How Big Government Drives Inequality

How Big Government Drives Inequality

DAVID MALPASS

Updated Jan. 15, 2014 10:53 p.m. ET

Inequality is the wedge issue that Democrats hope will carry them through the 2014 and 2016 elections, neutralizing the ObamaCare fiasco. The issue has popular appeal because median incomes (after inflation) have been falling throughout the recovery, while high-end incomes are increasing rapidly.For progressives, this situation seems made to order: If you want a flatter income distribution, don’t you need bigger government to get it? Yet experience shows the opposite: Washington’s increased size and power has concentrated income and wealth in fewer hands. Making government bigger will exacerbate this problem—it is already too big, intrusive and expensive to allow a robust economy that benefits everyone.

President Ronald Reagan rejected class warfare, advocating sound money and lower tax rates to boost growth and living standards. His policies worked. The economy grew faster than 7% in real terms for five quarters in a row starting in the second quarter of 1983. Gross domestic product grew on average 4.6% per year in real terms during the 1983-88 expansion, while real median incomes grew 2.1%. His policies were such an economic success that appeals to class warfare gained relatively little political traction for 25 years.

Since the Reagan years, growth policies have faded while the government has increased its control over the economy and national income. Top marginal federal income-tax rates have risen to nearly 44% today from 28% in 1988. The dollar has weakened while consumer prices have doubled in 25 years. Federal nondefense spending has nearly quadrupled to $2.8 trillion in 2013 from $750 billion in 1988, adding a huge burden on taxpayers as national debt grows.

Today, almost five years after the recession officially ended in June 2009, job growth from new business formation is running one-third below average, according to the Labor Department’s Employment Dynamics report. Real GDP growth has averaged a weak 2.3% over the past three years, while real median incomes have fallen 0.6% per year. This disastrous economic result sets up a political confrontation between those who believe that a bigger government makes things better and those who believe that it concentrates power and income in fewer hands, undercutting the middle class.

Progressives may concede the weakness of the economic recovery. Yet they urge more government spending and higher taxes, claiming that their policies will achieve higher growth and a fairer distribution of income.

Conservatives need to champion economic growth as Reagan did, but they also need to make a more forceful connection between the government’s centralization of power and income inequality.

Big government expansions in recent years have harmed individuals with modest incomes while exempting or benefiting people with higher incomes. These include the federal takeover of the mortgage industry, and the Federal Reserve’s decisions to keep interest rates near zero and buy some $3 trillion in bonds. Both of these expansions channel credit to the government and the well-connected at the expense of savers and new businesses.

Middle-income earners used to be the primary beneficiary of the rise in the value of their houses. Housing gains now lift Washington, allowing the government to pay itself huge “dividends” from Fannie Mae, FNMA +0.32% Freddie Mac FMCC -0.33% and the Federal Reserve, which owns nearly $1.5 trillion in the government’s housing-related bonds. The government promptly spends the windfalls, fueling a further accumulation of wealth and income for those with Washington access.

The financial industry is making billions in profits fueled by the government’s provision of zero-rate loans for those with connections and collateral. Wall Street’s upper crust is the epicenter for financing the contractors, lobbyists and lawyers that help the government spend money. Meanwhile, government grabs a huge share of the profits generated by small businesses. It piles on opaque regulations, complex tax rules and countless independent agencies, producing a system that works against small businesses and the middle class. The Affordable Care Act takes pains to exempt Congress, government, corporations and unions, but leaves the rest severely exposed, adding to inequality.

This week’s congressional budget deal saw a narrow group of Washington’s elite legislators and lobbyists working over the weekend to divvy up nearly $1.1 trillion in discretionary spending for 2014. Much of the spending and all of the lobbying and debt underwriting costs will benefit those with high incomes while the extra debt falls heavily on the middle class.

There is nothing wrong with an appropriate level of government services—it’s necessary. But we are long past that level. Growing the government shrinks the rest of the economy and after-tax paychecks.

The next debt limit increase is approaching fast, probably in March. Fiscal conservatives are likely to argue along traditional lines for a few spending cuts or some votes to highlight the ObamaCare calamity. That leaves Democrats with the inequality argument to use as a bludgeon against Republicans.

The debt-limit debate should be a national referendum on the size of the federal government and the need for new controls on its growth and power. That will be a critical step in restoring income growth, but as currently written, the debt-limit law forces votes in favor of more debt.

I’ve advocated strengthening the debt limit by adding a declining debt-to-GDP ceiling that, when exceeded, triggers extra controls on spending and a hair shirt for Washington. Extra debt should trigger a slowdown in automatic entitlement growth, pay cuts for senior officials and reductions in their subsidized benefits until they resolve the spending crisis.

A new debt law offering spending restraint would boost confidence among investors and entrepreneurs. Most important, it would allow median incomes to begin rising again once Washington leaves private enterprise more room to breathe and grow.

Mr. Malpass is president of Encima Global LLC. He served as deputy assistant Treasury secretary in the Reagan administration and deputy assistant secretary of state in the George H.W. Bush administration.