He says "Robert Downey Jr.", I say "Paris Hilton".

I had hoped to put my series of posts about inequality behind me (see Inequality, does it matter? and Inequality and the genetic lottery: Two views), but Greg Mankiw wrote a New York Times commentary in defense of the top 1% and I felt compelled to respond and my reply parallels Larry Summers' comments about America turning into a Downton Abbey economy. In the article, Mankiw's made two points. First, the wealthy are deserving of what they earn:

In 2012, the actor Robert Downey Jr., played the role of Tony Stark, a.k.a. Iron Man, in “The Avengers.” For his work in that single film, Mr. Downey was paid an astounding $50 million.

Does that fact make you mad? Does his compensation strike you as a great injustice? Does it make you want to take to the streets in protest? These questions go to the heart of the debate over economic inequality, to which President Obama has recently been drawing attention.

Second, the rich pay their fair share of taxes:

A reliable tax system is also important to ensure that the wealthy pay their fair share to support the public weal. That is generally the case. Our tax system is far from perfect and is arguably in dire need of reform, but examples of the tax-dodging wealthy are not at all the norm.

The Tax Policy Center estimates that in 2013, the top one-tenth of 1 percent of the income distribution, those earning more than $2.7 million, paid 33.8 percent of their income in federal taxes. By contrast, the middle class, defined as the middle fifth of the income distribution, paid just 12.4 percent.

Equality of opportunity
I have two responses to Mankiw's points. In my previous post (Inequality, does it matter?), I wrote that in order for the American Dream to flourish, it is the equality of opportunity that matters the most. Mankiw is partially right, most people would not begrudge an entertainer, sports figure, or company founder from his or her wealth.

The flip side of that coin is that people must also be allowed to fail, otherwise the free market becomes impaired by policies that support a segment of the population that did not earn their rewards. Otherwise, the "destruction" part of "creative destruction" doesn't happen.

I present, as Exhibit 1, Paris Hilton. How is someone like Paris Hilton, who is famous for being famous because of her surname, deserving of her wealth and career? Should a poor black girl in the slums who is similar self-absorbed be deserving of such fame and public notoriety?

As supporting evidence, I present the Rich Kids of Instagram, a generation of ultra-rich young men and women who did nothing to earn their wealth. While we might be inclined to congratulate and celebrate the accomplishment of the parents who were able to generate such riches, we are far less inclined to celebrate the behavior of a generation of out of control rich kids. These kids haven’t learned the value of a dollar. They certainly know how to spend it, but it is less clear they know how to make it.

Allowing downside of creative destruction to work is the same principle that I espoused when I advocated bringing back the partnership investment bank (see A proposal for reforming Wall Street). If you don't let the TBTF institutions to make mistakes, you end up with a case of mis-aligned incentives and, at best, a society dominated by crony capitalism.

Tax policy an instance of where the rubber meets the road in the application of the principle of creative destruction. Mankiw contends that the rich pay their fair share of taxes, but does current tax policy encourage the entrenchment of an Upstairs/Downstairs class system, or does it allow free market forces to do their work so that destructive part of creative destruction to occur?

Consider, as one of many examples, the Bush II dividend tax cut. What economic effect did it have? Ask yourself these questions:

1. Did it encourage more investment in the economy because it lowered the cost of equity? Or was the main effect a shift in preference between debt and equity financing?
2. Did it shift taxable individual investor preferences towards equity and away from municipal bonds, which raised the cost of capital for state and local authorities? If so, was that an intended or unintended side effect?

I would contend that current American tax policy, particularly under Bush II, has served to entrench established interests, encourage crony capitalism and ultimately impair market efficiency. An upstairs/downstairs society only impairs American competitiveness.

Surely, Greg Mankiw is not against allowing free market forces to work, is he?





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.