As I prepared to read these two books, I had different expectations. I thought Branko Milanovic’s Capitalism, Alone would contain some interesting defenses of capitalism, while The Myth of American Inequality by Phil Gramm, Robert Ekelund, and John Early would offer an easy and perhaps banal defense of existing inequality. After all, what should I expect from a politician like the ex-senator Gramm, even if he pursued some good policy ideas during and after Ronald Reagan’s presidency (when the Texan switched to the Republican side of the Senate aisle)?

To my surprise, I found Milanovic’s ideas rather banal and too uncritical of the zeitgeist of our times. Gramm et al., on the contrary, present deep and interesting statistical and economic analyses of the trumpeted inequality of American society.

Milanovic’s capitalism / Milanovic, a former World Bank economist, is now a senior scholar at the City University of New York’s Stone Center on Socio-Economic Inequality. His book argues that capitalism stands alone in today’s world because all successful regimes are variations of the same basic system. He uses the term “liberal meritocratic capitalism” to describe the political-economic system found in advanced Western countries as well as Japan and South Korea. It combines capitalism with legal equality and democracy, the latter two attenuating the market’s harsh meritocratic feature. “Social-democratic capitalism” is another form, which is supposed to have fleetingly existed between the end of World War II and the early 1980s in Western Europe and North America. Milanovic thinks that this form of capitalism tried to redistribute income more seriously. “Political capitalism,” represented by the Chinese model, is based on decentralized enterprises with “wide latitude” but under a powerful authoritarian state guaranteeing stability.

“Classical capitalism” is an obsolete form of capitalism that prevailed under Adam Smith and the Industrial Revolution. Milanovic believes that it was not ethical or consistent with today’s globalized world—nor presumably with our progressive elites.

The book contains some good ideas. Take the discussion of the “unfounded fear of technological progress.” Milanovic shows that there is no reason to fear that technological progress will reduce employment and cause social dislocation. We have experienced 200 years of technological progress, “and every time, after the shock is past, it turns out that [these fears] have been exaggerated.” When resources became scarcer, their prices increased, they were economized, and other resources were substituted for them (synthetic rubber is just one example). New resources and production methods were discovered or improved (beet sugar or fracking, for example).

Milanovic tells the instructive story of Stanley Jevons, a prominent 19th-century British economist, who believed that the supply of trees would run out, paper would become scarcer, and paper prices would go through the roof. He thus hoarded a large stock of paper. But new technologies reduced the cost of manufacturing paper as well as the cost of harvesting and replanting forests. Fifty years after Jevons’ death, his children had yet to use up his paper stockpile. “We are no smarter than Jevons,” Milanovic complains. “We, too, cannot imagine what might replace fuel oil or magnesium or iron ore. But we should be able to understand the process whereby substitutions come about and to reason by analogy.”

Shaky claims / The main thread of the book’s argument, however, is very shaky. Despite what he said about technological progress and reasoning by analogy, Milanovic is suspicious of Adam Smith and Friedrich Hayek’s autoregulated economic order. He sees capitalism as a regime that promotes the interests of capitalists instead of a set of free markets that satisfy consumers’ demand. It’s barely exaggerated to say that in his vision of capitalism there are no consumers with diversified preferences, just a mass of people who want “economic growth,” whatever that is! Consequently, it is only an empirical question which system produces more economic growth, liberal meritocratic capitalism or (if corruption is kept at a reasonable level) political capitalism, and which regime will come out the winner in the evolution of social institutions.

For Milanovic, it seems, capitalism is always crony capitalism, except if the political system dominates. He does not seem to realize that, between the capitalists’ special interests controlling the state on the one hand and, on the other hand, a state that controls capitalists and everybody else, there is a third alternative. The third alternative we may call “free markets” if the label “capitalist” is unavailable. In a free-market society, capitalists only have veto power against expropriation and state control. Besides that, consumers rule. That, contra Milanovic, should be the ideal.

Milanovic thinks the current system of globalized “capitalism” is naturally amoral, by which he seems to mean immoral. Except perhaps for his summary references to John Rawls, I would argue that it is Milanovic’s own approach that suffers from amorality if not immorality. Democracy, conceived as the mere rule of the majority and yearning for material equality, appears to be his only moral foundation. Nowhere in the book does he mention or cite James Buchanan or raise the question of whether individual liberty can foster, or be supported by, an ethics of responsibility and reciprocity. (See “An Enlightenment Thinker,” Spring 2022.)

The neglect of spontaneous economic order and a sketchy ethics mean that Capitalism, Alone leaves no room for limits on political power. The author seems to imagine a Brave New World made of economic growth—the production of as much as possible of something—and submission to some numerical majority or other benevolent ruler. He is blind to the danger of tyranny.

