India gained 19 dollar billionaires last year. Forbes, the magazine that keeps track of the riches of the rich, reports that India now ranks fourth in the world in the number of billionaires, and is likely to lead the world in another 10 years, outstripping the US. And yet statistical studies find that the increase in inequality in India post reforms was not very large. The fact is that inequality lies in the eye of the beholder. The choice of any specific measure of inequality carries an implicit value judgement on which part of the distribution of income (or expenditure) matters. The ?inequality did not increase very much? conclusion is based on the Gini Index of inequality (which is 0 when everyone shares alike, and 1 when one person has everything and the rest, none); but the Gini index is most sensitive to changes around median expenditure (or income). When the fiercest action occurs far from the median (which is well short of $2 a day) it stands to reason that the Gini index will not budge.
It is among the rich that inequality has increased the most. In financial services and in professional management, top compensation far exceeds the pay of those with even slightly less talent, or luck. What consequence follows from inequality among the top 1% of the population?
The issue is not with income, but with consumption. Conspicuous consumption by the rich inflicts a negative effect on the rest of society. This is not mere envy, the economic effects are real. Research in neuro-economics has confirmed the fundamental neural basis of what we have always known: human beings are programmed deep in the mind to value most types of consumption in a comparative way. The need to affirm social status through the consumption of positional goods is a part of being human.
The dilemma is that ostentatious consumption of the rich makes the rest of society feel poorer. My satisfaction with my work-a-day car is dented by my neighbour?s premium car. The more unequal the consumption in society, the worse off are its members, including most of those who are clearly doing rather well.
With the top income group racing furiously to affirm their standing through spending, the pattern of redirected consumption percolates down through to the rest of us whatever our income. Robert Frank has shown how in America, increased concentration of income and wealth at the top of the economic pyramid have set off expenditure cascades that raise the cost of achieving many basic goals for the middle class. The result is a net loss in welfare due to reduced spending on goods and services that are not positional?for example, savings accounts. And leisure (as distinct from expensive holidays), and many other welfare enhancing commodities that cannot be observed in consumption.
When consumption is not mainly for intrinsic utility, but aimed at status, your satisfaction is positively related to the price of the good consumed. This is why luxury brands are sold at prices well above marginal cost, even when they are not intrinsically superior to other brands. When the utility from positional goods is due to their price more than their substance, high marginal tax rates can extract revenue for the government with little burden on the consumer who is signalling his wealth. A carefully calibrated tax schedule on luxury brands will be non-distortionary in siphoning out excess profits. By its very nature, a progressive consumption tax will not attenuate the market for luxury goods very much.
No-one, including those of us who are less well off, will want a return to the old regime of high marginal tax rates on income, which threaten incentives to save, to invest, and to exert ourselves in contributions we are able to make in propelling the economy. But a progressive consumption tax focussed on luxuries should strengthen the incentives to save and invest?-spending the resulting tax revenue on public goods should be a win-win situation.
?The author is reader in economics at the Judge Business School, University of Cambridge, and fellow of Corpus Christi College