The textbook apology for the great inequality of wealth in the American economy is right out of Ayn Rand's Atlas Shrugged: A system where the most productive people in society receive compensation proportional to their productivity is necessary to cause those people to be productive; if we failed to provide these incentives, they would refuse to produce as much and our standard of living would crater.
The idea is powerful because has a kernel of truth in it. Incentives do matter. Given choices, people have a powerful tendency to do what makes them better off. Farmers who receive the fruits of their own labor are profoundly more productive than farmers in a collective farm whose fruits are shared according to need without regard to their efforts in producing its bounty. Undue reliance upon altruism and centralized planning by salaried bureaucrats were key factors caused the Soviet system to crumble.
But, this concept is also incorrect. What is wrong with it? Here are five reasons why this is the case.
1. Wealth has diminishing marginal returns.
The vast majority of Americans have quite a strong unmet demand for personal consumption. They would like a nicer house (or more houses) but refrain from buying one because they can't afford it. They would like a nicer car, but can't afford it. They would like to own a boat, but can't afford it. They would like to eat out more often at nicer restaurants, but can't afford it. They would like to wear finer clothes, but can't afford it. They would like to have a doctor who made house calls, but can't afford it. They would like to send their kids to a private college but can only afford a public one.
The desire for more is pretty much insatiable. But, it does get weaker. The desire to buy another house becomes less intense when you are John McCain and can't remember how many houses you already own. There are basically no million dollar cars available to buy new, and if you don't have an insatiable desire for speed and no children, it is hard to spend more than a hundred thousand dollars on car. There is no college education in the world that costs more than $500,000 for four years in tuition, room, board, tutoring and even other quite luxurious living expenses, and most children want no more than one college education. Add all the graduate school a child could want, and it is still hard to spend more than $1,000,000 per child on higher education. The most expensive available private schools from pre-school through high school cost perhaps $750,000.
Also, the wealthier you get, the less disposable your consumption becomes. Mansions, collector's items, fine works of art, jewels, and rarely used boats, don't lose value when you own them. People who acquire prize horses and dogs learn that the pedigreed children are themselves profitable. Their purchases increasingly aren't consumed in the way that food, or a cruise, or car that you use every day.
Also, don't forget that the people who make their own wealth typically do so, at the lower end, because they are prone to consume less than is typical for someone of their income, and because they are workaholics who are so absorbed in their work that they devote less time than the average person to leisure time which most forms of disposable consumption requires.
In my experience as an estate planning attorney for the wealthy, the break point, where people tend to find it difficult to engage in wealth reducing disposable consumption at a rate greater than their investment income without making uncomfortable changes to the lifestyle that made them wealthy is typically somewhere around $10,000,000 to $20,000,000 of net worth.
Around that point, in order to spend their investment income disposably, wealthy people have to do things like travel and ski more than they have enjoyed doing so thus far in their lives, acquire a taste for exceedingly fine foods and wines that haven't been important to them so far in life, develop a fashion sense that departs from the one that they imprinted on as their personal style in their twenties, and so on. Instead, the wealthy who step up their consumption as their investment income increases tend to favor purchases like art, fine jewels, collectibles and real estate that retain their value over time.
Soon enough, charitable gifts are the only significant form of disposable consumption that is available to someone who is still working with tastes and temperaments that caused them to be wealthy in the first place.
2. Dynastic instincts are not unlimited.
Of course, wealth is not acquired solely because the person who earns it wants to personally consume it.
Heirs to great wealth tend to have a much easier time figuring out ways to blow vast sums of money than the highly productive people who imparted wealth to them. When they are still developing their tastes for consumption they develop interests in pass times that require large amounts of leisure time and involve massive amounts of disposable consumption. The learn to value expensive sports cars, extravagant trips, high fashion, gourmet food, servants, recreational drugs, helicopter skiing, sky diving, live chamber music in their homes, and massive parties.
Paris Hilton is not an exception. She is someone who has responded naturally to having vast amounts of wealth without working to earn it whose primary purpose in life is to figure out how to most beneficially spend as much of it as possible. She looked at the limited amount of benefit that her parents had received from their vast incomes and decided that their philosophy of personal consumption and of work-life balance was insufficiently hedonist and decided not to repeat their mistake.
The people who earn great wealth are, for the most party, acutely aware of the potential of their wealth to spoil their descendants. They want their descendants to have healthy lives, get good educations, and to live comfortable lives, but they also want their descendants to replicate their own massive capacity to earn wealth, to work hard, to excel at what they do, and to develop an instinct for charity. I say this not as a matter of supposition, but from perosnal experience. They are happy to spend money on rehab, but are appalled that their children spend money on recreational drugs. They do not necessarily, like the stereotypical Japanese patriarchs, expect their children to all play active leadership roles in the business ventures that they created - they recognize that childrens talents are not necessarily the same as their own. But, they do want their children toil intensely at something in which they can excel and be as distinguished as they were in their calling.
