The Conservative Inequality Paradox

By Brink Lindsey & Steven Teles

Tuesday, November 07, 2017

Conservatives have two intellectual commitments that are increasingly incompatible. They believe that the American economy is clogged up with crony-capitalist corruption that hands out special favors and protections to organized interests. They also hold that economic inequality — in particular, the surging share of total income earned by those at the very top — is morally justified by the rights of property and the tendency of free markets to raise living standards overall.

These two commitments can no longer be squared. If our economy really is riddled with cronyism, then the beneficiaries must have pocketed large amounts of ill-gotten loot. The existing distribution of income and wealth, therefore, does not deserve the deference it would be due if all gains were derived from spontaneous, unregulated market transactions. Call it the conservative inequality paradox: Either conservatives have overstated the amount of crony capitalism, or their dismissal of the concept of inequality as envy is misplaced.

In our new book The Captured Economy, we argue that conservatives are not mistaken about the extent of what we call “regressive regulation” — government-created distortions of markets that have the effect of funneling income and wealth up the socioeconomic scale. Such schemes of upward redistribution have proliferated in the past few decades, an era that is often misunderstood as one of unceasing deregulation. And because these reverse–Robin Hood policies work by squelching and misdirecting competition, they exert a powerful downward drag on output and growth as well.

Accordingly, conservatives should redouble their willingness to attack these forms of regulation that — unlike health, safety, and environmental rules, which impose (sometimes necessary, sometimes excessive) costs on business — actually boost corporate profits by creating market distortions, including barriers to entry for new competitors. In addition, conservatives need to examine their instinctive defense of business interests and their hostility to redistribution. But that doesn’t mean conservatives need to become Bernie bros. There is a distinctly conservative way of addressing inequality in a world of crony capitalism — one that seeks to attack the inequality resulting from anti-market, growth-killing policies.

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Progressives may rant about “neoliberal” markets run amok, but many conservatives understand clearly that the U.S. economy is far from a textbook model of free competition and voluntary exchange. Senator Mike Lee, for example, has argued that “cronyist policies come in many shapes and sizes — from subsidies and loan guarantees to tax loopholes and protective regulation — but they all work the same way: The elite leaders of big government, big business, and big special interests collude to help each other climb to the highest rungs of success, and then pull up the ladder behind them.” And in the 2015 debate over the Export-Import Bank, which primarily subsidizes big-business exports, soon-to-be House speaker Paul Ryan rejected claims that the existence of similar subsidies abroad justified providing them here. “We should be leading by example,” he said. “We should be exporting democratic capitalism, not crony capitalism.”

If anything, conservatives have been too modest in their assessment of the breadth and scope of crony capitalism. In our book, we focus on four big case studies: financial regulation, patent and copyright law, occupational licensing, and zoning. In all of them, government-caused market distortions have been growing rapidly over recent decades. Between 1980 and 2006, the financial sector as a percentage of GDP grew by almost 70 percent, fed by regulatory subsidies for securitized mortgages and a string of “too big to fail” bailouts. Copyright terms have lengthened from a maximum of 56 years to the current life of the author plus 70 years, while laxer standards for patentability have caused a nearly 400 percent increase in the number of patents awarded annually. This excessive expansion has created a field day for lawyers and inflated profits for Hollywood, big pharma, and Silicon Valley with higher prices and licensing fees. But new innovators faced with traversing this legal minefield are not so fortunate.

In 1970, only one in ten Americans worked in a job subject to mandatory government licensing; now it’s closer to one in three. Most of that growth has occurred because of a huge expansion in the number of licensed occupations, now over 1,100 and counting. And in the nation’s big coastal cities, increasingly restrictive zoning has levied an ever more burdensome tax on new-housing construction — equal to 50 percent of the total price of housing in Manhattan, San Francisco, and San Jose. While boosting real-estate values for lucky legacy homeowners, zoning has imposed a serious drag on national economic output — as much as 10 percent, according to recent estimates. The loss is due to geographic misallocation of the labor force: The country’s most productive places can’t accommodate all the people who want to live and work there.

But do these market distortions really have anything to do with inequality? After all, the pursuit of profit through the political system (what economists call “rent-seeking”) is nothing new: James Madison was writing about the problem of “faction,” or special-interest corruption, in The Federalist Papers 230 years ago.