The Chinese model looms large in Milanovic’s scenarios and in his attraction to political capitalism. He is not the only one to think this way. It is strange that so many economists have not realized that the Chinese economy can only provide meaningful economic growth—that is, growth that responds to market demand—to the extent that it gets closer and closer to real, non-political capitalism. Through international trade, it is now easy to start an industrial revolution; maintaining its momentum is another matter. It is strange that we could ever believe that more economic dirigisme and more industrial policy would make the Chinese model more attractive instead of compromising its economic success. But it is now becoming obvious. (See “Getting Rich Is Glorious,” Winter 2012–2013.) It is also obvious that the Chinese government does not need the ill-advised cooperation of the protectionist U.S. government to undermine the enrichment of Chinese citizens (or subjects).

Egalitarianism / Milanovic more-or-less assumes that economic inequality is bad, large, and increasing. If it continues to grow, liberal meritocratic capitalism will have to move toward a more advanced and egalitarian stage. “We must set ourselves an entirely new objective: We should aim for an egalitarian capitalism based on approximately equal endowments of both capital and skills across the population” (emphasis in original).

His proposed policies include:

  • tax advantages for the middle class;
  • higher taxes on the rich, including higher inheritance or wealth taxes that could finance a “capital grant” for every young adult;
  • employee stock ownership plans;
  • better public schools; and
  • forbidding private contributions to political campaigns, which he expresses as “strictly limited and exclusively public funding of political campaigns.”

This last mantra seems to always pop up in progressive wishes, as if Donald Trump would not have been elected under a populist election financing system!

Otherwise, we are warned, liberal meritocratic capitalism is likely to evolve toward a plutocratic regime and eventually into political capitalism. The majority will want to drop democracy in favor of equality, stability, and growth. The good state will intervene to control all that. But, he should realize, the equalizers will be less equal than the equalized.

Gramm et al.’s very different book / The Myth of American Inequality is a very different book: more focused, more critical, and better grounded in the values underlying the ideal of a free society. It challenges the accepted idea or assumption that large and increasing inequality is a huge problem under the sort of capitalism that we know in America (even if it is far from classical capitalism). The authors are three economists: Gramm, who at the beginning of his career taught economics at Texas A&M University; Ekelund, a professor emeritus at Auburn University who passed away as I was putting the finishing touches on this review; and Early, a mathematical economist and consultant who, interestingly, was once a legislative assistant of the late Democratic senator George McGovern.

As announced in the title of the book, the authors argue that the problem of large and growing inequality in America is a myth. Whatever inequality exists in earned income (market income) largely results from individual choices in pursuit of economic opportunities. Besides, it is much attenuated by the welfare state’s transfers and taxes. These transfers, however, have generated a worrisome “decoupling of low-income households from the workforce” and created a whole class of dependent people with reduced opportunities.

The authors carefully document how income inequality is exaggerated in many published statistics from the Census Bureau and the Bureau of Labor Statistics (BLS) because real income is inaccurately measured. The required correctives are well-known and have been documented and published elsewhere by these or other government agencies.

Earned-income inequality / I will first consider the measurement of earned income—that is, household income before taxes and transfers. The taxes considered in Gramm et al. include federal and state personal income taxes, payroll taxes including Social Security and Medicare taxes, sales and property taxes, and all “other” taxes at any level of government.

A measurement problem that is well-known and has been researched for several decades is that the ordinary Consumer Price Index (CPI), as opposed to the “chained” CPI (C‑CPI) or to the Personal Consumption Expenditure Price Index, overstates inflation by something like 1 percentage point every year. One reason is that the CPI does not timely recognize the substitutions that consumers make by moving away from more expensive goods toward less expensive ones when relative prices change—for example, by substituting chicken for beef if the price of the former decreases or the price of the latter increases. Technically, the quantities used to weigh prices in the index lag (by up to three years) the decisions consumers make to maximize their utility. That difference matters. If we use C‑CPI, which includes this corrective, instead of the ordinary CPI, we obtain an increase of 31.8 percent in real wages from 1967 to 2017, or more than three times the official 8.7 percent published by the BLS.

A reminder might be useful: a price index is meant to extract from money income the general depreciation of the currency’s purchasing power. Having more money does not help if prices have generally increased by the same percentage. As Gramm et al. point out, the federal government is hypocritical (my expression) on this because it does use the C‑CPI to adjust tax brackets, which reduces the inflation offset and thus increases the tax grab!

