Income inequality: Why it took off in recent years

Last week I examined income inequality trends in the United States over the past 90 years. But here’s the big question many Americans are pondering these days: Why has income inequality been growing so fast lately?

A number of explanations have been offered; let’s scrutinize them:

It’s all an illusion
This idea first appeared in the early 1990s, and still reappears from time to time. The basic notion is this: The apparent increase in inequality is actually the result of changes in how income is reported on tax returns. In other words, there is no real increase in inequality, just a relabeling of income that makes it appear that way.

For instance, many small companies today are organized as S-corps, allowing their owners to report their income on their personal income tax form. This benefits them because they pay a lower tax rate than if they had organized as a C-corps, a standard stand-alone corporation that must file a separate tax return.

This change and others was the result of federal tax reforms enacted in 1986. These reforms caused an increase in reported incomes among the top income earners, but it was not an actual increase in their incomes.

Emanuel Saez of the University of California, Berkeley, and Thomas Piketty of the Paris School of Economics, whose data I discussed in last week’s article, examine this possibility and reject it. The chart below shows the share of income received by the top 1 percent of income earners by source of income.

The column on the left shows the percent of all income that the top 1 percent of income earners received as wages and as entrepreneurial income.
Source: lvaredo Facundo, Anthony B. Atkinson, Thomas Piketty and Emmanuel Saez, “The World Top Incomes Database”
The column on the left shows the percent of all income that the top 1 percent of income earners received as wages and as entrepreneurial income.

The line labeled “entrepreneurial income” measures income received via S-corps and similar tax vehicles. This clearly jumped after the 1986 tax reforms. However, the line for “wage, salaries, and pensions” rose even more steeply, with wages and the like for the top 1 percent increasing from less than 4 percent of total income to roughly 10 percent of total income. So even without the effects of altered corporate-income reporting, income inequality rose sharply.

It’s all Reagan and Bush’s fault
Another possibility is that tax policies favoring upper-income earners increased income inequality. That is, the tax cuts of the early 1980s and early 2000s disproportionately benefited the rich, increasing their share of total income.

The data do not support this hypothesis. The Congressional Budget Office (CBO) computes lifetime effective tax rates — the share of income people pay in taxes over the course of their life — by income levels. (The report is available here.) CBO’s analysis confirms that effective taxes decreased for upper-income people, but they fell for those with lower incomes as well. So tax policy was probably a wash in terms of income inequality.

It’s globalization
The share of trade in U.S. output, measured as exports plus imports, rose from less than 10 percent to over 30 percent between 1960 and 2010. The share grew especially starting in the late 1970s. Did this cause increased income inequality?

The data are mixed. In 1994, economists Paul Krugman and Robert Z. Lawrence analyzed the data and found that trade, in general, and outsourcing, in particular, probably increased wages a bit at the upper end of the income distribution and decreased wages a bit at the lower end.  However, the effect was small relative to the rise in inequality up to that point.

Since 1994, economists have argued about this and reached no consensus. Some analysts, such as Krugman himself, say trends changed starting in the late 1990s and that globalization depressed wages for manufacturing workers and others engaged in sectors that had a lot of exposure to trade. Others have examined the same data and found little evidence to support this argument.

It’s about technology and economic growth
Claudia Goldin and Lawrence Katz, professors of economics at Harvard, provide the best analysis of increasing income inequality in their book “The Race Between Education and Technology.”

As they explained in an article in the Milken Institute Review: “The title of our book on this subject was taken from a remark by Jan Tinbergen, the first Nobel laureate in economics. Inequality, he said, is the outcome of a race between education and technology. When technological advance vaults ahead of educational change, inequality generally rises. By the same token, when increases in educational attainment speed up, economic inequality often declines.”

Goldin and Katz document how, between the 1920s and the 1970s, America “went to high school” and saw the nation’s average educational achievement rise from middling to the highest in the world. This made it possible for U.S. workers and companies to adopt and utilize the latest and greatest technologies developed anywhere in the world, providing the foundation for paying the highest average wages in the world.  As a bonus, rising educational attainment created a larger pool of potential innovators; their innovations drove rapid productivity growth, further increasing average incomes.

Goldin and Katz point out that income inequality began rising when educational attainment stopped rising in the 1970s, and has continued to increase as the rate of technological change has outstripped our ability to adapt and use it.

Institutional change and income inequality
One ingredient is missing from all of these explanations: the interaction between markets and their institutional environment.

