Inequality and free markets

(This post is a summary of the main things I found while diving into the economics literature on income inequality. Will try to condense my findings as much as possible, but there’s a lot to talk about. TL;DR at the end for lazy folk)

First, a note on terminology

Before getting into the published research on this topic, I started by surveying articles from popular news sources. I was curious to ultimately compare the standard media presentation to what I’d find in the scientific literature.

A large portion of what I read consisted of debates about the meanings of terms – one person says that capitalism is a lightly regulated market with a social safety net, another says any social safety net is socialism and therefore not capitalism, another says that a free market with any form of government regulation is corporatism, not capitalism, and they all yell at each other about terms and don’t get anything done.

By contrast, the terminology used in the economics and public policy literature was consistent, straightforward, and clear. I’ll define the controversial terms right here at the start to avoid confusion. These definitions are in line with the way that the terms are used in the literature.

Economic freedom: A combination of factors including limited regulation of businesses, protected rights to own private property, trade freedom, and small government.

Free marketAn economic system characterized by high degrees of economic freedom.

Capitalism: A free market economic system.

Stuff that everybody agrees on

Some of the main things that there seemed to be a consensus around in the literature are the following:

  • Economic freedom leads to more rapid growth and higher average income per capita.
  • Economic theory gives no clear answer to the question of if free markets cause inequality.
  • The wealthiest 1% in advanced economies have experienced an enormous boom in wealth starting in the 1970s.
  • This is especially pronounced in the United States.
  • Rapid economic growth in developing nations like China has been accompanied by steep rises in inequality.
  • The middle income and low income classes have been growing apart in wealth.
  • Unions have become less powerful and laborer bargaining power has decreased since the 1970s.

If we amended this section title to Stuff that virtually everybody agrees on, we could add:

  • Globalization causes unemployment in developed countries through offshoring and trade effects.
  • Progressive taxation reduces inequality.
  • A rising skill premium increases inequality between the bottom and the middle class.
  • Erosion of unions in the US has led to overall income dispersion.

After this, it pretty much all gets thrown up in the air. For most conclusions you’ll see cited in a paper on inequality, you’ll be able to find a stadium of other papers arguing the opposite.

So let’s brace ourselves, and dive into the controversy!

The controversial bits

I found remarkably little agreement on apparently straightforward empirical questions. There were different descriptions of the direction of trends in the capital shares of income in recent decades,[10][40] in social mobility,[6][27] and in inequality in developing countries.[1][26]

Given this, it’s no surprise that there is also wide disagreement on broad questions about the relationship between free markets and inequality and the causes of recent inequality trends in America and China.

Do free markets actually increase inequality?

On Piketty’s Capital

You can’t have a discussion about inequality in the United States today without mentioning Thomas Piketty and Capital in the 21st Century.

Piketty’s fundamental thesis is that capitalism inevitably leads to concentration of wealth and inequality in the absence of state intervention.[34] The explanation relies on a distinction between the labor share of income and the capital share of income.

The labor share of national income is the fraction of the nation’s gross domestic product (GDP) that is invested in labor. And the capital share of national income is the fraction of GDP invested in capital (which consists broadly of anything besides labor that can be used to produce wealth, including technology, land, property, machinery, etc).

Piketty claims that in a free market, the rate of return on capital (denoted r) increases over time faster than the growth rate (denoted g). When this happens, wealth tends to cluster towards the top of the income distribution.

Piketty has been hugely influential on the discussion around income inequality and its relation to capitalism, but his contribution is by no means the end of the story. On one level, many of the empirical claims of his book have been challenged. Barkai found that the historical story Piketty tells about current macroeconomic trends is false – capital shares have not been rising, and in fact capital shares have been plummeting even more quickly than labor shares.[10]

A report from the IMF analyzed his basic theoretical claim that countries in which rate or return on capital exceeds growth rates (r > g) experience wealth concentration.[19] They found no empirical support for it, and in fact found the opposite trend. 75% of countries studied in depth exhibited dispersion of wealth when r was greater than g.

