ECONOMIC VIEW; If All the Slices Are Equal, Will the Pie Shrink?

November 19, 2006

ECONOMIC VIEW; If All the Slices Are Equal, Will the Pie Shrink?

By EDUARDO PORTER

THE chief executive of Wal-Mart Stores, H. Lee Scott Jr., made more than $15 million last year in cash, stock and options, according to the company's annual report, an amount equivalent to roughly 850 times the pay of Wal-Mart's average ''associate'' tending to shoppers on a superstore floor.

Mr. Scott isn't even at the top of the income-disparity league. Bruce E. Karatz, the former chief executive of the homebuilder KB Home, made $150 million last year, according to the Corporate Library, a research firm. According to government statistics, a residential construction worker makes less than one four-thousandth of that.

Executives are gorging themselves across the economy. In a study published this year, the economists Emmanuel Saez of the University of California, Berkeley, and Thomas Piketty of the École Normale Supérieure in Paris reported that the top 0.1 percent of Americans in income receive nearly 7 percent of the total, the highest share since the 1920s.

Yet while the chasm between the lavish pay packages dished out in America's executive suites and the wages of the minions below may jar archetypal notions of fairness, economists point out that not all inequality is bad. While it may have nasty side effects, some inequality is needed to spur growth.

''Clearly, perfect egalitarianism wouldn't lead to much effort or output,'' said Lawrence Katz, an economist at Harvard. ''If you're just talking about making the pie as big as we could, it is not clear what level of inequality is best.''

Like any other difference in prices, economists say, income inequality allows people and companies to better allocate investments of money and effort. Pay differences encourage the best and brightest into the most profitable lines of work, and the most profitable companies to hire them. Inequality, according to this view, provides an incentive to work extra hard to come out on top.

In a recent study that caused a bit of a stir in academia, two young economists, Xavier Gabaix of the Massachusetts Institute of Technology and Augustin Landier of the Leonard N. Stern School of Business at New York University, argued that the fast climb in pay for corporate chief executives had simply followed the rise in the size of American companies.

The difference in talent between the No. 1 and the No. 150 executive might not amount to much, but when the companies for which they work are humongous, these tiny differences could translate into real money. As they have grown, America's corporate behemoths have bid up the price of executives in their quest to get the best.

Matching the best executives with companies that can profit most from them, and thus pay them the most, will produce wealth, Mr. Gabaix said. ''Optimal inequality is whatever the market dictates at any given time,'' he said. Put differently, efforts to share the pie in a more egalitarian way may reduce the size of the pastry.

In their study, Mr. Saez and Mr. Piketty found that recent growth has been faster in countries where the share of income going to the wealthy has increased sharply, including the United States, Britain and Canada, than it has in more egalitarian nations like France or Japan.

''In recent decades it looks like the link is true,'' Mr. Saez said. Still, the breakneck speed at which America's richest have increased their take of the economy since the 1980s is disconcerting to many analysts.

Many are skeptical that the chasm between the rewards of the rich and the rest needs to be quite so big to spur the economy along.

''If the growth in inequality is just about improving incentives, it's gone beyond what looks necessary,'' Mr. Katz said. ''I don't think the added incentive of earning $100 million over $50 million is very different than the incentive of making $10 million over $5 million.''

Mr. Saez pointed out that Japan's postwar economic boom, which lasted until 1990, wasn't hurt by the country's relatively homogeneous income distribution. Mr. Katz noted that the United States economy grew very quickly from 1947 to 1970, a period when the distribution of rewards was much more egalitarian than it is today.

Moreover, the growing gap between rich and poor has costs that may be harder to quantify.

To begin with, growing inequality will strike many as unfair, prompting social tensions. But there are worries beyond fears of unrest. The growing share of income devoted to those at the top is leaving less and less to share among the rest of us.

In one recent study, Robert Gordon and Ian Dew-Becker, economists at Northwestern University, found that half of the income gains derived from the increase in productivity from 1966 to 2001 accrued to the top 10 percent of earners. The wages of typical American workers, meanwhile, barely grew at all.

A shrinking share of the nation's economic spoils will not only reduce workers' stake in the current social setup; it will leave them with few resources for investment in economically crucial items like education. Rising inequality will also hamper teamwork. And it may ultimately destroy incentives. If the rewards of economic growth are monopolized by the very top earners, the rest of us may find little reason to make an effort.

Using a golf metaphor, Richard Freeman, an economist at Harvard and the National Bureau of Economic Research, said, ''If Tiger won everything, nobody would want to play.''

AND if extreme income disparities produce anomie at the bottom, they can have even more perverse effects on the incentives at the top. For instance, those who benefit most from the current system will be tempted to help friendly politicians win elections to ensure that future economic arrangements still go their way. And, as has been shown by the run of shenanigans from the creative earnings management practiced by Enron and WorldCom a few years ago through the recently discovered backdating of options, some executives will simply cheat.

Mr. Freeman and Alexander Gelber, a Ph.D. candidate in economics at Harvard, recently ran an experiment to figure out how inequality affects workers' efforts. They gave three groups of participants puzzles to solve and rewarded them in different ways.

The first group, in which everyone received the same reward, regardless of performance, didn't solve many puzzles. The group in which the best maze solver got all of the rewards -- and no one else got anything -- didn't do too much better. The group that had a sliding scale of rewards, based on performance, did the best.

Yet the most interesting result of Mr. Freeman's experiment was not about maximizing output. In an unexpected twist, some subjects of the test found ways to rig the system. Few did so when the rewards were spread in an egalitarian way. But when the rewards gave participants an incentive to compete, they also provided a powerful inducement to cheat.