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of World War IL At the time of their defeats in 1945 almost all the physical capital of Germany and Japan had been completely destroyed in air raids. Months before the war ended, the American air force reported itself out of worthwhile German industrial targets, while the British continued to bomb what litde remained of the urban housing stock. So great was the devastation that the American occupadon forces estimated that all the surviving works of man in Germany were worth less than a billion dollars. Similarly, even before the atomic bomb was dropped on Japan, incendiary bombing by American B-29s had utterly destroyed Tokyo as well as most other major Japanese cides. Almost the only German and Japanese capital to come through the war without massive devastation were the farms. Thus, for a time, the wealthiest people m both shattered countries were the farmers; nobody else could inherit any significant wealth for the simple reason that almost everything of value had been destroyed. Clearly, if physical capital is more important that human capital in producing wealth, then the farmers should have emerged as the next wealthy generation of Germans and Japanese. On the other hand, if it is human capital which is ultimately decisive, some other group should have risen to the top. When we look at the facts, we find that todays German farmers, far from enjoying overwhelming wealth, are heavily dependent on state subsidies in order to maintain a decidedly middle class existence. The situation in Japan is litde different. Japanese farmers depend upon tariff barriers and agricultural quotas for protection against more efficient foreign growers.

Moreover, if inheritance is the primary source of human wealth, then a devastating war or a prior period of massive under-development should always be a long-lasting setback to a countrys ultimate prosperity. After all, under such conditions, there is almost no wealth to inherit. On the other hand, if prosperity is generated primarily through current work efforts, it should be possible for a country to make a rapid -ery from war or to pass from extreme poverty to relative prosperity in a few decades.

Again, the facts fail to support the inheritance model. Although the German and Japanese recoveries from the war are often described as "economic miracles," there is really nothing miraculous - or even unique - about them. Rapid recovery from war has been noted as early as the nineteenth century economist John Stuart Mill. While the physical capital of both countries was utterly wiped out, Japanese and German survivors of the war preserved - and uldmate-

ly expanded - their human capital as soon as incentives allowed. As a result, both countries made early and complete recoveries from the war.

Some countries, however, not only lack physical capital, but also human capital. Again, if inheritance plays the key role in generating income, we should never expect to see such countries leap into prosperity since they simply lack a legacy to inherit. Yet, when we look at the post-war history of such countries as Hong Kong, Singapore, Taiwan, and South Korea, we find an astonishing jump from the most grinding forms of poverty into considerable relative prosperity by world standards. Tnje enough, all four countries followed low-tax and free market strategies which made them attractive to multinational companies, but all their human capital and much of their physical capital was selfgencrated.

Even though inheritance plays a relatively small role in income generation and inequality, some argue that any inheritance is a windfall which should be taxed away on ethical grounds. While ethics lies beyond the boimds of economics, our tools allow us to analyze the effects of such a policy. Not every inheritance is a windfall. For example, at least some people create wealth because they wish to leave a large legacy for their children. Moreover, many children care for their aged parents on the understanding that they will ultimately inherit an estate. A high inheritance tax would diminish, if not wipe out, these incentives. In any case, abolishing inheritances through a one-hundred percent tax would not abolish windfalls: the government rather than private individuals would simply receive them. After all, a vnndfall means a stroke of unearned good fortune, and the government does nothing whatsoever in exchange for its receipts. Moreover, according to our theory, people faced with a steep inheritance tax will substitute into alternauxe means of conveying wealth to their children. Gifts, fancy and expensive educations, endowments of physical capital, and trusts would simply increase in the face of higher inheritance taxes.

High inheritance taxes would also interfere with the transmission of much human capital. For example, many people develop the human traits needed to run family businesses because they ultimateb expect to inherit those businesses. If the business is confiscated by the government upon the death of the founder, the incentive to acquire diis human capit?l will diminish even though the survivors have a comparative advantage for running the business. In this case, society as a whole will ultimately .suffer because

the business may pass imo less capable hands.

