Why Are They Paid So Much?

Sometimes seeing the same old thing a different way allows new insight. I was struck by that when reading this article about salaries in the financial business. Perhaps I’ve understood an answer without understanding the question.

The right questions are these: why do some people earn so much more than others? What is the source of income inequality?

To answer this, you have to understand three things about people with high incomes:

  1. They possess particular skills
  2. The skills they possess are valued by society and are in relatively short supply
  3. They work hard applying those skills

People buying the use of those skills are willing to pay a lot because the skills are both valuable and in short supply. A consequence of this is that it provides incentive people for acquiring valuable skills and applying them. This is all self-regulating: the more people acquire and apply these skills, the greater the supply. Greater supply means people are willing to pay less. This is the result of free market supply and demand: a self-regulating price system.

The key, which is often overlooked, is that people with these scarce skills often can choose how hard to work. Nothing forces anyone to work hard. These fortunate people can choose to work more and earn more or work less and earn less. This is the problem with progressive taxation: the higher the rate of taxes, the less incentive there is to work more. Thus the surgeon may decide to perform a few less operations every month and play a little more golf. The businesswoman may decide to forego expanding her business (and hiring more people) because, after taxes, the rewards don’t seem worth the risk. The consultant might decide not to accept more business until the following year because of tax implications.

How much does this kind of thing happen? I doubt that anyone knows, but I know with certainty that it does happen. Progressive taxation may sound like a good idea, but one consequence is it deprives society of benefits that come from people with valuable skills. Is it worth it?

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