Piketty himself has stated that his explanation is not the end of the story. A year after publication, he recognized that “the rise in labor income inequality in recent decades has evidently little to do with r – g, and it is clearly a very important historical development.”[19]

A survey of top economists found that only 2% agreed with Piketty’s claim that r > g is the primary cause of recent inequality in the US:[33]

33 Poll on Piketty.png

The survey includes scathing comments from some professors, including “poor theory and negligible empirics”, “Argument nicely destroyed by Justin Wolfers (and many others). Too bad for the t-shirt makers”, and “Don’t find r-g a partiularly [sic] useful summary of anything.”[33]

That said, many economists agree with Piketty. All this just goes to say that popular opinion does not scientific consensus make. The questions of the causes of income inequality and its relationship to capitalism are still very far from settled.

Some standard arguments

Besides Piketty’s argument about capital investment, I’ll list a few other arguments I’ve seen repeatedly referenced about the relationship between free markets and inequality.

  1. Kuznets U-curve: Capitalism and free market reforms tend to result in booms of rapid economic growth.[26][27] Simon Kuznets described that economic growth causes an initial growth in inequality as wealthy investors reap the benefits of growing cities, new markets, and industrialization. Then market forces drive inequality down as rural laborers move to the city for better-paying jobs. With a shrinking supply of workers, wages rise in the rural labor market, eventually coming to an equilibrium with the urban labor market.[3][12]
  2. Capitalism confers economic power on owners of capital, who have an active interest in exploiting laborers, driving their wages down, and maximizing their own profits.[41] Over time, this results in a cycle of increasing inequality as the wealthy capitalist class holds onto their wealth and more effectively exploit the poor laborer class.[38]
  3. Free markets lead to economic growth that spread prosperity across society, giving the poor additional opportunities to rise in the income distribution.[4] Wealthy business owners are also invested in the growth of the middle and lower class, as a more productive base of consumers means more profits.[35] Free markets also involve protection of property rights, which are especially vulnerable among the bottom of the income distribution and are necessary for generation of capital.[3] In the long run, this leads to decreased inequality as well as overall higher standards of living.
  4. Free markets without strong anti-trust legislation naturally lead to a few large firms ruling the market and preventing competition, resulting in economic inefficiency and mark-ups that hurt the poor and help the wealthy.[15]


What does the data say?

But enough of this theorizing. Pretty much everybody in the economics literature agrees that theory by itself delivers no strong verdict one way or the other on the relationship between economic freedom and inequality.

What is needed to progress with this question is actual data. And lucky for us, the economics literature is rich with research searching for relationships between economic freedom and inequality.

Unluckily, this literature is hugely conflicted and far from a consensus. Most of the papers I found argued that for a negative relationship between economic freedom and inequality[3][4][12][13][23][37] and a substantial minority argued for a positive relationship.[9][21][24][30] One key component of this is that economic freedom tends to result in rapid economic growth and higher average income levels.[22]

One of the ‘negative’ papers found a beautiful trend in the relationship between inequality (measured by GINI) and economic freedom from 1979 to 2004:[12]

12 Freedom and Inequality U-Curve

Kuznets’ U-Curve! Well, a slight variant of the curve, as his original theory was about a relationship between growth and inequality, not economic freedom and inequality.

This suggests that the effect of moving to a freer market will depend on how free the economy was before the policy change. In a heavily state-controlled economy, it is likely that the policy change will result in an increase in inequality. But in a freer market, moves towards less regulation and more economic freedom will decrease inequality.

But my favorite study was published just a few months ago.[11] It attempted to replicate numerous past conflicting findings with expanded data sets, looking at multiple measures of inequality and economic freedom across 112 countries from 1970 to 2010. In its conclusion, it reported finding (drum roll….)

Ambiguous results.

That is, if you choose your inequality measure one way, you get one result, but if you choose it another way, you get a different result.

