Running out of excuses for high inequality

American views on inequality have profoundly shifted. In 1995, 30 percent believed that poverty is due to circumstances beyond individual control. Today, fully 55 percent of Americans take that view. Two decades ago, most Americans didn’t see a role for government in addressing inequality. Now, most do.

The traditional economic argument against addressing inequality is that it blunts the incentives for the wealthy to invest. But while cutting top tax rates might give the most affluent a larger share, the consequence can be that governments need to cut productivity-enhancing measures like infrastructure and education spending. As a result, growth slows. The wealthy end up with a bigger share of a smaller pie. They have more in relative terms, but less in absolute terms.

The other long-standing case for inequality concerns the value of entrepreneurial innovation. It won’t surprise you that this is a view commonly held in Silicon Valley. Paul Graham, founder of the successful startup incubator, Y-Combinator, wrote that he was “a manufacturer of inequality.” What he means is pretty simple: If an entrepreneur works hard to develop and bring an innovation to market, their prize is to enjoy Scrooge McDuck-like riches. Taxes take away that prize, lowering incentives to become entrepreneurs. Fewer entrepreneurs reduce innovation. By this logic, inequality is a necessary price to be paid for more innovations.

Few people would be happy to give up their iPhones for seeing one less zillionaire. But that is not the way things usually work. Many of the super-wealthy made their fortunes based on cornering a market rather than inventing a new product or service. Do they all need a free ride so that we have more innovation?

More critically, alongside entrepreneurship comes risk and uncertainty. Risk, of course, can bolster the argument that we shouldn’t mess with the prizes from innovation. After all, everyone – including those who try and fail – are contributing to the innovation process. But it also reminds us that the tax changes that are typically contemplated tend to be fairly small in the scheme of things. A 10 percent tax cut may boost the prize of entrepreneurship by 10 percent. But that 10 percent will play little role in the calculus of someone deciding whether to build a startup or do something else.

One way to think about this is in terms of a chain of probabilities. The famous Drake equation is a calculation that takes the number of galaxies in the Universe and slowly factors it down to work out the likelihood that we co-exist with intelligent civilizations in our part of the Milky Way. Multiply the number of stars in our galaxy (which is large) by the probability that those stars have life-producing planets and then again by the probability that those planets have produced life today and you end up with a very small number.

The same is true of entrepreneurship. Even a generous assessment would estimate the probability that a startup succeeds at about 10 percent. Thus, if success were obtaining $1 billion in wealth, then the value of the gamble would be a tenth of that or $10 million — not a small amount. But if you suddenly cut the taxes of $1 billion by 10 percent, then the value of the gamble only rises to around $11 million. And we haven’t even factored in the notion that our talented future Steve Jobs was likely to find a high-paying career regardless. So the chance of those higher taxes causing them to change their entrepreneurial aspirations is, as a matter of pure economics, pretty unlikely.

If that isn’t compelling enough, here is some evidence. In a recent article, Alex Bell, Raj Chetty, Xavier Jaravel, Neviana Petkova and John van Reenan found that higher taxes on the wealthy would not cause a reduction in the number who chose innovative career paths. Instead, what drove them to become innovators had more to do with other factors other than monetary rewards, such as their exposure to innovators at early stages of their lives.

Between theory and empirical evidence, the argument that we need to accept high inequality to achieve greater innovation does not have strong support. Tax policy needs to consider not only how the money is raised but also how it is spent. How many more promising young innovators in disadvantaged communities could emerge if every school had a great entrepreneurship program?

The success of Silicon Valley itself owes much to government research programs — funded by tax revenues. Those who want to protect the wealthy from taxes will have to look elsewhere for an economic rationale.

Joshua Gans is a professor at the University of Toronto. Andrew Leigh is a member of the Australian parliament. Their new book is “Innovation + Equality: How to Create a Future That Is More Star Trek Than Terminator.”