Work. Some people and many groups enjoy high incomes simply because ihey work more than others. For example, incomes in Chinese households are higher than the national average in part because a high percentage of Chinese households have three or more income earners. Moreover, the Chinese often enter the labor force earlier, retire later, and work more hours than do most other ethnic groups.

Discrimination. Incomes may also differ because some groups are discriminated against in employment. Here there are two possibilities. Demand side discriminadon exists when employers preferentially hire or pay certain racial groups more than others of equal productivity. Supply side discrimination exists vvhen one group of sellers destroys or injures the compeddon of another racial group. We shall confine ourselves in this discussion to discriminadon by business. Supply side discrimination will be treated when we discuss unions.

Since discriminadon, unlike such factors as schooling and age, cannot be directly observed from data, efforts to measure its impact focus on so-called unexplained residual differences in incomes. In other words, labor economists try to account for the income differences between \arious ethnic groups and whites by focusing on such factors as experience, age, educa-don, and so forth. The differences between black and white incomes that remain after due allowance for such factors, i.e., the unexplained residual, is sometimes attributed to the impact of discrimination. Whether this inference is a valid one remains unclear. For example, we may observe considerable differences between the incomes of black and white high school graduates of the same age from Watts and Beverly Hills, but the data will not reveal whether the differences are due to discrimination, to differences in the qualit) of education in the two cities, or to some other factor High school graduates from Beverly Hills may enjoy higher incomes partially because they have received more human capital in their homelife. To that extent, the unexplained residual falsely reflects actual discrimination.

Discussions of di.scrimination routinely focus on the costs to the victim and completely ignore the costs to the discriminator Yet, trade is a two way street; it benefits both parties. The irrational refusal to transact with another group of people whether as an employer, lender, real estate broker, landlord, or in any other capacity - is to deny oneself opportunities to make profitable trade. As such, competitive capitalism

puts a price on discriminadon. Ifthe discriminator is a seller, his total revenue will be lower; if he is a buyer, his total cost will be higher At the same rime, discrimination confers advantages on those competitors who are not discriminating; the victims simply take their business to this compeddon. Hence, we ought to see less discrimination in environments where the cost in foregone profit is high and more discriminadon where the profit foregone is low. Experience bears these implications ouL Udlities regulated under average cost pricing, for example, are guaranteed a normal rate of return regardless of whether they hire employees on merit or other grounds. As such, their cost of discriminating is relatively low. Thus, for years, many utilities simply refused to hire blacks, Jews, and Cathohcs. Today the same utiUties "preferentially" hire many of the groups they once rejected, thereby discriminating against those whom they formerly favored. After all, a preference for groups A, B, and is inherendy discrimination against groups X, Y, and Z. Similarly, Universities discriminated against Jews in faculty hiring at least until the end of the Second World War.2 Like the private utilities, these academic institutions did not feel the pinch of lost profit

A few people argue that racial discrimination is caused by capitaUsm, but the empirical facts are wholly at variance with this assertion. If this claim is true, then we ought to find an absence of racial discrimination in non-capitalist societies. Yet, when we look at the history of the world, we find racial animosities in all manner of non-capitalist countries. As one example, tribal feehng, often exploding into murderous warfare, was common in Africa long before Europeans arrived and continues to this day. The ancient Egyptians had never heard of capitalism, but that did not prevent them from destroying a Jewish temple in Egypt hundreds of years before the birth of Christ. Moreover, if it is capitahsm that causes racism, how do we explain the severe discrimination against Jews in die Soviet Union, against the Tibetans in China, and against the Chinese boatpeople of Vietiiam?

