Economic debates about inequality usually begin with a familiar question: Who has how much income?
It is an important question. But perhaps it is not the only one we should be asking.
A society can change who becomes rich without substantially changing how unequal the society is. Regulation can weaken one economic elite while creating opportunities for another. Entrepreneurs and investors may lose relative influence while lawyers, compliance specialists, lobbyists, consultants and regulatory experts gain it.
The Gini coefficient may barely notice.
Income distribution and income-source distribution are not the same thing.
Regulation does more than redistribute income. It changes the relative returns to different kinds of knowledge and human capital. And when those returns change, talented people respond.
Elite Substitution
Imagine an economy in which high returns come primarily from producing things consumers voluntarily buy. Entrepreneurs search for new products, engineers improve production and investors search for promising companies.
Now introduce an increasingly complex regulatory system.
Those activities do not disappear. But another set of skills becomes more valuable: interpreting regulations, satisfying disclosure requirements, obtaining government permissions, anticipating political decisions and influencing the rules themselves.
The relevant question is not simply whether regulation reduces inequality. It is what happens to the return from creating economic value relative to the return from navigating political and regulatory institutions.
If intervention reduces the return to one form of economic power while increasing the return to another, we may get what I call elite substitution.
The elite does not disappear. Its composition changes.
Sarbanes-Oxley and the Fixed Cost of Complexity
Consider the Sarbanes-Oxley Act of 2002.
Following Enron and WorldCom, Congress sought to strengthen financial reporting and restore investor confidence. But compliance costs are not necessarily proportional to firm size.
A large corporation and a small public company may both need auditors, lawyers, internal-control systems and compliance personnel. The large company can spread those expenses across billions of dollars of revenue. The smaller company cannot.
GAO research has found that Sarbanes-Oxley compliance costs, although generally higher in absolute terms for larger companies, are proportionately more burdensome for smaller companies. GAO also found that companies moving from exempt to nonexempt status experienced a median increase of about $219,000, or 13 percent, in audit fees in the year of transition.
Sarbanes-Oxley did not cause the rise of private equity by itself. But increasing the fixed cost of public ownership changes the relative attractiveness of public and private organizational forms.
That matters because public markets allow ordinary investors to participate directly in corporate growth, while many private-market opportunities have historically been concentrated among institutional and accredited investors.
Regulation intended partly to protect ordinary investors can therefore inadvertently encourage some activity to migrate toward markets to which those same investors have less access.
Who Can Afford the Maze?
I saw another version of this phenomenon while working in the wealth-management industry before 2008.
I remember a rule of thumb concerning sophisticated offshore trusts: they generally became economically worthwhile only for estates of roughly $75 million or more. The precise threshold varied, but the economics was straightforward.
Lawyers, accountants, trustees and other specialists were expensive. Below a sufficiently large asset level, the cost could exceed the benefit.
That experience taught me something important:
Complexity has a fixed cost.
A $100 million household can economically justify sophisticated legal and tax strategies whose professional costs would make little sense for an ordinary household.
The same principle applies to businesses. A small company may struggle to employ one regulatory specialist. A multinational corporation can maintain entire departments of attorneys, accountants, lobbyists and compliance professionals.
Rules may formally apply equally while imposing very unequal economic burdens.
This creates a paradox. Regulation intended to constrain powerful economic actors can sometimes increase their relative advantage because they possess the resources necessary to navigate the resulting complexity.
We have not necessarily eliminated privilege. We may simply have changed its technology.
Dodd-Frank and Yesterday's Crisis
The same issue appears in banking.
After the 2008 financial crisis, Dodd-Frank increased the importance of compliance officers, attorneys, risk specialists, consultants, programmers and regulatory analysts. A Government Accountability Office study found that community banks, credit unions and industry associations reported increased staffing, training, employee time and compliance-system expenditures associated with selected Dodd-Frank rules.
The obvious defense is that this activity may prevent another financial crisis. If so, its social return could be enormous.
But that argument contains a difficult knowledge problem.
Major financial regulations are often responses to observed failures. Sarbanes-Oxley followed Enron and WorldCom. Dodd-Frank followed the financial crisis.
But the next crisis need not resemble the last one.
Financial institutions adapt. Capital moves. Technology changes. New products appear and risks migrate. The Federal Reserve's financial-stability framework itself acknowledges that shocks are inherently difficult to predict and therefore focuses primarily on monitoring vulnerabilities rather than predicting particular shocks.
This does not mean regulation produces no benefits. Higher capital, greater liquidity and improved risk controls may make institutions safer.
But the costs are relatively visible: compliance departments, legal expenses, reporting systems and management time. One of the largest claimed benefits—the crisis that did not happen—is much harder to observe.
The economic question is whether the marginal resources devoted to regulation make the financial system sufficiently safer to justify their opportunity cost.
The ACA and the Value of Political Knowledge
The Affordable Care Act illustrates another side of the same phenomenon.
The ACA changed subsidies, insurance rules, reimbursement arrangements and government-financed coverage. These changes affected expected revenues and profits throughout the healthcare industry.
Economists Mohamad Al-Ississ and Nolan Miller examined Scott Brown's surprise 2010 Massachusetts Senate victory, which reduced the perceived probability that the pending healthcare legislation would survive in its expected form.
They found striking differences. Managed-care firms experienced abnormal returns of about 6 percent, pharmaceutical companies about 2.8 percent, while healthcare facilities experienced abnormal losses of about 3.5 percent.
This does not prove that these gains and losses were political rents. A hospital could become more valuable under expanded insurance simply because more patients could pay their bills.
But it demonstrates something important:
Government rules can change expected private cash flows sufficiently that political events become capitalized into asset prices.
Once the government determines reimbursement formulas, subsidies and eligibility rules, understanding government becomes part of business strategy.
Political knowledge acquires economic value.
And when political decisions can create or destroy substantial corporate value, firms rationally devote resources to anticipating, navigating and influencing those decisions.
What the Gini Coefficient Cannot See
Imagine two economies with identical income distributions.
In one, high incomes depend primarily upon success in markets. In the other, they depend much more heavily upon successfully navigating political and regulatory institutions.
The Gini coefficient could be identical.
The economies would not be.
This is why inequality statistics tell us only part of the story. We measure how much income people receive but rarely ask enough about what activities generate that income.
None of this establishes that regulation necessarily makes society poorer. Preventing fraud, improving disclosure or correcting genuine externalities can create social value. Elite substitution and a smaller economic pie are separate propositions.
But every society has unusually talented and ambitious people. The important question is what institutions reward them for doing.
Do they receive the highest returns from inventing products, building companies and allocating capital successfully?
Or increasingly from mastering the rules governing those activities?
People respond to incentives. Economists have understood that for centuries. There is no reason the principle should stop operating when the government enters the picture.
Sarbanes-Oxley, Dodd-Frank and the Affordable Care Act addressed very different problems and may have produced important benefits. But all three raise a question conventional discussions of inequality often overlook:
When the government changes the rules, does it eliminate economic privilege—or merely change who is best positioned to capture it?
And when talented people discover that navigating the rules offers greater rewards than creating value outside them, we should ask one final question:
Did we redistribute the pie—or did we also make it smaller?