For example, businesses can pay out productivity increases through higher wages and benefits, keep the fruits of innovation as profits or do some combination of both. Firms tended to do the former before 1980 and the latter after 1980. Why?

Peter Temin and Frank Levy, economics professors at MIT, provide an answer in their paper “Inequality and Institutions in 20th Century America.”   They write that rising income inequality derives in part from “the shift from one complex of policies to another — from the Treaty of Detroit to the Washington Consensus.”  

The Treaty of Detroit refers to a set of policies that prevailed from the end of World War II to the late 1970s. Under this arrangement, Temin and Levy write, “even in peacetime, business-labor relations would remain a tri-partite process” with government actively involved “as the third man in the ring.” Labor-management relations were conducted with government playing the neutral party acting to curb the excesses of each side. The result was both healthy profits and rising incomes across the board.

This framework collapsed in the late 1970s. Specifically, “the firing of the air traffic controllers, the 1978 defeat of labor law reform and the lowering of tax rates were signals that the third man — government — was leaving the ring,” the economics professors argue. “From that point on, business and labor would fight over rewards in less regulated markets with many workers in an increasingly weak position.” In a nod to a similar set of policies that governed international trade, Temin and Levy call this new situation the Washington Consensus.

Why did the Treaty of Detroit collapse? There are myriad reasons, but one in particular is critical: Average labor productivity grew much more slowly starting in 1973. This meant that the pie from which wages and profits were cut did not grow as rapidly after 1973 as before, so arguments over how to slice pieces became increasingly heated. Unfortunately, economists are still not sure why productivity growth slowed, and even more frustrating, why it began growing more rapidly again after 1995.

Inequality and public policy
The rise in income inequality is real. Changes in educational attainment and social and political institutions contributed the most to the more polarized income distribution.

One important question remains: Will policies that involve more government spending and transfers in an effort to reduce inequality hurt economic growth? We’ll address it next week.

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Comments (26)

  1. Submitted by Jeff Klein on 11/23/2011 - 10:10 am.

    “So tax policy was probably a wash in terms of income inequality.”

    I wouldn’t be so fast with this. Lower taxes meet less in terms of services – like public schools – which the lower class needs the most. Cutting those services affects them more.

  2. Submitted by Erik Hare on 11/23/2011 - 10:32 am.

    Try something very simple – the decline in manufacturing jobs.

    http://erikhare.wordpress.com/2011/09/02/labor-creates-all-weath/

    The peak of manufacturing jobs was a bit over 20M in 1980, or 22% of the workforce. Today, there are less than 12M or about 9% of the workforce.

    Manufacturing jobs typically pay well because they require some skill. More importantly, they also include many entry-level jobs that people can get right out of school and grow into, learning skills on the job.

    If you look carefully at the growth in income inequality you’ll see that 13% of the population being thrown out of the Middle Class explains it pretty well. This becomes especially stark when you look at unemployment for those under 25, which has been stubbornly high (around 20%) for many years.

  3. Submitted by John Olson on 11/23/2011 - 11:02 am.

    One other possibility to consider is the effects of the stock market. Stock options as a part of compensation packages for those in nicer offices grew in popularity about that time. The employee with stock options could theoretically improve their own bottom line by taking steps to favorably improve conditions for all shareholders.

    Unlike 30 years ago, anyone can buy and/or sell stocks, mutual funds, etc. today from wherever they can get an internet connection. Obviously, one has to have the working capital to do this (and maybe some antacid), but the do-it-yourself approach to buying and selling stocks without a broker could also be a part of this equation as well.

  4. Submitted by bruce fisher on 11/23/2011 - 11:40 am.

    Chance alone is the reason for excess wealth accumulation according to a study conducted at the University of Minnesota’s applied economics department by John Fargoine, http://www.ncbi.nlm.nih.gov/pmc/articles/PMC3140971/. “We demonstrate that chance alone, combined with the deterministic effects of compounding returns, can lead to unlimited concentration of wealth, such that the percentage of all wealth owned by a few entrepreneurs eventually approaches 100%.”

    That is why the best public policy is to tax the very wealthy at a high estate tax rate to help alleviate the social problems associated with excessive wealth accumulation.

  5. Submitted by steven gray on 11/23/2011 - 11:43 am.

    Great article, thanks!

  6. Submitted by Aaron Sinner on 11/23/2011 - 11:46 am.

    After reading the book “Winner-Take-All Politics,” I’m somewhat skeptical of the Technology & Education argument.

