The unseen cause of inequality

In recent decades, income inequality in the United States has increased sharply, and the novel coronavirus crisis seems to have exacerbated the problem. Some blame tax cuts for creating billionaires and leaving the middle class behind, but it’s not that simple. While lower taxes did influence inequality, taxes alone are a red herring. Mounting evidence shows something else driving the uptick in inequality: Regulation.

Taxes are salient to this conversation, while regulation is silent. Every year on your W-2, and even more frequently on your paycheck, you see how many dollars of income you lose to taxes. Yet there is no such accounting for the unseen power of regulation to lower the average American’s income, raise prices and protect the position of the wealthy.

As the coronavirus hit, the costs of federal regulations restricting the production of needed hand sanitizer and masks became clear. Eventually many of these were lifted, and regulators recognized the costs of their well-meaning rules. 

Even regulation with tangible benefits can increase costs for small businesses and exclude people with low incomes from getting jobs. Consider a would-be barber who cannot find the time and money to pay thousands of dollars and complete 1,500 hours of training for a license to cut hair. This ends up driving inequality by preventing someone with little or no income from getting a higher-paying career. 

Optimists call for federal regulation to reduce inequality by raising the minimum wage and regulating Wall Street excess. But will more regulation correct the root of the problem? Not if the rich reap most of the benefits. 

Regulation does not spring, fully formed, from the heads of idealists. It’s a product of a political process influenced by special interests. For example, financial regulators need the input of people within the industry, who know their business better than anyone. These close connections can allow regulators to be “captured” and create preferential rules that enrich those who are already well off. This is part of the reason why banks with more political connections and which engaged in more lobbying received larger bailouts during the financial crisis.

Established businesses even lobby to be regulated, because it increases costs for new competitors who would like to enter the market. In many states, our would-be barber must train for more hours than a police officer, an indication that these regulations are about blocking competition, not health and safety. After all, who is better equipped to comply with costly rules or complex legal requirements — a small shop or an established company with a legal team and lobbyists?

Even Jamie Dimon, CEO of JPMorgan Chase, admits that the Dodd-Frank financial regulations created a “moat” around large banks. Shielded from competition, established businesses grow larger and reap profits at the expense of small firms, consumers and entrepreneurs, increasing poverty and income inequality. 

Economists have long decried the phenomenon. Today, more evidence is emerging.

Income inequality in the United States has increased by about 6 percent since 1997. Over the same period, the number of restrictions from federal regulations has increased by a staggering 28 percent, and by more than 40 percent in manufacturing and more than 50 percent in the health care industry. Each new restriction has benefits but also serious costs. My new research with Dustin Chambers shows that states exposed to more federal regulation have higher income inequality. 

According to our analysis, as much as half of the increase in income inequality in some states can be tied to their exposure to more federal regulations since 1997. Over this period, tax rates have barely budged.

A fixation on taxes has clouded judgement on both ends of the political spectrum. Progressives focus on flashy wealth taxes, and conservatives fixate on temporary tax cuts. Neither side grapples with some of the underlying causes of both prosperity and inequality. 

The roots of higher inequality are countless, including the rising importance of skills, the new “winner-take-all” quality of the economy and, yes, taxes. But a serious conversation about income inequality must take a hard look at the unseen regulations that paradoxically burden the poor and protect the wealthy.

Colin O’Reilly is associate professor of economics in the Heider College of Business at Creighton University and coauthor (with Dustin Chambers) of new research on “Regulation and Income Inequality in the United States,” published by the Mercatus Center at George Mason University.