Conservatives as a rule have failed to see a connection between government policies and changes in the income distribution. Harvard economist Greg Mankiw, who served as President George W. Bush’s top economic adviser, displayed this blind spot in a 2013 article in the Journal of Economic Perspectives entitled “Defending the One Percent.” “There is no good reason to believe,” he wrote, “that rent-seeking by the rich is more pervasive today than it was in the 1970s, when the income share of the top 1 percent was much lower than it is today.”

The problems with this analysis are apparent once you scrutinize who exactly occupies the apex of America’s economic pyramid. Financial professionals and managers made up 14 percent of the top 1 percent in 2005, up from 8 percent in 1979. And while top financial executives earned the same as their peers in other industries in 1980, they were making a 250 percent premium by 2006. Doctors accounted for 16 percent of the top 1 percent in 2005, while lawyers accounted for 8 percent. The representation of doctors and lawyers in the top-earners’ club has been quite stable for decades; this means that their incomes have been growing much faster than the incomes of most other Americans, since the threshold for entering the top 1 percent has been moving up rapidly over time as incomes get more unequal. Doctors and lawyers both use occupational licensing to raise their incomes by restricting the supply of practitioners and use the state to inflate demand for their services — in the case of doctors, primarily through their influence over Medicare-reimbursement schedules; in the case of lawyers, by larding up every law and regulation with dysfunctional but highly litigable complexity.

So nearly 40 percent of earners at the top of the income distribution are finance professionals, doctors, or lawyers — all major beneficiaries of government largesse at our expense. Corporate executives make up another 31 percent of the top 1 percent, and a healthy chunk of them are in industries (such as movies, recorded music, or pharmaceuticals) whose profit margins are fattened by government policy.

Even if it were true, as Mankiw contends, that rent-seeking by the rich is no more prevalent now than in the past, incomes at the top are nonetheless swollen with government-created rents. Top-end inequality — the percentage of total income that goes to earners in the top centile — could therefore be reduced significantly if those benefits were eliminated or reduced through policy reforms.

Meanwhile, a review of America’s changing political economy makes clear that, while rent-seeking has been a constant, its distributional consequences have clearly changed over time. Beginning with the New Deal, the initial decades of activist government featured a great deal of downward redistribution: The National Labor Relations Act encouraged unions; the Davis-Bacon Act raised wages on government contracts; the minimum wage was relatively high; the federal government set universal-service requirements for telephones and utilities; municipalities inaugurated rent control and tenant-protection laws. Such policies feature much less prominently today.

Of course, there was plenty of New Deal–era government intervention in behalf of business as well, including high trade barriers and price and entry controls for airlines and trucking. But because the affected industries typically employed large numbers of semi-skilled, unionized workers, a substantial portion of the rents to business ended up shared with workers earning modest incomes. Today, by contrast, the technologically leading industries that occupy the “commanding heights” of the economy (and that thus tend to be the focus of industry-specific regulation) mostly employ highly skilled workers. Government favoritism for those industries thus mostly benefits the well-off. Accordingly, the evidence strongly supports our contention that rent-seeking has moved upmarket — and, therefore, that a good chunk of the rich’s income is indefensible.

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Conservative attitudes on inequality have long been shaped by Robert Nozick’s famous metaphor of the basketball player Wilt Chamberlain. Nozick argued that Chamberlain’s high income was derived from mutually beneficial exchange and was therefore justifiable. Who could say that there was anything unfair about a basketball player trading his skills for the money of fans? And how could a distribution of income produced by that sort of mutual exchange be unfair?

But the Wilt Chamberlain metaphor does not apply to an economy characterized by extensive high-end rent-seeking. Even if you believe that market returns are inherently just and therefore worthy of being defended on ethical grounds, how do you justify windfalls that are a function of distorted rules of the game? The answer is you can’t.

In the best of all worlds, conservatives would respond to this state of affairs by attacking rent-derived inequality at its source. Their economic agenda would focus on curtailing subsidies for finance, excessive protection of intellectual property, the licensing of high-end professionals, and overly restrictive land-use regulation. Doing so wouldn’t require conservatives to become crusading egalitarians, as these reforms would also unleash economic dynamism, innovation, and growth — familiar conservative priorities.