While the literature here is very conflicted, one thing that is clear is that there are many possible mechanisms through which market freedom can affect inequality, and that these mechanisms can vary substantially with historical context.

I want to explore what these more fine-grained causes of inequality are. Let’s go to America, the inequality capital of the developed world!

What’s up with America?

The last 50 years in the United States have been characterized by three main trends in inequality:[31]

  1. Wages at the middle pulled strongly away from those at the bottom in the 1980s. Starting in the 1980s, wages at the bottom caught up with wages in the middle. These wages were stable for the 1990s and 2000s.
  2. Since 1980, there has been a large and continuous increase in the distance between wages at the top and the middle (slower since the mid 1990s).
  3. Astronomical rise in wages of the top 1%, and even greater in the top 0.1%.

These trends in the United States are echoed in other advanced economies, but are especially pronounced here.[1][2][20]

1 Income Dispersion Cross-Country.png

20 Income Share of Top 1% Cross-Country.png

So what’s going on with us? Why do we have the dubious distinction of being the most unequal economy in the developed world?

The left will point at capitalism, increasing monopolization, concentration of wealth in the hands of greedy bankers, and corrupt CEOs warping the political system and raising their own wages without limit. The right will point to crony capitalism, China, bad monetary policy from the Federal Reserve, immigration, and regulatory capture of corrupt bureaucrats.

The literature points quite clearly to a few main factors. Unsurprisingly, the question of which of these is the most important is highly disputed.

Listed in order of agreement in the literature:

  1. Globalization
  2. Automation
  3. Decrease in labor bargaining power
  4. Rent-seeking behavior from CEOs
  5. Skill premium

I’ll go through these one at a time.

Is globalization evil?

Globalization has affected income inequality in the US in two primary ways: through increased international trade and through offshoring of American jobs, both of which increase US unemployment, lower wages, and lead to lower labor force participation rates.[5] One paper found that two-thirds of all lost US manufacturing jobs could be traced to the growth of trade in China.[29]

29 China Unemployment

The effect of international trade has grown more significant since 2001, when China joined the World Trade Organization and Chinese imports to the US surged.[18] Increasing rates of imports into the country lower the bargaining power of US workers, resulting in wage declines and lowered labor participation.[18] And companies that don’t rely on local labor are able to shift their supply of labor to foreign countries, directly leading to higher unemployment of US workers.[31]

So is globalization all bad? No. There is strong agreement among economists that international trade is in general a great boon to all parties involved. And even if it causes inequality within countries, it may reduce inequality globally by providing better jobs and cheaper goods to the developing world.[13][37][25]

But in general, international trade doesn’t necessarily result in net unemployment, as typically both countries in a trade will stand to gain from the other’s comparative advantages and trade will be bi-directional.

But Chinese trade practices have led to a highly unbalanced trade relationship, with China exporting almost four times as much to the US in 2013 as the US exported to China.[29] Which trade practices am I referring to? Yep, currency manipulation.

The Chinese yuan “does not fluctuate freely against the dollar. Instead, China has tightly pegged its currency to the U.S. dollar at a rate that encourages a large bilateral trade surplus with the United States.”[29] We know this because China buys massive amounts of US Treasury bills every year, artificially lowering the purchasing power of their dollar.

On one analysis, a fully balanced trade relationship would increase US GDP by up to $720 billion and add 5.8 million US jobs. In addition, it’s not even clear that China’s trade policies are good for China. Its economy has become entirely dependent on US consumers, its middle class has an artificially depressed purchasing power (the value of the yuan is about a sixth of what it should be), and they hold trillions of dollars in foreign exchange reserves that could be invested into public goods to grow their economy.[29]

Is automation killing jobs?

Automation affects inequality by replacing low-skill labor, depressing demand for blue-collar production jobs and white-collar office, clerical and administrative support positions.[7] It also increases demand for high-skill labor involving the designing and operation of the technology, contributing to the gap between the low- and middle- income classes.[25] The International Monetary Fund (IMF) estimated that about half of the decline in the labor share of GDP can be traced back to the impact of technology.[40]

This increase in value of technical skills is one component of what has been called the rising “skill premium”. Estimates of different researchers as to the degree to which rising skill premiums explain US wage dispersion range from 55% to 95%.[7]

7 Wage Trend by Education Level.png

This effect has also been especially pronounced in the United States, helping to account for the especially strong rise in inequality here.