The wealthy very much want to leave some inheritance for their children and later descendants, but it is rather unusual for someone wealthy to want their descendants to inherit so much that they have no economic need to work if they want to have more than a very modest life, if they are capable of working. In practical terms, what this boils down to is that the intensity of the desire to leave a large bequest to descendants starts to diminish greatly as that bequest starts to approach something like $10,000,000 per child. A significant minority of wealthy individuals who have children who have either already succeeded on their own financially, or clearly have the capacity to do so if they apply themselves, wish to leave their descendants nothing more than token bequests that have sentimental value (perhaps a family vacation home and personal effect).
In very large estates, there is a strong shift towards leaving a legacy, first to descendants beyond one's children, and then to society as a whole in the tradition of the great philanthropists. Not everyone actually does this, but there is a palpable shift in the direction as one moves up the scale of the very wealthy.
3. Wealth makes leisure more tempting.
There is a Laffer Curve for income. The vast majority of people receive the vast majority of the funds that they use for consumption from their earned income, i.e. by working. This is true of the working class, the middle class and the upper middle class all the way up to the lion's share of specialist doctors, partners in large law firms, successful writers, professional actors and athletes, and hard working business executives.
But, as wealth accumulates investment income starts to provide a larger share of one's income than working. It happens most quickly for the managerial and professional workers who have the highest incomes and for managerial and professioal workers who inherit substantial wealth as well. As one reaches the point that working isn't necessary to maintain a comfortable level of disposable consumption, the economic incentive to produce more in order to maintain disposable consumption and provides a suitable dynastic bequest diminishes.
Many of these highly productive managerial and professional workers continue to work even though none of their earnings are necessary to maintain their disposable consumption during their lives, or to make a sufficient dynastic bequest. Highly productive workers typically really enjoy their work, which they are good at, and like the power it affords them in the business world. Also, old habits die hard. If you've spent the last twenty years of your life spending seventy hours a week at the office, you simply get used to it.
Also, some very wealthy people are philanthropists who work to support their charitable goals rather than their personal and dynastic consumption.
But, the key point to understand is that once someone is wealthy enough, having acquired many tens of millions of dollars somehow or another, working ceases to be an activity engaged in for the personal economic benefit of the person working or that person's family. At that point, working becomes something that one is doing out of habit, as a form of leisure, for love of power, or out of some form or another altruism. People who were in it for the money retire early at that point, at least, cut down they amount by which the produce significantly.
Beyond a certain point, wealth causes the most productive members of society to withdraw their productive efforts, not to continue them. In real life, it is far more common for the elite to retire early to pursue their hobbies than to refrain from working because they don't think that the personal economic rewards that they receive from their productive labors are adequate. Atlas Shrugged has it backwards. There are mountain towns full of titans of industry lazing around, Beaver Creek, Palm Springs, and Martha's Vineyard, for example, as they do in a town modeled on Ouray, Colorado in Ayn Rand's book. But, they have withdrawn from the world not because our political economy failed to reward them enough to spur them to work, but because we gave them so much that they no longer need to work.
4. Incentives need not be either proportional or monetary to be effective.
The vast majority of people are wage and salary workers whose incomes are only dimly tied to their performance monetarily - they must merely work well enough to avoid being fired. And, even where there are incentives that tie productivity to work, these incentives can be quite effective without being proportional economically to the productivity involved. The direction of the incentive, and relative strength of the incentive relative to other incentives, matters more than the actual amount of the incentive, and money is not the only currency in which incentives are denominated. For example, some of the most powerful incentives are reputational, rather than monetary.
5. The very rich are not very rich because they are the very most productive people.
For a salaried or hourly employee whose income puts them anywhere from the working class to the upper middle class, their income is largely a function of their personal ability to be productive. The labor market is largely driven by the supply of workers able to do the work, rather than the desirability of the work to workers, which is a decidely secondary factor in setting wages. The pay premium for doing a really unpleasant or dangerous job that requires a certain skill set over a much more pleasant job that requires the same skill set, is surprisingly modest. But, the pay premium for doing something that requires an extremly rare skill set, like neurosurgey, over even doing something else that requires a rare but not extremely rare skill set, like internal medicine, is extreme. Education and job skills make one capable of doing work that fewer people can do and increase one's income significantly.
But, the wage scales of entire industries are set by factors only dimly related to individual ability, and the incomes of the self-employed and of a subset of commission and bonus compensated workers, depend significantly on factors completely unrelated to personal ability or productivity. And, marginal economic productivity, which is supposed to drive compensation in simpler version of economic theory, is far less obvious in practice than theory would suggest.