Nevertheless, making regressive regulation a conservative priority would be a distinct change in approach. Too often, conservatives’ idea of a pro-growth policy agenda starts and ends with tax cuts, despite the overwhelming evidence that moderate increases or decreases in the top rate have little effect on growth. When conservatives do turn their attention to regulation, they usually think about providing “regulatory relief” for business by lightening health, safety, environmental, and labor regulations. In our view, though, the regulations with the most pernicious economic effects are the ones that subsidize business by blocking competition or by otherwise distorting markets.

In some cases, conservatives would be able to build on existing strengths when conducting such a campaign. Much of the mischief caused by regressive regulation occurs at the state and local levels: occupational-licensing rules, land-use regulations, and a host of other industry-specific protectionist policies such as those that limit competition for auto dealers, undertakers, and hospitals. A network of free-market think tanks and activist groups is already up and running to push back against this rent-seeking — but these organizations could be doing a lot more. There is no way to fight regulatory capture by the well-off unless other wealthy people make countervailing efforts to even the political playing field, creating the institutional infrastructure needed to ensure that rent-seekers face determined opposition. Conservatives can provide that countervailing power by deepening their investments in state and local policy reform.

In one important respect, conservatives would need to execute a complete change of direction. For decades now, conservatives have favored slashing congressional staff and eliminating congressional support agencies such as the Office of Technology Assessment. These are false economies, as all they do is make Congress’s shrunken army of under-resourced patronage staff ever more deeply dependent on industry lobbyists for the information legislators need to govern. To insulate our politics more effectively against insider takeover, legislators need to be able to draw on deep internal expertise. As Lee Drutman and one of us (Teles) argued in a 2015 Washington Monthly piece, “A New Agenda for Political Reform,” a major upgrade of legislative staff with a larger, better-paid, and more professional cadre of civil servants would arm Congress with the knowledge needed to counter the rent-seeking lobbies that seek to twist rules to their own advantage.

Even if conservatives were to take our advice, a sustained campaign against regressive regulation would not meet with quick, easy victories. What awaits is, in the words of Max Weber, “the slow boring of hard boards.” The disproportionate influence of the wealthy over the basic rules of the economy is deeply embedded, and the best we can do is chip away at it, a little at a time.

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That leaves a hard question, namely, how conservatives should think about inequality in a fallen, second-best world in which so many of these rents survive. At a minimum, there’s a strong case for reconsidering the conservative obsession with reducing top marginal income-tax rates. For too long, conservatives have overhyped the growth effects of tax cuts, as well as the dubious “starve the beast” theory according to which members of Congress would respond to tax cuts by restraining government spending. Many conservatives did not look carefully at the evidence behind these dodgy empirical claims because they believed that they held the moral trump card: By cutting taxes, they were returning wealth to its rightful owners. But in the “captured economy” we’re currently living in, this belief is due for reexamination. Not only is a significant fraction of the rich’s income morally tainted by government favoritism, but it is also used to fund yet more rounds of regressive rent-seeking.

One way to begin solving this problem would be to build a veritable bonfire of the deductions that the wealthy use to shield their income from taxation. The exclusion from taxes of employer-paid health insurance, retirement savings through 401(k)s and IRAs, and education savings accounts could either be scrapped or converted into refundable tax credits. We could also consider a financial-transaction tax, which could raise a lot of revenue while also reducing the incentives for excessive trading of assets. Changes such as these would allow us to claw back some of the rents at the top of the economy without increasing the marginal income-tax rates that conservatives are so concerned with.

If conservatives took seriously the presence of ill-gotten gains at the top of the income spectrum, they might also look at immigration policy in a new light. Over the past few decades, the United States has exposed those at the bottom of the economic pile to intense global competition, whether in the form of products from China or workers from Mexico. As Dean Baker has argued, it is high time to expose the wealthy to those same bracing forces of competition by opening up the economy to more high-skilled immigrants, especially in protected professions such as medicine and dentistry.

Conservatives need to face and resolve their inequality paradox. They must double down on their principled advocacy of free, competitive markets — while taking a few giant steps back from the assumption that large incomes reflect large contributions to the general welfare.