    If I’m remembering my numbers correctly, 25% of the population has a bachelor’s degree or higher, and 10% has a professional degree. If education were a major driver of income inequality, we’d expect to see inequality divided roughly in line with those percentages, no? But instead of a top 25% or 10% pulling away from everyone else, we have a top 1% pulling away from the rest of the top decile, and a top .1% pulling away from the top percent. “Winner-Take-All Politics” has numbers suggesting educational attainment among these groups isn’t markedly different; I believe it also makes the argument that income data from other countries does not support Technology & Education as the primary driver of income inequality.

  7. Submitted by Alec Timmerman on 11/23/2011 - 12:39 pm.

    Here is why tax policy was not a wash.

    As income taxes decreased for the rich, there was more incentive to take more profit as income. Less and less was invested in payroll, labor, and capital improvements. Under the old model, they re-invested at higher rates in order to reduce their taxable income because tax rates at those upper levels were so high.

    With higher income taxes, there was higher investment in labor and capital. That is one reason it really mattered.

    Another difference is the magnitude of actual savings.

    Let’s say I gross 50k and pay 10%
    And Bob grosses 5,000k and pays 10%

    Now, we each get the exact same tax cut, of say, 3%.

    I take home an extra $150 or an extra $12.50 a month. Spent immediately.

    Bob takes home an extra $15,000 a year or an extra $1,250 a month. Bob, is much, much more likely to put his into savings, and accumulate wealth.

    A tax cut for me does not accumulate wealth as much as a tax cut for Bob.

    Simple.

  8. Submitted by Rich Crose on 11/23/2011 - 12:54 pm.

    If you’ve got money, you make money. If you’ve got a lot of money, you make a lot of money.

    For example: In 2007 Goldman Sacs went to Warren Buffett and offered him a guaranteed 10% return on his money if he would borrow them $5 Billion. When I put my money in the bank I get .25%. Warren makes billions, everyone else made pennies.

  9. Submitted by Connie Sullivan on 11/23/2011 - 01:02 pm.

    A thought-provoking discussion, so far. I wonder, though, if the CBO analysis that asserts that tax policies have had no effect on income inequality took into account the effects of all the newish tax-sheltering opportunities for those who have more than subsistence wages and can put tens of thousands of dollars aside each year.

    Along with tax cuts on income from 90% after WWII to about 35%, the wealthier among us can shelter, tax-free, income in IRAs (est. about 1983), Roth IRAs (est. 1997-8), and other salary-based tax shelters like 401(k)s and 403(b)s, plus 529 accounts, deferred compensation accounts, etc. Amounts that can be sheltered in those accounts are gigantic now, compared to the measly $2,000 contribution cap there was on IRAs and Roths in the beginning.

    But, you have to have those tens of thousands of yearly surplus dollars to begin with, to pile up assets without paying taxes on them. This article minimizes this disparity, I think, by judging only taxable wages/dividends/capital gains.

  10. Submitted by Dennis Tester on 11/23/2011 - 01:48 pm.

    “That is why the best public policy is to tax the very wealthy at a high estate tax rate to help alleviate the social problems associated with excessive wealth accumulation.”

    Uncle Karl would be proud of you. Fine, you go ahead and use the tax code for social engineering, just don’t call yourself a free society.

  11. Submitted by Dennis Tester on 11/23/2011 - 02:24 pm.

    “Why did the Treaty of Detroit collapse? There are myriad reasons, but one in particular is critical: Average labor productivity grew much more slowly starting in 1973. This meant that the pie from which wages and profits were cut did not grow as rapidly after 1973 as before, so arguments over how to slice pieces became increasingly heated.”

    The energy crisis of the 1970s coupled with double-digit inflation and interest rates caused the cost of doing business to skyrocket, reducing the profit “pie.”

    “Unfortunately, economists are still not sure why productivity growth slowed, and even more frustrating, why it began growing more rapidly again after 1995.”

    Technology entered the scene with email, mobile phones and the internet, dramatically reducing the cost of doing business and increasing productivity and profits.