Another reason why the ordinary CPI overestimates inflation is that the BLS takes many years to correct for price increases stemming from improved or new goods (say, cars with navigation systems) or services (in medical care, for example). Part of such price increases comes from improvements that consumers are happy to pay for, not from a general depreciation of the currency. Including both the substitution effect and the effect of improved products reduces by close to half the measured inflation between 1967 and 2017. As a consequence, we observe that real wages increased not by 8.7 percent, not by 31.7 percent, but by 74 percent during that period. And the real median household income nearly doubled, instead of increasing by the reported 33.5 percent.

I wouldn’t say, like the authors of The Myth of American Inequality, that “as a nation, we need to get our facts straight,” because that holist phrase is meaningless. A nation cannot get its facts straight any more than it can read Adam Smith or eat at McDonald’s. Nobody can act “as a nation,” as if he were 334 million individuals. But the federal government should certainly correct highly misleading statistics that only help politicians increase their power and bureaucrats boost the importance of their bureaus.

The Gini coefficient is a measure of income equality that varies between 0 for perfect equality and 1 if only one household received all income. Between 1967 and 2017, the Gini for earned income increased by 27 percent to 0.561. Many factors contributed to this. As we will see, the proportion of poor people who don’t work doubled, thereby earning lower incomes than they would have otherwise. The market incomes of the most qualified workers increased faster than those of the less qualified. Those who pursued more education got larger remuneration increases. Not only education choices but also marriage choices have played an important role: more educated women entered the labor market, married higher-income men (a phenomenon called homogamy), and thus increased the relative incomes of richer households.

It is important to understand that real earned incomes increased all over the distribution ladder. In 2017, 44 percent of households even earned real market incomes that, 50 years before, were only earned by those in the top quintile.

The wealthiest / But what about the filthy rich? The first thing to realize is that the super-rich are not very numerous. Sometimes, the supposed super-rich are not all that rich. A household earning $600,000 in pre-tax annual income has already entered the top 1 percent of the income distribution. That is certainly a good income, but not outrageous when one realizes it typically goes to a two-earner household. Moreover, the average one-percenter household pays 40 percent of its income in taxes, more than the average tax rate for any of the five income quintiles. Note also that among households earning $1 million or more a year, only 21 percent received any inheritance.

It is only at the top of the top 0.001 percent of the income distribution that the average tax rate decreases, from 40 percent to about 32 percent for the 400 richest American households. Up to there, the average tax rate increases all along the income ladder, from the first to the fifth quintile. Regarding these superrich households, Gramm et al. calculate that “if government seized all of their after-tax income, it would fund the federal government for less than six days.” Note also that the assets of the very rich are taxed at 40 percent upon their death.

According to Forbes, the 400 richest American individuals have an average net worth of more than $2.9 billion. It is estimated that almost two-thirds of them came from poor to upper-middle-class families, including 7 percent from poor ones. Only 6.5 percent of the 400 live on merely inherited wealth.

How can economists like Emmanuel Saez, Gabriel Zucman, and Thomas Piketty claim that the very rich pay a lower tax rate than nearly everybody else, an urban legend echoed everywhere? Because their calculations add to the earned incomes of the very rich the returns on their assets (that is, their capital gains) that have not been realized, artificially increasing the denominator of the tax rate. The implicit idea is that these people should pay a tax on their capital as well as a tax on the annual income from that capital. It is as if a worker were taxed not only on the annual return of his human capital—taxed on what he earns as wages or salary—but also on the increased value of his human capital. It is as if every year in which one’s human capital increases in value (because of education or experience or better health), one has to immediately pay taxes on all future earnings to flow from this new capital.

Inequality and government transfers / Let’s now consider the distribution of total income, adding to earned income all the assistance that governments provide. Gramm et al. call “transfers” all forms of such assistance, whether in cash (e.g., Social Security) or not (e.g., Medicaid). The problem is that the Census Bureau’s income statistics, designed in 1947, count only some government transfers. For example, food stamps, Medicare, Medicaid, and the reimbursable Earned Income Tax Credit and Child Tax Credit are not counted. More than 90 percent of the more than 100 federal transfer programs are not counted. The majority of state and local transfer payments are not counted either. Overall, in 2017 only $0.9 trillion (32 percent) of the $2.8 trillion of government transfers were included in income. Families classified as poor are eligible for more of the excluded transfers and receive higher benefits from them, so Census counts only 12 percent of the transfers that they actually receive.

Counting all transfer payments (federal, state, and local), they add up to 22 percent of all earned household income (before taxes) in 2017. In the average bottom-quintile household, total government transfers amount to $45,489 compared to $4,908 in earned income.

If we recalculate the poverty rate by adding all the transfer payments (net of taxes) and using a proper price index, it falls to 1.1 percent in 2017 compared to the official rate of 12.3 percent. Applying the same adjustments to the whole bottom quintile, we find that the real average family income after transfers and taxes has multiplied nearly eight times since 1947, a faster growth rate than all other quintiles including the top one.

