Author Edward Conard discusses his book, The Upside of Inequality: How Good Intentions Undermine the Middle Class.

the-upside-of-inequalityThe growing income gap between the nation’s richest 1% and the rest of America has prompted policy makers to propose solutions like raising taxes on the wealthy to address this inequality. But such income redistribution actually will end up hurting the middle and working classes, according to Edward Conard, visiting fellow at the American Enterprise Institute and author of the book, The Upside of Inequality: How Good Intentions Undermine the Middle Class.

“Growing income inequality is a real phenomenon, but a misdiagnosis of its causes and consequences leads to policies that slow growth and damage an already slow-growing economy,” Conard wrote. Instead, the path to robust economic growth — and higher wages for the working and middle classes — lies in encouraging businesses to take risks that lead to innovation, and having enough properly trained workers to hire in this knowledge-based economy. Conard recently talked about his book on the Knowledge at Wharton Show on Sirius XM channel 111.

An edited transcript of the conversation follows.

Knowledge at Wharton: Tell us about this idea you had regarding the 1% and the 99% that was the basis for your book.

Edward Conard: I provide explanations for why I think the 1% has been so successful, and also why the growth of the wages of the middle and working class has been slow, relative to GDP growth.

In the first case, we live in a knowledge-based economy. It’s not very capital intensive anymore. You see companies — the most obvious ones, such as Google, Facebook — can scale up to economy-wide success with very little need for capital, so the innovators who create those businesses can capture a larger share of the value that they create than the capital-intensive innovators in the past, who had to share the value more broadly with a lot more investors.

On the other side of the equation, I argue that because capital no longer constrains growth, that talent and risk-taking are now the constraints to growth, and that when you spread those constraints over more workers — low-skilled immigrants, for example — you see less supervision, lower productivity growth, and as a result, lower wage growth.

“Our workers at the high end of the wage scale are way more productive than the rest of the world’s workers.”

Knowledge at Wharton: Where have businesses failed in that process of trying to build up the workforce in general?

Conard: When you think about talented workers, they can do three different tasks. One is they can create innovation — like an iPhone, for example, that grows the entire economy. They can become doctors and lawyers, who aren’t really producing innovation as much as they’re just keeping the gears moving. Or they can become supervisors of less-skilled labor, sometimes as entrepreneurs, although there’s a lot of high-tech entrepreneurialism on the innovation side where they try to organize hourly or less skillful workers, to make them more productive, more effective in serving the needs of customers, and that will also drive wages up.

If you look at the U.S. workforce, the statistics are actually quite shocking. About 25% of our workforce scores in the top third of academic tests, but 45% score in the bottom third, so we have about one high-skilled worker for every two lower-skilled workers. In Germany, it’s 1-to-1. In Scandinavia it’s 2-to-1. In Japan it’s 3-to-1. And so with fewer high-scoring workers relative to low-scoring workers, we’ve been able to produce faster growth, higher median wages, and much faster employment growth. U.S. employment grew twice as fast as Germany and France, three times faster than Japan.

So, our most talented workers in the United States are a very scarce resource, but because of our institutional capabilities like [those in] Silicon Valley, for example, our workers at the high end of the wage scale are way more productive than the rest of the world’s workers.

But what we see is this emerging opportunity on the innovation side. We see high wages on the doctor and lawyer side because of the shortage, and so what we see is a shortage of people who are really willing to roll up their sleeves and put lower-skilled workers to work. On top of that, is a huge influx of low-skilled workers. We have 40 million foreign-born adults, 20 million native-born adult children, 60 million adults, and 35 million of those are predominantly low-skilled Hispanic workers, and so what you see is we are spreading our skilled workforce over more unskilled workforce.

Knowledge at Wharton: You talk about the fact that education in general in this country needs a little bit of a rethink to prepare kids for careers afterward. I think we don’t do that enough at times. But there are people who are working for companies right now, who may have been valuable resources for a company for 20 years, but the positions they have been in may be phased out. There needs to be more effort made to retrain them and bring them into another sector of the company.

Conard: I’m a little bit skeptical about retraining. If you’ve spent your whole life in a job, and you’re 50 years old and you lose your job, it’s very difficult to get back to the same productivity level and find a similar job, to get retrained at 50, to enjoy five more years of high productivity. So I think we have to be very, very sensitive to those workers.