  12. Submitted by Wm. Sweeney on 11/23/2011 - 06:05 pm.

    Great discussion…I don’t know if there is any one answer to this phenomena — although the ‘chance’ argument does seem to have merit!
    I would add that management practice has had a great effect — particularly in larger organizations. The job duties of many administrative type positions (finance, real estate, insurance, etc.) have become more specialized — to the point of being ‘dumbed down’ — lowering the skills/knowledge required to perform a job along with the compensation offered. “The Star System” of employee compensation has also become popular — providing extraordinarily high compensation for those perceived as extraordinarily gifted or productive (this phenomena goes well beyond the area of professional sports).
    But of all the possible reasons for this change in income/wealth distribution, two stick out for me:
    1) the decline in Union membership and power, and
    2) a philosophical change to the belief that unregulated Capitalism is the most efficient economic system. Promulgated by the growing number of managers educated in business schools, the appeal of Reaganism, and confirmed by the collapse of the Soviet system — there was a shift in the attitude of the typical American regarding business. The deification of successful business leaders like Jack Welch, Bill Gates and Steve Jobs is symptomatic of that attitudinal shift.

  13. Submitted by Paul Udstrand on 11/23/2011 - 06:17 pm.

    Best article yet from Johnston. Finally wrote an article that matched the title for thing.

    I think tax policy gets a short shrift however. The wealthy have seen greater decreases in their tax rates than everyone else. They’ve seen their tax rate cut by more than 50% compared to 20%-30% for everyone else. Furthermore, corporate taxes have been cut. Beyond that, as budget deficits emerged as a result of the tax cuts have led to cuts in the services that the poor and middle class use while preserving the services and subsidies that the wealthy use.

  14. Submitted by Paul Udstrand on 11/23/2011 - 06:20 pm.

    I love it when Republicans pretend their Randian free market assault on the middle class isn’t a form of social engineering.

  15. Submitted by Alec Timmerman on 11/23/2011 - 06:42 pm.

    Uncle Karl?

    How about Uncle Adam Dennis?

    Adam Smith taught the students who attended his jurisprudential lectures that “there is no point more difficult to account for than the right we conceive men to have to dispose of their goods after death.” He thought inheritance was clearly justified only when it was necessary to provide for dependent children.

    How about Uncle Thomas?

    Another means of silently lessening the inequality of property is to exempt all from taxation below a certain point, and to tax the higher portions of property in geometrical progression as they rise. Whenever there is in any country, uncultivated lands and unemployed poor, it is clear that the laws of property have been so far extended as to violate natural right. The earth is given as a common stock for man to labor and live on.”
    –Thomas Jefferson to James Madison, October 28,1785.

    Sorry Dennis. When everything is socialism and everyone a communist, you kind of lose your credibility.

  16. Submitted by Alec Timmerman on 11/23/2011 - 06:43 pm.

    Is it just “chance” that our most massive inequality happened right before the great depression and then again before the great recession?

  17. Submitted by Bill Gleason on 11/23/2011 - 07:42 pm.

    To muddy the waters further on loss of manufacturing (and other)jobs in the US.

    To a certain extent businesses in the US compete at a disadvantage due to the fact that many of our competitors have medical care systems where the government has most of the financial responsibility.

    Thus US companies face an additional labor expense that of providing, at least to some extent, health care benefits.

    This is a complex issue, but a lead reference to this situation is: “Healthcare Costs and U.S. Competitiveness.”

    From the Council on Foreign Relations, link: http://on.cfr.org/gEajqL

    The irony of this of course is that many businesses would be better served economically by supporting the pejoratively named “Obamacare.” In the future this title will be seen as an honorific.

    As that old class warrior, Saul Alinsky, used to say: If you can’t get them to do the right thing for the right reasons, get them to do it for the wrong.

  18. Submitted by Tom Anderson on 11/23/2011 - 11:10 pm.

    #7 Unless Bob is unlike most Americans, he buys a bigger house, bigger car, another jet-ski, and sends his kids to better schools.

    The minimum income is zero. It will always be zero. The maximum income increases every year. It will continue to increase. The income inequality will keep getting greater and greater. Really simple.

  19. Anonymous Submitted by Anonymous on 11/24/2011 - 07:12 am.

    The real reason income inequality has taken off in recent years can be described in one word: Politics. Hacker and Pearson wrote an entire book on it called Winner Take All Politics. It is a reasonably long book that is expertly researched and reported and debunks many of the arguments made here. What it basically comes down to is that the wealthy have waged a political and economic campaign against the rest of the country. They have used their increased wealth to wage a political campaign to protect and extend their economic advantages.

  20. Submitted by Dennis Tester on 11/24/2011 - 08:19 am.

    “The irony of this of course is that many businesses would be better served economically by supporting the pejoratively named “Obamacare.” In the future this title will be seen as an honorific.”