7 Skill Premium Cross-Country.png

A quote that stood out to me:[7]

This supply-demand explanation for the rise of U.S. inequality may appear almost too simple to be credible. After all, we are comparing just two economic variables: the college wage premium and the supply of college graduates in the U.S. workforce. But a host of rigorous studies commencing with Katz and Murphy confirm the remarkable explanatory power of this simple supply-demand framework for explaining trends in the college versus high school earnings gap over the course of nine decades of U.S. history, as well as across other industrialized economies (most notably, the United Kingdom and Canada) and among age and education groups within countries.

A fascinating detail from the same article explains why the end of the Vietnam War caused the take-off of the US skill premium in ’82. During the war, college enrollment could be used to defer their draft-required military service, so graduation rates were artificially boosted.

Thus, when the war ended in the early 1970s, college enrollment rates dropped sharply, particularly among males. The fall in enrollment produced a corresponding decline in college completions half a decade later, and a surge of inequality followed.

Another feature of technology that contributes to inequality is ‘audience magnification’, which allows some wealthy individuals to perform on a larger scale and receive greater compensation.[27] This has been offered up as an explanation for the rise in wages of the top 1%.


A lot of research traces US inequality trends back to a pattern of policies that began in the ’80s with Ronald Reagan. But most think that the pattern goes back further than Reagan. Some researchers trace it back to deregulation of various industries in the ’70s that led to decreasing wages.[31] Others see it as starting in the 1960s, noting that 60% of economic growth since then has gone to the top 1%.[21]

Overall, the policy pattern involves a move towards erosion of union power, a weaker minimum wage, more regressive tax policy, weakened anti-monopoly legislation, and lax corporate management around rent-seeking behavior in CEO pay.

I’ll take de-unionization first. Union power has been decreasing since the ’70s. In 1973, 24% of the private sector were union members, compared to just 7% in 2011.[7] The effect of this is to lower labor bargaining power and drive wages down.[2] This has apparently affected men more than women.[20] One study found that de-unionization can explain a full third of the entire growth of wage inequality among men.[31]

Minimum wage policies are also commonly pointed to as causes of inequality, especially for women.[20] There’s a huge economics literature on the effects of minimum wages, and I don’t have the time now to get deep into that debate. But in reading a few reviews of the literature, I found two common themes: first, that minimum wages raise unemployment,[32] and second, that even accounting for this unemployment, minimum wages result in an average increase in income for those at the bottom of the income distribution.[39] The Congressional Budget Office estimated the effects of a $1 and a $2 raise to the minimum wage, nicely summarized in this chart:[39]

39 Minimum Wage

Starting in the 1980s, the real value of the minimum wage began a decades-long decline due to inflation and a fixed nominal value.[7] As purchasing power declined, low-income wages dropped in real value, pushing apart the bottom and middle of the income distribution.

The wage gap between the bottom and the middle stabilized in the 1990s and 2000s, which has been attributed to the rise in the minimum wage during this period.[31] Some researchers have attributed two-thirds of the growth of the wage gap for women from 1980 to 2010 by these minimum wage trends.[31]

Minimum wage policies and de-unionization help explain the gap between the bottom and the middle, but the rise in income share of the wealthiest Americans has also been attributed to policy choices involving tax cuts for the wealthy, weakened anti-trust legislation, and deregulation.

