Does Canada have an income-inequality problem?

Inequality is a necessary condition of a dynamic economy

Published: Dec 7, 2017

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Changes in wealth and income inequality around the world are largely the result of two structural changes in society: The role of government and the dynamics of economic change. Neither have been particularly controversial until the publication of Thomas Picketty’s Capital in the Twenty First Century (2014).

Picketty’s book is an exhaustive analysis of changes in wealth and economic growth over time. Unto itself, the analysis is not that controversial, but his conclusion is: When the return on capital exceeds the rate of economic growth, the ratio of wealth-to-GDP inexorably increases over time. In a free market economy, what inevitably follows is that ‘inequality’ naturally increases as the wealthiest sit back, clip their coupons and live off of their growing wealth.

Picketty’s analysis touched a chord in many countries, particularly in the UK and the U.S. — both of which were still recovering from the worst financial and economic crisis since 1937 as well as the political disturbances of the ‘occupy movement’ and railings against the ‘1%’. Just as John Maynard Keynes became the voice of liberal interventionist economic policy in the 1930’s, Picketty has become the voice of left leaning policymakers and journalists after the financial crisis.

This has been particularly true in Canada, where recent Liberal governments in Ottawa and Queen’s Park have owed much of their success to ‘strengthening’ the middle class by increasing taxes on the 1%. As always, much of the analysis flowing into Canada comes from rhetoric from the U.S. and UK. But how true is it of Canada, and how concerned should Canadians really be about inequality?

Although wealth and income inequality are different, I will focus on income inequality. What matters here is where you start, what you count, and how you factor in taxes and government transfers. This is because inequality is inseparably bound up with the growth of government spending and debt. As most economists recognize, taxes are a cost and tend to be pushed forward so that pre-tax inequality is significantly different from inequality based on disposable income — that is, after we adjust for taxes and government transfers. For example, in Post Capitalist Society, early 1990s isproved the notion that taxes can permanently affect the distribution of after-tax income.

Prior to World War I, there were no income taxes in Canada and federal government revenues were almost entirely derived from customs duties and excise taxes, with spending focused on nation building. Yet between 1871 and 1918, the average rate of real economic growth was 5.4% and real per capita income increased 2.5X — or an average of 2.1% per year. There was significant income and wealth inequality at the time because, to a great extent, inequality is an inevitable side effect of a dynamic economy — as we will see. All of this changed after World War I.

Between 1914 and 1919, Government of Canada debt increased five fold, with personal and corporate income taxes introduced to pay the interest on the debt, which by 1919 had increased nine-fold since 1914.

In 1939, the second half of the German war started and made things worse, as Government of Canada debt — which had barely increased over its 1919 level — increased six-fold by 1946. However, 1946 was not like 1919, as the Government of Canada introduced a wide range of entitlement programs such as Old Age Security, family allowances and expanded employment relief. By 1952, this increase in social programs had quickly jumped from zero to cost 20 per cent more than the cost of servicing the much bigger public debt, while at the same time, the Korean War significantly increased defence spending.

It is at this time that taxes started to dramatically increase. In 1939, personal income taxes had raised $45 million and corporate taxes $78 million, while in 1952, after the passage of the Income Tax Act in 1948, they had increased to $1,225 and $1,227 million, respectively. In 1949, the top tax rate was 84 per cent, but more importantly, the tax rate hit 50 per cent at $25,000 a year — and despite rapidly-increasing inflation, stayed about that level until tax reform in 1987.

In Canada, the U.S. and the UK, the early post-war period is commonly referred to as one of ‘financial repression’, as the priority was to lower the burden of the public debt in the face of increasing government spending. In the UK, the situation was exacerbated by what Correlli Barnett calls  ‘Christian Socialism’, where out of a sense of ‘fairness’, the UK continued to subsidise the 19th century industries that Great Britain’s wealth had been based on— mainly coal, ship building and steel—long after they were past their prime.

To finance this spending, the top income tax rate in the UK as late as 1979 was 83 per cent on earned income and 98 per cent on unearned, that is, investment income. The inevitable economic problems with the effective confiscation of capital led to an IMF bailout in 1976, and to paraphrase Margaret Thatcher, a belated recognition that ‘The problem with socialism is, sooner or later, you run out of other people’s money’. In 1974, the UK hit the wall in a similar fashion to Greece in 2010, as other people refused to finance continued government spending.

In Canada, the problems of the post-war period were not as severe, but the inefficiencies introduced by the mounting tax burden led to the Carter Commission report in 1966. The basic recommendation was to lower personal income tax rates to no more than 50 per cent on any form of income and to broaden the tax base. These recommendations were not adopted until 1987, when tax reform lowered the top rate to 43.5 per cent and with a delay, introduced the GST.

