Why Are the Rich So Rich?

Yesterday, Tyler Cowen noted a paper arguing that the income of financial professionals makes up a large proportion of the top incomes.  Since income inequality has been growing at the very top, this has led many to the conclusion that the very wealthy--and particularly those in the finance sector--have arranged things so that most of the rising incomes in society go to them.

It's certainly not a thesis that I find impossible.  Markets are governed by rules, and incumbents will seek to alter those rules to their own benefit. The thesis seems especially convincing in the light of the university-based meritocratic elite that has emerged over the last four decades.  Bankers are very cosy with the elites in other fields, which is why you see so many folks from Goldman and other top banks cycling through the policy apparatus of both Democratic and Republican administrations.

That said, the proponents of this thesis are all a bit vague on how, exactly, this feat is managed.  What rules, for example, are enabling such a small fraction of bankers to charge such exorbitant fees for IPOs?  One could argue that rule changes such as the SEC's 2004 decision to allow broker-dealers to increase their leverage ratios made that business much more profitable, while socializing the risk onto the rest of us.  But that doesn't explain something that is pointed out in the excerpt on Tyler's blog:  the prevalence of hedge fund managers at the very top.

...for 2004, nonfinancial executives of publicly traded companies account for less than six percent of the top 0.01% income bracket. In that same year, the top twenty-five hedge fund managers combined appear to have earned more than all of the CEOs from the entire S&P 500. The number of Wall Street investors earning over $100 million a year was nine times higher than the public company executives earning that amount.

For the "political capture" story to work, you'd want to explain this in terms of the carried interest tax rule.  Hedge fund managers take a substantial part of their compensation as a percentage of the returns that the fund earns; these returns are taxed, not as ordinary income, but as capital gains, at the lower rate.  I haven't heard many convincing explanations of why this should be the case; the compensation may be contingent, but that is not the same thing as putting capital at risk.  (For that matter, I think that we should eliminate the corporate income tax, and tax capital returns as ordinary income.  But that is an argument for another day.)

But while I can certainly explain the continued taxation of hedge fund income at capital gains rates as a function of lobbying--the Democrats still haven't managed to change this, even though they've been talking about it for years, which seems a bit mysterious given that we just passed a huge financial services reform bill.  But that doesn't explain why they're making so much pre-tax income.

A different story--"skills based technological change"--seems like it might be a better fit.  Arguably, computers are especially useful in analyzing financial markets, which has vastly increased the ability of those with the best computers, and computer skills, and financial theory, to make money off of small anomalies in the market.  These people are making the markets more efficient--Bob Rubin's first job was simply calling London, and trading based on the differences between prices in London and New York.  And they're profiting hugely from the anomalies they find.  (Also, arguably, from taking on an unwarranted amount of tail risk--but except to the extent that computers allowed them to magnify it, the tail risk was there before.  The profits weren't.)

You can even fit the regulatory story into this, from a different angle:  the government doesn't have the best computers or theorists, and so it can't keep up with the constantly multiplying financial complexity.  If it did, maybe it would crack down.  That doesn't speak to capture so much as our willingness to pour resources into regulation.  If we were serious about regulation, the SEC would have the best paid guys on Wall Street, not the worst.  But that's politically unthinkable.

Besides, that still leaves athletes, executive compensation, and whole lot of other factors--this paper says "The data demonstrate that executives, managers, supervisors, and financial professionals account for about 60 percent of the top 0.1 percent of income earners in recent years, and can account for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005."  It's hard to explain how the wealthy are manipulating the regulatory apparatus to make Apple vastly more profitable than it would have been forty years ago.