These analyses reveal another remarkable fact: government redistribution through taxes lifts the average income of households of the first quintile to 89 percent of the second quintile.

These conclusions are not that surprising because, although poverty does exist, casual observation does not often reveal it, except in the marginal phenomenon of homelessness. Of course, any measure of poverty or inequality is an average, and extreme cases exist. Two-thirds of the Census Bureau poor have cable or satellite television, and almost three-quarters have a car or truck. In 2009, according to a Census Bureau study, poor and middle-income children had diets with equivalent amounts of protein, vitamins, and minerals. “Among families defined as poor,” the authors of The Myth of American Inequality write, “hunger has been virtually eliminated, inadequate housing has all but disappeared, and the amenities of daily life have expanded.”

After we correct the Gini coefficient to include all government transfers and correct for some technical changes in its calculation over the years, inequality of total income has decreased by 3 percent between 1947 and 2017, from a Gini of 0.345 to 0.335.

A perverse consequence of the massive transfers to bottom-quintile households has been to incentivize these people to decouple from the labor force. In 1967, in that quintile, those who had a job represented 68 percent of able-bodied, working-age individuals not studying full-time. In 2017, after 50 years of War on Poverty programs, only 36 percent worked. The proportion of the employed increases steadily as we move up the quintiles, until we find that 100.5 percent are working in the top quintile, indicating that even some individuals past the retirement age plus some students are employed. The work factor is the main cause of the increased inequality in earned income over this half-century.

Other numbers illustrate this dependence on the welfare state. For example, 13 percent of the American population now benefits from food stamps. It was not meant to be like that. Franklin D. Roosevelt thought that able-bodied individuals should earn their keep. Similarly, Lyndon Johnson declared: “The War on Poverty is not a struggle simply to support people, to make them dependent on the generosity of others. It is an effort to allow them to develop and use their capacities.” The two presidents obviously did not think about the economic logic of a system that rewards the opposite of self-reliance.

Social mobility / The Myth of American Inequality argues that the American Dream is alive and well. Contrary to accepted wisdom, the country shows a high rate of income mobility despite the government essentially discouraging many individuals from rising above relative poverty. Two sets of numbers stand out.

Consider, first, absolute earned-income mobility, correcting for overestimates of inflation. Gramm et al. find that in 2017, 44 percent of households earned a real income that would have placed them in the top quintile in 1967.

Second, we consider relative intergenerational income mobility (income being defined roughly as taxable income plus some government transfers) by following each one of two generations of families with panel data. Three different studies are used to follow the position of adult children across income quintiles during the first or second decades of the 2000s compared with the position of their parents’ families. If perfect mobility obtained, the family incomes of the now-adult children would be distributed randomly across the five quintiles; with zero mobility, at the other extreme, the children’s family incomes would all fall in the same quintile as their parents’ families. The results of the three studies all fall between those extremes, but much closer to the random case—that is, to perfect mobility: “On average…, adult children’s income distribution showed that 29.2 percent of adult children stayed in the same quintile as their parents.” The rest, 70.8 percent, changed quintile. For example, 63 percent of bottom-quintile children moved up to another quintile with their families, and 62 percent of the top quintile moved down.

With relative mobility, if some unit moves up, another must of course move down. But as we saw, real incomes have generally increased over time. Recall that real wages increased by 74 percent over the past 50 years and the real median household income nearly doubled. Economic growth allows both income mobility and a general increase in real income.

Solutions and questions / Government transfer payments provide a big lift to the incomes of poorer households, but we have also seen that the welfare state’s value is ambiguous because it traps first-quintile (and some second-quintile) households into idleness and economic dependence. Another example is that one in eight Americans gets food stamps. This raises fundamental issues about how the state can offer some “income insurance,” as James Buchanan and many other classical liberals proposed, without creating a society of dependent wards.

The authors of The Myth of American Inequality advance four policy proposals that follow from their analysis:

  • The federal government should stop misinforming people with misleading statistics.
  • It should also stop incentivizing able-bodied, working-age individuals to stay out of the labor force.
  • Elementary and secondary education should be reformed through competition (charter schools, scholarships to private schools, vouchers).
  • Abolish government barriers to opportunities, notably occupational licensure, which hit 5 percent of workers in 1950 and 25 percent in 2012.

These proposals would make a good first step. But it is doubtful they would be sufficient, or even possible, without more fundamental changes in the role and power of governments and without a general understanding of the conditions of a free society. Obviously, neither the Republican Party nor the Democratic Party is on the right track. They are going in the opposite direction.

At any event, it is difficult to discuss equality, inequality, prosperity, and the future of our more-or-less free societies without the numbers that Gramm, Ekelund, and Early put before our eyes.