However, reforming the Canadian tax system — while simultaneously expanding social programs — only led to mounting government deficits and ballooning debt. By the mid 1990’s, Canada had run into the same problems faced by the UK in the 1970’s: It had largely run out of money. Financing the deficit was crowding out private investment, with financing needs almost 10 per cent of GDP (almost at Greece’s level). It was left to the Liberal government of Jean Chretien to sort out Canada’s fiscal mess with acrossthe- board cuts of 20 to 30 per cent in government programs that moved the deficit into a surplus by 1997 and restored some sanity to government finances.

This short history lesson is important, because most analyses of rising inequality use the 1980’s as a benchmark, as in ‘inequality has increased over the last 30 years’. Further, they simply look at the statistics without any discussion of the underlying economic situation that generated them. Yet the basic fact is that the 1970’s in the UK and the 1990’s in Canada represented unsustainable periods in financial history. Many of us remember inflation over 10 per cent, Treasury Bill yields over 20 per cent, government deficits near 10 per cent of GDP and a government committed to expanding entitlements beyond its capability to finance them. True, it was a period of relatively low inequality and ‘a chicken in every pot’ — but it was paid for with borrowed money and could not continue.

The second problem is that inequality is a necessary condition of a dynamic economy. To an economist, labour has a price, just like any other commodity. When buggywhip manufacturers faced competition from cars, the market signal was not just a loss in value for the firms involved, but also differential wages, that is, inequality to encourage workers to shift to car assembly lines. Only in a stagnant economy will there be relatively few changes in inequality, since there are no new market signals. The buggy-whip manufacturers and their employees would doubtless wish that cars had never been invented, but for the rest of us, we need income inequality to meet our needs, not those of employees in dying industries. In this context, being ‘fair’ and taxing workers in the car industry to subsidize workers making buggy whips is the most short-sighted economic policy I can think of.

So, what are the disruptive changes that may have increased income inequality today? The two main candidates are information technology (IT) and globalization.

There is absolutely no question that IT is revolutionizing industries — particularly if you are a taxi driver (Uber), a hotel owner (AirBnB), a retailer (Amazon) or in marketing (Facebook and social media). Notice the names of these disruptive new firms: They are all American. Now ask yourself a simple question: Would you like Facebook to have been founded in Toronto rather than Boston, Microsoft in Vancouver rather than Seattle, Google in Montreal rather than Santa Clara? Of course, the answer is Yes, as they have created thousands of very well-paying jobs and countless multi millionaires. Equally obvious: Income inequality in Canada would be far greater, because the more dynamic the economy, the greater the income inequality.

There is an indirect effect of IT, as well as a direct effect. To illustrate, suppose you go into a pub in Manchester, England and there are ten people having a beer, all earning $40,000 to $60,000, so the average and median (middle) income is $50,000. In walks Paul Pogba. For those who don’t know, Pogba, at 24, is the world’s most expensive football player, whose club, Manchester United, pay him about $400,000 a week, even when there are no games, and who, with celebrity endorsements, probably makes at least $30 million a year. As a purely statistical matter, the average income in the pub immediately jumps to $2.77 million ($30.5 million/11) even though the median (middle) and modal (most likely) income is still $50,000.

In this case, the pub has immediately gone from having very low income inequality to one with a highly unequal distribution of income. However, what is important is that the ten people having a beer before Pogba walked in are no worse off after he came in than they were before. What really matters is not whether income is unequal, as that is a quagmire of statistics, but individual standards of living.

The Pogba example is also important because football is an industry. The Football Association (FA) in 1885 initially restricted players to amateur status, then to professionals within a six-mile radius, then to salary caps and finally to contracts that restricted them from joining other clubs. Removing these constraints were victories won in the face of fierce opposition from the clubs, who saw an obvious threat from market wages to their profitability. In the end, it took a decision by a UK High Court Judge to allow market wages and for Pogba to earn his market value.

If you think this bankrupted English football clubs, think again. In 2012, Forbes ranked Manchester United as the richest professional sports franchise in the world. English football has gone from a six mile franchise around the club to a regional fan base, a national fan base and now thanks to the Internet, a global franchise. In the process, football players have gone from amateurs, to being paid twice average industrial wages, to super star salaries.

In a 1999 article in Rotman Management, I wrote: “The rewards for being better than others will be phenomenal, and the costs for being ‘a bit off ‘ are going to be disastrous, just as a perfect market tells us they should be. Disappearing market barriers and rapid advances in information technology have created the economies of superstars.”

This forecast was only too accurate. Notably in the latest rich list for the UK, only two of the top ten were born in the UK and Manchester United’s Swedish centre forward Zlatan Ibrahimovic entered the top 1,000 with a wealth just less than $200 million. That is a phenomenal return for a football player; interestingly, Adele and the stars of the Harry Potter franchise were also on the list.