I do think in education, there’s an awful lot of emphasis on math and science, as if everybody at the top end of our test scores is going to go into science. Very few actually go into science. They largely go into business. We don’t really teach the business skills that are required to put your fellow man to work and to make him as productive as he can be and to serve customers as effectively as we can. I don’t think we necessarily have a shortage of talent. I believe that we have a shortage of properly trained talent.

I do make an argument that we should have a lower corporate tax rate — the lower the better because entrepreneurialism is one way to grow the economy. But it’s a very risky and tough row to hoe, because very few people end up being successful. You want to draw the world’s corporations [with lower tax rates, those that provide] the really high-quality, stable jobs — companies that have already been successful and have scaled [globally.] The more of those you can pull into the United States, the better. Then the last related recommendation I make is we should just go out and recruit the highest skilled workers.

We have a little more than 100 million full-time workers. The top 5% is 5 million. There are about 7 billion non-Americans in the world. The top 5% would be 350 million. [I estimate that the number of foreign high-quality workers who might move to the U.S. are] about 50 million. We issue a million green cards a year. So if we went out and issued, say, a half a million green cards to the top 5% of workers in that 50 million-person pool, we could radically shift the ratio of high-to-low skilled [worker] in this country. … We could potentially double the growth rate in the United States.

“I don’t think we necessarily have a shortage of talent. I believe that we have a shortage of properly trained talent.”

When the baby boomers retire, the Congressional Budget Office expects government spending as a percentage of GDP to grow by 9 percentage points. State, local and federal are already at 36% today. That would bring it to 45%. You’ve already got debt at 75% of GDP, so you need much faster growth than we can get organically. Then you have to worry, after you get done feeding all the baby boomers, that the Chinese are waiting to compete with you. You really need to conserve your resources for what could be an existential fight at the end of this road. I just think we have to find a way to engineer much higher growth than we can possibly achieve organically.

Knowledge at Wharton: What do you think is the best way to go about that? Obviously, the corporate tax issue is one that was a very important topic during the presidential race.

Conard: The right target to try to hit is 15%. I think if you look at a lot of high-tech companies, they basically have a 15% tax rate. They’re doing that by paying the 15% to Ireland, instead of the United States.

We could bring [back] a lot of tax revenue that’s being paid offshore by companies [seeking] to lower their tax rate. … I argue that to offset that, we ought to raise the personal capital gains rate back to the ordinary income level, to try to neutralize as much of the lost revenue as we can. One of the reasons for having a low capital gains rate is because of the double taxation of profits — when they’re earned by companies, corporations pay taxes, and then when they’re distributed to shareholders, they do too.

If we could get the corporate tax down, there’s less reason for a lower capital gains rate. But it’s sort of like a consumption tax. If you pull the money out of the company and distribute it to the shareholders, you think of that income as consumption. If they really had investment opportunities, they would keep the money and reinvest it.

But if you do that, I think that probably gets pretty close to where we should optimally be on taxes. Otherwise, I think if you don’t cut spending, you can cut taxes and run up big deficits. It’s obvious to me that if I loan the government money or I pay them in taxes, then ultimately in the future, they’re going to come back and raise my taxes to pay off my loans, so I really paid those taxes today, not in the future. I think people are kidding themselves on that.

Knowledge at Wharton: You talked about risk a few minutes ago. What do you think are the main reasons why people and corporations don’t take more risk right now?

Conard: I think there are a variety of reasons for that. One of them is we have become an innovation-driven economy, and innovation is riskier than traditional investment. It hasn’t really been funded by risk-averse savings debt, for example. We have no way to diversify all the risks and eliminate the undiversified risk — if you will, the investment-specific risks. What you see is a large portion of our workforce is actually exposed to investment-specific risk because they’re employees at companies.

I think part of it is they’re dialing back in other ways, to compensate for that increased risk. Part of it is, I think, that our financial system blew up. We recognize that banks are inherently unstable. We’ve made the Fed less effective than it was because of politics. I think people look at that and say, “I have to be a lot more cautious because of this risk I didn’t see in 2007.” And lastly, the trade deficit floods us with risk-averse savings. We buy a car from Germany. Germany doesn’t buy products from us that employ our workers. They loan us the money back. We have to take the risk to borrow and spend that money. We did that through subprime mortgages, basically subprime consumption. We’ve shut that down.

