Inequality and Risk

August 2005

(This essay is derived from a talk at Defcon 2005.)

Suppose you wanted to get rid of economic inequality. There are
two ways to do it: give money to the poor, or take it away from the
rich. But they amount to the same thing, because if you want to
give money to the poor, you have to get it from somewhere. You
can't get it from the poor, or they just end up where they started.
You have to get it from the rich.

There is of course a way to make the poor richer without simply
shifting money from the rich. You could help the poor become more
productive — for example, by improving access to education. Instead
of taking money from engineers and giving it to checkout clerks,
you could enable people who would have become checkout clerks to
become engineers.

This is an excellent strategy for making the poor richer. But the
evidence of the last 200 years shows that it doesn't reduce economic
inequality, because it makes the rich richer too. If there
are more engineers, then there are more opportunities to hire them
and to sell them things. Henry Ford couldn't have made a fortune
building cars in a society in which most people were still subsistence
farmers; he would have had neither workers nor customers.

If you want to reduce economic inequality instead of just improving
the overall standard of living, it's not enough just to raise up
the poor. What if one of your newly minted engineers gets ambitious
and goes on to become another Bill Gates? Economic inequality will
be as bad as ever. If you actually want to compress the gap between
rich and poor, you have to push down on the top as well as pushing
up on the bottom.

How do you push down on the top? You could try to decrease the
productivity of the people who make the most money: make the best
surgeons operate with their left hands, force popular actors to
overeat, and so on. But this approach is hard to implement. The
only practical solution is to let people do the best work they can,
and then (either by taxation or by limiting what they can charge)
to confiscate whatever you deem to be surplus.

So let's be clear what reducing economic inequality means. It is
identical with taking money from the rich.

When you transform a mathematical expression into another form, you
often notice new things. So it is in this case. Taking money from
the rich turns out to have consequences one might not foresee when
one phrases the same idea in terms of "reducing inequality."

The problem is, risk and reward have to be proportionate. A bet
with only a 10% chance of winning has to pay more than one with a
50% chance of winning, or no one will take it. So if you lop off
the top of the possible rewards, you thereby decrease people's
willingness to take risks.

Transposing into our original expression, we get: decreasing economic
inequality means decreasing the risk people are willing to take.

There are whole classes of risks that are no longer worth taking
if the maximum return is decreased. One reason high tax rates are
disastrous is that this class of risks includes starting new
companies.

Investors

Startups are intrinsically risky. A startup
is like a small boat
in the open sea. One big wave and you're sunk. A competing product,
a downturn in the economy, a delay in getting funding or regulatory
approval, a patent suit, changing technical standards, the departure
of a key employee, the loss of a big account — any one of these can
destroy you overnight. It seems only about 1 in 10 startups succeeds.
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