The impact of IT on global franchises is one aspect of globalization. The other is the shift of manufacturing and outsourcing to cheaper locations. David Ricardo’s trade theory from almost 200 years ago showed that as countries specialize where they have a comparative advantage, everyone gains — and this is as true now as it was when the UK moved to free and open trade and unilaterally repealed the Corn (wheat) Laws in 1846. In the process, a cheap food policy devastated English farming to the great benefit of lower income groups, who spent a greater proportion of their income on food. (think about the impact of farm support programs in Canada!)

The situation today is no different from England in the 1820s, when Luddites destroyed textile equipment that was taking away their jobs. You can’t halt technological change. When I was growing up, ‘Made in England’ was a sign of quality; today, it is near impossible to find. Americans are going through the same process, as ‘Made in China’ has become ubiquitous. In reaction, they have elected a President who promises to ‘Make America great again’ and bring back jobs; but this isn’t going to happen—anymore than the Luddites were going to prevent industrialization in England.

Sure, under pressure from President Trump, Carrier has agreed to maintain production in Indiana, but make no mistake: all those jobs are not going to stay! As Greg Hayes, CEO of United Technologies, Carrier’s parent recently said: “We will take a lot of those jobs that today require very low skill and …. eliminate [them] through automation.” The fact is, the U.S, Canada and the UK should not want jobs involved with putting three screws into a gas furnace every 27 seconds. Such jobs can and should go to low-skill economies and improve their standard of living.

The World Bank points out that in 1981, 43 per cent of the world’s population was ‘extremely poor’; but by 2013, that had dropped to just 10.3 per cent. It took Great Britain 100 years to make the adjustment, but China is on track to see its number drop from 660 million in extreme poverty to 25 million in 35 years, despite an increase in population. The reason for this drop, of course, is free trade, and the shift of manufacturing jobs from the developed world to China. It is a moral question whether getting 635 million Chinese out of extreme poverty is worth more or less than the consequences felt in Rust Belt, U.S.A.

So, how important have the two trends of globalization and IT been to inequality in Canada?

The answer: Not very. In 2015, the OECD issued a major report on changes in income inequality from 1985 to 2015. Apart from the fact that the start date and tone of the report reflect an obvious bias, the data for Canada do not reveal any obvious problems: The OECD notes that inequality has generally increased, but the change for Canada has been minimal and less than average. The main focus of the OECD report was on the U.S, where inequality was already amongst the highest and increased even more, exceeded only by Mexico.

The question is, why has inequality increased steadily in the U.S., whereas in Canada, any changes have been below average for a developed country?

The answer lies in the two aforementioned causes of increased inequality: Free trade and globalization have not affected Canada to anywhere near the extent they have affected the U.S, for the simple reason that manufacturing is less important to Canada. Further, people forget that the Canadian dollar was down to US$0.65 before China was admitted to the World Trade Organization in 2001. Since then, commodity prices have dramatically increased, and with them, the Canadian dollar, as China has industrialized to manufacture all those things exported to the developed world.

In other words, it doesn’t matter to Canada whether it imports from the U.S. or China, but by industrializing, China has been buying Canadian raw materials and creating jobs in Canada. The massive expansion of the Oil Sands in Alberta would not have occurred if China had not been admitted to the WTO.

And now, back to IT: Would Canada be better off with Google, Facebook, Microsoft, Amazon, Apple etc. based in Canada? Obviously the answer is Yes, but our income inequality would then be much closer to that of the U.S. As it is, and unlike the U.S., Statistics Canada reports that median income in Canada increased from $46,700 in 2000 to $55,600 in 2014 (constant 2014 dollars). Put simply, there is no indication of stagnating middle-class incomes in Canada.

In closing
To avoid U.S.-style inequality, left leaning politicians and journalists would probably indicate that they would regulate or tax. But the first thing you learn in a tax course is, you tax the immobile factor for the obvious reason: The mobile factor leaves, and then you don’t get any tax  revenues at all. In 2010, the UK government increased its top tax rate from 40 per cent to 50 per cent, but seriously missed its revenue targets. In 2012 the top tax rate was rolled back to 45 per cent and the Chancellor of the Exchequer, George Osborne, claimed the UK raised more money due to the more competitive tax rate.

Way back in 1901, the football clubs tried capping salaries in England, but the result was the formation of a competitive league without salary caps. If it tried that now, the English Premier League would no longer be the dominant global sports franchise. Many of the clubs have no or very few English players, with little loyalty to their clubs except for their pound sterling pay cheques, so they would simply move to the Continent. The fact is, Pogba is French, and he is as mobile as any other talented professional. RM

Laurence Booth is the CIT Chair in Structured Finance and Professor of Finance at the Rotman School of Management.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]

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