Scale, Profits, and Inequality


After my post last week on inequality, I got a number of (surprisingly reasonable) responses. I pulled one line out of a recent comment, not to call out that particular commenter, but because it encapsulates an argument for *not* caring about inequality.

"Gates and the Waltons really did probably add more value to humanity than the janitor at my school."

The general argument here is about incentives. Without the possibility of massive profits, people like Bill Gates or Sam Walton will not bother to innovate and create Microsoft and Walmart. So we should not raise taxes because those people deserve, in some sense, the fruits of their genius. More important, without them innovating, the economy wouldn't grow.

But if we take seriously the incentives behind innovation, then it isn't simply the genius of the individual that matters for growth. The scale of the economy is equally relevant. In any typical model of innovation and growth, the profits of a firm are going to be something like Profits = Q(Y)(P-MC), where (P-MC) is price minus marginal cost. Q(Y) is the quantity sold, and this depends on the aggregate size of the economy, Y.

The markup of price over marginal cost (P-MC), is going to depend on how much market power you have, and on the nature of demand for your product. This markup depends on your individual genius, in the sense that it depends on how indispensable people find your product. Apple is probably the better example here. They sell iPhones for way over marginal cost because they've convinced everyone through marketing and design that substitutes for iPhones are inferior.

The scale term, Q(Y) does not depend on genius. It depends on the size of the market you have to sell to. If we stuck Steve Jobs, Jon Ive, and some engineers on a remote island, they wouldn't earn any profits no matter how many i-Devices they invented, because there would be no one to sell them to.

People like Gates and the Waltons earn profits on the scale effect of the U.S. economy, which they did not invent, innovate on, or produce. So the "rest of us", like the janitor mentioned above, have some legitimate reason to ask whether those profits are best used in remunerating Bill Gates and the Walton family, or could be put to better use.

There isn't necessarily any kind of efficiency loss from raising taxes on Gates, Walton, and others with large incomes. They may, on the margin, be slightly less willing to innovate. But if the taxes are put to use expanding the scale of the U.S. economy, then we might easily increase innovation by through the scale effect on profits. Investing in health, education, and infrastructure all will raise the aggregate size of the U.S. economy, and make innovation more lucrative. Even straight income transfers can raise the effective scale of the U.S. economy be transferring purchasing power to people who will spend it.

Can we argue about exactly how much of the profits are due to "genius" (the markup) and how much to scale? Sure, there is no precise answer here. But you cannot dismiss the idea of taxing high-income "makers" because their income represents the fruits of their individual genius. It doesn't. Their incomes derive from a combination of ability and scale. And scale doesn't belong to individuals.

The value-added of "the Waltons" is particularly relevant here. Sam Walton innovated, but the profits of Walmart are almost entirely derived from the scale of the U.S. (and world) economy. It's the presence of thousands and thousands of those janitors in the U.S. that generates a huge portion of Walmart's profits, not the Walton family's unique genius.

Alice Walton is worth around $33 billion. She never worked for Walmart. She is a billionaire many times over because her dad was smart enough to take advantage of the massive scale of the U.S. economy. I'm not willing to concede that Alice has added more value to humanity than anyone in particular. So, yes, I'll argue that Alice should pay a lot more in taxes than she does today. And no, I'm not afraid that this will prevent innovation in the future, because those taxes will help expand the scale of the economy and incent a new generation of innovators to get to work.

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