On the other hand, no less a racist than Adolf Hider used to decry capitalism for producing the prosperity of the German Jews. In this respect, Hider was correct; an early attempt by the Nazi government to organize a voluntary boycott of Jewish businesses had to be called off because it failed. Similarly, de.pite years of private and government hostility - including school and housing segregation, incarceration, and the loss of property during World War II - Japanese Americans today enjoy incomes about 30% higher

than the national average.* Chinese immigrants to this country faced similar private and government discriminadon (thongh not the special wardnie hardshijxs of the Japanese) and are today also one ol tlie wealthiest groups in this country.5 If racism necessarily leads to poverty, then how do we explain the economic success ofthese two groups? Conversely, if poliucal activism is required for a mistreated ethnic group to better its lot, then what accounts for the historical absence of Japanese and Chinese civil rights leaders? On the other hand, given that the government conspicuously tried and failed to block the economic progress of Orientals, why should we assume it has the power to advance the welfare of other ethnics?

AFFIRMATIVE ACTION

One government program to advance the welfare of certain racial minorities - partially at the expense of sdll other racial minorities - is diat of affir-madve acdon.

Originally, the term meant that government should take posidve steps to remed)- the disparides between the educational offerings available to blacks and whites. With the passage of dme, however, the phrase has come to stand for hiring and other preferences for certain minority groups, somedmes extending to rigid numerical quotas. For example, a few police departments are under court order to the make the police department reflect the percentage of blacks in the general populadon. Usually such orders mean massive disproportionate hiring of new black recruits. (The courts routinely forget that blacks are a higher percentage of the whole population than they are in the age groups old enough to be police officers.) But whether affirmative action extends all the way to rigid quotas, it inevitably means the explicit consideration of race as a factor in hiring and promotion. In an effort to remedy past inequities, some races are to be currendy favored and others disfavored.

Affirmative acdon quotas presume that in the absence of discrimination, various gioups would be proportionately represented in each profession as they are in the population as a whole, i.e.. if blacks are eleven percent ofthe population, they would be eleven percent of all doctors and eleven percent of all bricklayers. The historical experience of other groups who are not victims of discrimination shows this presumption to be quite simply false. For example, except for the First World War period, Germans have not encountered racial discrimination in this country. Therefore, if the proportional representation hypoth-

esis is correct, Germans should be about equally represented in various professions. Yet, instead of finding proportional representation, we find Germans over-represented in agriculture, engineering, chemistry, and on the boards of large companies, while they are under-represented among politicians and small business owners. Persons of British ancestry are likewise over-represented in mining, especially in Appalachia, where they conunue to live in some of the most enduring poverty in America. Discrimination against the Irish ceased years ago, yet the Irish remain over-represented among politicians, the police, and the Catholic clerg)- and are under-represented among small businessmen. On the odier hand, could the huge over-representation of blacks in professional sports and the equally immense under-representation of Orientals be because of discrimination in favor of blacks and against Orientals? Similarly, does the heavy over-representation of Orientals in the National Academy of Sciences occur because of discrimination in their favor?

The fact is that different groups enter different professions in complicated ways that have nothing whatsoever to do with discrimination. Conversely, efforts by the government to pound groups into pro-ponionate representation are both bound to fail and to interfere with comparative advantage.

In addidon, empirical-evidence- suggests-that---

quotas actually injure precisely those minorities theyre supposed to help, while benefiting those who are already well off. For example, black males with 8 to 11 years of schooling and less than six years of work experience earned 79% as much as white males ofthe same description before quotas in 1967, but only 69% as much in 1978 after quotas. During the same period, the earnings of black males who had completed college and gained six or more years of experience rose from 75% of the income of their white cohorts to 98%. After quotas in 1980, college educated black couples earned more than college educated white couples. Both the loss of ground by the least educated and experienced blacks and the accelerated gains made by others can be traced to die quota system. As the distinguished black economist Thomas Sowell puts it:

WTiile government pressures to hire designated groups created an incentive for employers to include represeniauves of such groups among their employees, continuing government scrutiny of their subsequent pay, promotion, and discharge patterns made it especially risk)- to have emplov-ees from these groups who did not work out well. In short, the tendency was to increase the demand for