. The less governments hobble it, the more it will continue to do so.

Additionally, more economic freedom means more jobs. Those at the top generally have the skills and experience to stay employed no matter what happens, which is why recessions hit the poor hardest. In 2013, the unemployment rate for families making under $20,000 per year was 21 percent. The unemployment rate for those making $150,000 per year was 3.2 percent.

Recessions hit low-income citizens hardest. But conversely, job creation, fueled by economic freedom, disproportionately benefits the poor.

In fact, some scholars have quantified how economic freedom reduces inequality. In “Income Inequality and Economic Freedom in the U.S. States,” Nathan J. Ashby and Russell S. Sobel analyze the 48 continental states of the Union over 20 years and find that more economic freedom shrinks inequality by benefitting the poor. In particular, Ashby and Sobel found that increasing the economic freedom of a state by one unit (equivalent to moving from 40th-freest state to 7th-freest-state) increased the incomes of its poorest residents by 11 percent. By contrast, the same change increased the incomes of the richest quintile by just over a third of that (4.3 percent). As states become more economically free, the economic gap between rich and poor narrows.

The free market undeniably helps the poor. But what many fail to realize is that bigger government benefits the wealthy.

Regulations are often written to benefit one company, reducing barriers to entry and hurting consumers. Government contracts also enrich politically-connected companies, driving CEO pay for those companies ever higher. CGI Federal, the company behind the botched Healthcare.gov rollout, brought in $950 million in government contracts in 2012. Michael Roach, current president and CEO, receives over $6 million per year.

If we’re serious about shrinking income inequality, we need to shrink government. The private sector distributes its gains to rich as well as poor. By contrast, big government, by promoting crony capitalism, just makes the disparity between rich and poor even larger.