Top income tax rates peaked in the US around 1950, and have followed an inverted U-shape since.[2] Effective tax rates for the 400 highest earning taxpayers declined from 27% to 17% from 1992 to 2012.[17] Globally, top tax rates show a strong negative correlation with the top 1% income share.[2]

2 Top Income Shares Cross-Country Since 1960

The enrichment of the top 1% has only been matched by the enrichment of the top 0.1%.[14][31][36]


CEO compensation really took off in the 1990s, and from 1979 to 2012, CEO pay grew 876%, more than double the real growth in the stock market.[14]

The main explanations for this extreme enrichment tend to point towards price markups, rent-seeking behavior, and lax corporate governance.

A Federal Reserve Board paper found that mergers in the US manufacturing industry from 1997 through 2007 “significantly increase markups on average, but have no statistically significant average effect on productivity.”[15] A more controversial paper claimed that “the decline in labor share is due entirely to an increase in markups, [and] is accompanied by a decline in output and consumer welfare.”[10]

Several researchers[14][31] have attributed the rise in CEO pay to rent-seeking by corporate insiders whose wages are set by peers on corporate boards, as well as a change in social norms around wage increases. ‘Rent-seeking’ here is used to mean that the increase in income did not result in any additional productivity by the individual CEOs.

There is also, of course, the concern about political corruption and the role of money in politics, which has also become increasingly significant.[16]

16 Campaign Contributions.png

Weirdly, recent surveys of attitudes towards inequality reveal that the wealthy are apparently as concerned about inequality as the poor.[28] Part of the reason for this concern is self-interested – a stagnant middle class does not make for active consumers.[35]

So, what now?

A 2016 World Bank report detailed the recent decline in inequality in Latin America, and found that it was the result of two main forces: a declining skill premium and progressive government wealth transfer programs.[30]

And a 2017 article reported that inequality in China was turning around after a several-decade rise.[1][30] Explanations given for this have been the tightening of the rural labor market caused by migration into richer urban areas, heavy government investment in infrastructure in the rural sector, rising minimum wages since 2004, and social programs that have been getting stronger from the 2000s onwards (including medical insurance that covers 95% of the rural population and rural social security programs).[26]

One of the amazingly universal consensuses I found across the literature was that progressive taxation works.[1][2][3][7][12][13][27][30][34][36] Even the generally pro-free-market sources I read would stop to praise progressive taxes in the middle of arguing against large government and wealth redistribution.

But in general, the solutions to issues of inequality depend on what you think the primary cause of the problem is, and what trade-offs you’re willing to make. We’ve seen a wide variety of opinions on this, ranging across the political spectrum.

If inequality is a necessary side effect of economic growth, and economic growth results in net happiness (as is suggested by some research[8]), then maybe there is nothing to be done. And if the problem is that economic growth in the early stages of a Kuznets curve causes a temporary rise in inequality, then the solution is to wait for the market to naturally cause inequality to decline.

If you think that the problem is globalization, then maybe the most important solutions are modifications to WTO rules allowing imposition of tariffs on imports from currency manipulations, restriction of Chinese imports, or removal of tariffs on US exports to China.

If the problem is technology and the rising skill premium, then the solution is an expansion of educational opportunities and broadening access to education and skill training, in order to allow more people to get in on the premium and lower its value.

If the problem is weakening of the bargaining power of laborers, then the solution is increasing the power of unions, more employee ownership programs, stronger social insurance policies, and a revamped set of labor regulation policies.

And if the problem is rent-seeking CEOs and monopolization, then the solution is steeply progressive taxation, stricter corporate governance, and stronger anti-trust legislation.


TL;DR for everything

  1. Inequality is booming in the developed world, especially in the US.
  2. The relationship between free markets and inequality is unclear.
  3. Rises in inequality in the US have been proposed to follow from:
    1. Globalization
    2. Increasing skill premiums
    3. Automation
    4. De-unionization
    5. Monopolization
    6. Lax corporate management
    7. Regressive taxation
    8. Decline in the value of the minimum wage
  4. Solutions to inequality look like:
    1. Progressive taxation
    2. Wider education access and skill training
    3. Strengthening unions
    4. Strong social programs to protect the poor
    5. Repairing China-US trade relations
    6. Stronger minimum wages
    7. Wage subsidies


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