    No, the real irony is that, much to the chagrine of the class warriors, the working class would be better served economically by cutting the corporate income tax and capital gains taxes paid by the evil rich. For a real boom economy, I suggest they be eliminated altogether so we’re attracting manufacturing jobs from all over the world. heh

  21. Submitted by Alec Timmerman on 11/24/2011 - 09:58 am.

    “The income inequality will keep getting greater and greater. Really simple. ”

    Tom,
    What you say is simply not true, and does not hold up to even casual scrutiny.

    From 1933 until 1978, income inequality went down. That’s a pretty big sample size refuting your claim. Could you provide some evidence for your statement please?

  22. Submitted by Richard Schulze on 11/24/2011 - 10:29 am.

    I’m actually surprised that there is any gain for the lowest quintile, these are inflation-adjusted dollars, yes?

    Whatever the cause, the data is powerful because it tends to support two prejudices. First, that a system that works well for the very richest has delivered returns on labor that are disappointing for everyone else. Second, that the people at the top have made out like bandits over the past few decades, and that now everyone else must pick up the bill. Of course it is a little more complicated than that. But this downturn ought to test the normally warm feelings in America of the 99% towards the 1%.

  23. Submitted by Paul Udstrand on 11/25/2011 - 09:30 am.

    I’ve never been able to figure out whether or not some people around here actually don’t know the difference between a Marxist and a liberal or if they’re just being silly. On one hand it’s hard to believe someone could be that ignorant, on the other hand…

    At any rate, back to the issue of disparity, another reason we’ve seen increased disparity is the drop in labor union participation. For a while there almost 50% of the American labor force had labor contracts, now that down to around 10% or 12%. The switch to “at-will” employment by such a huge segment of the population has driven down wages and salaries, while executives get bonuses for driving those wages down.

  24. Submitted by Paul Udstrand on 11/25/2011 - 10:29 am.

    Actually, I’m afraid Mr. Johnston’s conclusion that tax policy is a wash based on the CBO report is seriously flawed. To begin with this study doesn’t actually look at the effects of income disparity, it merely studies distributed tax burden.

    The biggest problem with any claim that this data is relevant to disparity is the time period chosen by for study by the CBO. for one thing, some of data is based on different short time periods. some of the data is from 1991-1997, another data set covers 1993-1995, and a third data set looks at data between 1987 and 2000. The time period we’re actually concerned with here is form 1950-2010. This data is a disjointed snapshot of a very selective time frames.

    One huge problem with this data is it excludes entirely the Reagan tax cuts. Reagan enacted two tax cut, one in 1983 that lowered the tax rate on top earners from 75% to 50%, and then another in 1986 that lowered rates from 50% to 29%. It doesn’t look to me like the data set includes those tax cuts. This data excludes both the Reagan and Bush tax cuts.

    There are other problems, for some reason they average tax rates, I don’t even know why you would do that when your interested in trends. Then they do this goofy longitudinal analysis that looks like it’s base on averages. I don’t get that, but that could be math ignorance on my part.

    At any rate I don’t think you can draw any meaningful conclusions about income disparity from a data sets that exclude every major tax policy change in the last 30 years. One certainly cannot exclude the Reagan-Bush tax cuts as cause of disparity using data that excludes the Reagan-bush tax cuts.

  25. Submitted by Jon Kingstad on 11/26/2011 - 12:41 am.

    The “Treaty of Detroit” must be a made up term by Temin and Levy but it sounds fairly accurate as a way of describing the shift in government policies. No question that the 1981 air controllers’ strike symbolized a major shift in government equalizing balance of power in labor vs. management. I would say that was not so much as government “leaving the ring” as deciding to support management versus labor and especially unionized labor.

    I think the comments about labor productivity decline from 1973 to 1990’s would be interesting to explore. Computers did not become widely used until the late 1990’s so that must be a factor but how was labor productivity measured before then and what factors account for the decline? I’ve grown suspicious over the years of all government indicators, including inflation and unemployment. Why should measurements of labor productivity be viewed with any less skepticism especially if they are coming from a an anti-union/anti-labor government?

  26. Submitted by Tony Wagner on 11/30/2011 - 06:23 pm.

    “Unfortunately, economists are still not sure why productivity growth slowed [after 1973]”

    Mr. Johnson: isn’t technology surpassing education a valid reason for this? One that you endorsed earlier in the article? Not sure how that squares with the post-1995 productivity gains, though.

    Great series, by the way, and I am sorry that the comments seem to be mostly the same left-vs-right drivel as always.

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