The contribution of finance to rising inequality

by pdxblake

Business Insider provides an interesting chart from a NY Times blog of inequality state-by-state that reveals interesting trends across the US in inequality.

The purple states are those with the highest levels of inequality and as the colors become lighter, that represents lower levels of inequality.  There seem to be a few trends, for example, the high level of inequality across the South and generally in states that have large concentrations (NY, CT, IL) and those with large technology industry(MA and CA).

It is impossible to attribute causality to the high levels of unemployment without more analysis, but that’s not going to stop me from trying.  The high inequality in the financial states (those containing Wall Street, Greenwich and Chicago) may reflect the underlying trend over the past 30 years of an increasing financialization of the the economy, where financial companies generate a growing share of corporate profit (after tax).

The financial industry has become more deregulated during (particularly the last 30 years, and the profits after tax have risen in line).  There has also been a decline in the taxation on many profits from financial services (for example, by having more favorable tax rates for capital gains and dividends compared to ordinary income).  Financial companies also pay much more interest (and to be more leveraged) than non-financial companies.  Interest expense is deductible from income, so higher leverage benefits companies both from accentuating the profits and losses of the companies, but also by lowering taxable income of financial services companies.

Finance is also a relatively capital-intensive business (there are fewer people needed to generate its profits).  There were 7.7 million financial sector employees in July 2012, out of 133.2 million total non-farm employees (pdf), or 5.8% of total employees, yet finance generated nearly 50% of total profits.  States with large concentrations of finance (which to some degree includes MA and CA through the role of finance in venture capital that has financed the technology and biotech industries) therefore would likely have higher inequality than states that rely less on financial services industries.

That is not to say that these levels of inequality should necessarily lead to policies that stifle some areas of finance (I’m not saying it is time to try to undo the development of the internet, iPhones Google, etc).  Just that finance is doing quite well but doesn’t need any extra incentives in the form of lower tax rates on profits and favorable treatment of highly leveraged companies (through allowing the deduction of interest expenses).

Incentivizing leverage leads to more of it being used, which–all other things being equal–will increase the variation in profitability (larger swings to profit and loss).  Since 2008, it has been clear that the rewards in finance tend to be privatized and the losses are socialized.  Below is a graph that shows the annual percentage changes (continuously compounded) of financial profits or losses.

Because the 2008 crisis was so big, I had to stop the data in mid-2008 to make it viewable.  But it shows a distinct rise in the level of volatility in financial profits (look how many times the blue line gets above 60% and below -20% after about 1980 compared with before).  The costs of financial boom and bust (particularly involving institutions that are too big to fail) are large, and borne by taxpayers (well, last time we made a profit, but to took several years).  Profits accrue to the private financial institutions and are magnified by leverage.  This leads to even more outsized gains when things are doing well, which will–other things equal–lead to higher inequality.

And that leads me to the conclusion that while there have been a large amount of positive things in the past 30 years, and finance has contributed to making them happen, incentivizing financial institutions to take larger and larger risks by using greater amounts of leverage, while also giving favorable tax benefits to the profits makes very little sense and not only enhances the income inequality of the country, the times when things go wrong (and taxpayers have to step in) effectively acts as a subsidy to the financial industry.  With the relative positions between the Republican and Democratic parties on regulating finance more tightly and on shifts in the tax rates on higher income people, it is not surprising that a lot of the campaign money (particularly from the large financial institutions) has flowed towards Mitt Romney.  They benefit from the higher leverage that is encouraged by allowing interest expense to be tax deductible, and also pay a lower proportion of their income in taxes that will be used to step in when things go wrong.

I leave a discussion of why the South is more unequal to you.