An Upside To Inequality?

COMMENTARY Poverty and Inequality

An Upside To Inequality?

Jun 30th, 2007 2 min read

Research Fellow, Labor Economics

As research fellow in labor economics at The Heritage Foundation, James Sherk...

Is the American Dream dead? Some seem to think so. They point to studies showing that income for the rich is growing faster than for the poor. In this view, we've become a class society where a minority lives in opulence while most struggle with little hope of getting rich themselves. But new research suggests that greater inequality may be both fair and beneficial.

According to a study by the National Bureau of Economic Research, much of the increased inequality in the past generation--including almost all the gains among top earners--occurred because companies upped their use of performance pay. That is, inequality has risen for a good reason: The economy is increasingly rewarding hard work.

Of itself, inequality is neither positive nor negative. What matters is why incomes are unequal. In a class-based society where a few families control wealth through inheritance or coercive means, rising inequality does indeed cause harm. Higher inequality, in 17th century England or in Saudi Arabia today, means increased hardship for most workers.

However, in a society where most wealth is earned, some greater inequality can benefit most citizens. Consider Google Inc. founders Larry Page and Sergey Brin, who each worth $16 billion, thanks to their stake in the search giant. Their success has made America a demonstrably less equal country--who wouldn't want to swap paychecks with them?--yet most people are better off for it. Google's services allow tens of millions of Americans to find what they want fast on the Internet and use a quality e-mail service free of charge. Page and Brin got rich, and thus increased inequality, by improving the lives of others.

That's why it's dangerous for government to intervene when hard work and innovation raise inequality. Instead, policymakers ought to examine what caused inequality before concluding it ought to be rectified.

One major change in the economy has been wider use of performance pay that bases workers' compensation, at least in part, directly on their productivity. New technologies have made it easier to measure the performance of individual workers. More employers use commissions, piece-rate pay, or performance bonuses to compensate workers. The proportion of jobs with pay tied to performance rose from 30% to 45% from 1976 to 1998. Half of salaried employees today work in jobs with at least some performance pay. Companies have embraced this system because it encourages employees to work harder.

But performance pay increases inequality in two ways. First, it rewards those who produce more. Imagine two car repair shops: The first pays every employee a flat hourly wage for installing replacement windshields; the second pays workers a flat fee for each windshield. The second company has a less equal workforce than the first, because its performance pay gives greater rewards to more diligent and productive workers, meaning higher inequality.

Second, employees in performance-pay jobs step things up a notch and work harder. Consequently they earn, on average, more than workers with a set wage or salary. So higher wages for performance-pay workers, but not others, also increase inequality.

The NBER study by economists Thomas Lemieux, W. Bentley MacLeod, and Daniel Parent shows that, after controlling for factors like the increasing value of education, 24% of the increase in inequality from 1976 to 1993 occurred because of the increase in performance pay (enjoyed most by managers, salesmen, craftsmen, and professionals). More strikingly, performance pay explains almost all of the increase in inequality for the top 20% of wage earners. The top earners have made so much through hard work, not family background.

Many assume that rising inequality means people born into poverty will have a harder time getting ahead. Performance pay, however, increases inequality and opportunity simultaneously: By encouraging employees to work harder, it raises average wages. And with performance pay, which rewards the best workers, race or family background matters less.

Yes, an economy that rewards hard work generates inequality. But that economy is indisputably fair. That's why, rather than bemoaning inequality, policymakers must search for ways to expand the number of jobs that can base pay on performance and allow more workers to share in the gains.

James Sherk is Bradley Fellow in Labor Policy in the Center for Data Analysis at The Heritage Foundation.

First appeared in BusinessWeek