Companies are net-cash-flow positive, so on that, they’re contributing to risk-averse savings. They’re not really using them. Rich people never really borrowed against their wealth and took more risk. They don’t want to take more risk than just spending or investing all the money that they earned. So even when housing prices went up, they didn’t really borrow against the real estate, and spend more and invest more. So, you don’t really see other outlets.

“We have to find a way to engineer much higher growth than we can possibly achieve organically.”

The other thing is the innovation economy. You see most of these companies with large cash piles because, in part, they’re worried that there’s going to be disruptive technology, and they want to swoop in and buy it so that it doesn’t disrupt their business. So you see a lot of these tech companies holding a tremendous amount of cash because they can’t risk putting all of their resources into internal development, and miss some innovation that disrupts their business.

If you look at Facebook, for example — Instagram would have had a major impact on Facebook, which is why Facebook bought it. Anybody who has kids knows this. And today, SnapChat’s going to have a major impact on Instagram. So if you are Facebook, you want the whole chain, from the picture you take and give to your friend, to the picture you put in your storyline, to the picture that you write a story about in your storyline. You want all three channels. They’re holding a lot of money to try to minimize the risk of disruption in this innovation age.

Knowledge at Wharton: Where do you stand on the potential reduction of regulation?

Conard: The first thing I’d say is that I think that if you look at a recent paper by [former Treasury Secretary] Larry Summers, it shows that we’ve put a lot of regulation on banking, and we haven’t really reduced the inherent instability of the banking system.

There are two kinds of risks in banking, by the way. One is, I make you a bad loan, and you can’t pay me back. We’ve got to make sure that the banks suffer 100% of the costs of making bad loans. Otherwise, they’ll make bad loans. We don’t want to bail them out for that. And it doesn’t look like we really did.

The second is inherent in this unstable equilibrium. If you leave the corn in the silo, instead of eating and planting it, it slows down growth, it slows down wages, it increases unemployment. You want to get the corn out of the silo and either invest it or consume it. That requires lending it, and somebody else borrowing it, and taking the risk of using it.

… You don’t want banks to go bankrupt in a bank run. … If you hold [banks] responsible for that, they have to hold a lot of corn in the silos to be able to pay out the depositors when they want withdrawals. Look at Goldman Sachs. It was shorting mortgages, and it still couldn’t pay withdrawals and basically would have gone bankrupt, had it not been for the Fed. And the Fed is actually a low-cost alternative for solving this problem. It can print money; let the depositors withdraw. When the panic subsides, the depositors put their money back in the banking system, they burn the money, and we get on with it.

Knowledge at Wharton: What is your the short term view on the U.S. economy going forward? President-elect Trump has said he believes he can find ways to see 4% GDP growth in the near future.

Conard: In order to grow faster, you have to reallocate your resources in a different way. And what is the most important resource? It’s properly trained talent. It’s the guys who go to Wharton who are the most valuable guys. … We have re-allocated them, say, from finance to technology — it’s probably a better use of our most important resource. [But then again] we might be over-allocated to technology. … You can end up with a lot of money if you win the tech lottery [by hitting it big in Silicon Valley], so we probably are over-allocating the talent there at the moment.

“We’ve issued a million green cards a year, largely to low-skilled workers. We have squandered the single best opportunity for growth.”

In the last eight years, we’ve issued a million green cards a year, largely to low-skilled workers. We have squandered the single best opportunity for growth, and that is to go out and get a million ultra-high-skilled workers every year, and bring in another 5 million and double the potential growth rate. I think it’s achievable that way.

I don’t think it’s going to be achieved if we just cut taxes, but don’t change government spending. That’s going to have a small impact, not a large impact. If we change the investment incentives by changing the corporate tax rate and encouraging [higher-wage-paying global] companies to move here, those changes will have a gradual compounding effect, because workers work at companies that [are] like Google and Facebook. They have better on-the-job training. They coalesce into communities of experts, and those institutions make our workforce much more productive.