Needed: Meaningful Progress on Income Inequality

Income inequality in the United States has been rising for decades. As I’m sure many of you know, the best source for data on income inequality is Piketty and Saez.  The pictures below (which I’m shamelessly stealing from Piketty and Saez) give you a pretty good sense of the problem. [1]

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Today, the top 10 percent of income earners take home roughly half of all pre-tax income earned in a year.  Inequality was really high in the first 40 years of the twentieth century but then fell sharply and remained low for the next 30 years.  Then, sometime around 1970, income inequality began rising gradually.  This basic pattern holds essentially regardless of how you define the top income earners.  This figure shows the dreaded top 1 percent of income earners.

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Keep the magnitude of these figures in mind. The top 1 percent claims almost 25 percent of all income.  The top 0.1 percent is even more striking.  They take home more than 10 percent of all income.  That is, these households earn essentially 100 times what the average household earns in a year.

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The source of this income is also noteworthy.  The graph below decomposes the top 0.1 percent according to the source of the income. Clearly a lot of the increase in income inequality is due to wage income. In the past, the ultra-rich were the owners. This isn’t entirely true today. Many households in this group are rich because of extraordinary labor income.  (Many CEOs are compensated for the “work” they do rather than their ownership stake in the company.)

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I submit to you that this state of affairs is simply unacceptable.  This current degree of income inequality is probably the most disruptive, most corrosive and most troubling problem confronting the U.S. economy today.  Even if inequality is a “natural” consequence of market based economies it doesn’t mean that we should tolerate it. (Bee-stings and allergies are also natural but you don’t just stand there and do nothing while your friend goes into anaphylactic shock.)  I only need to watch 10 min of the Real Housewives of Orange County before I become convinced that we are really in dire need of aggressive income redistribution.  It would be nice to see someone make a reality show called The Real Housewives of Gary Indiana; or the Real Housewives of Flint Michigan; or the Real Housewives of Allentown Pennsylvania.

In the past some hard-core economists might respond to inequality by saying that we can’t make meaningful comparisons across people because utility is only an ordinal concept. This response is totally unpersuasive to non-economists – and the non-economists are right. Empathy is a very real human trait and it is completely reasonable to desire a more even distribution of income for its own sake.  (Perhaps utility has a cardinal component to it after all.)  The challenge for economists and policy makers is to propose policies which effectively redistribute income to produce a more tolerable distribution of well-being while at the same time causing the least amount of damage to markets and incentives.  This is a challenge for both Republicans and Democrats.

Republicans need to come to the realization that extraordinary income inequality is real and it’s a huge problem. A very cynical view might be that we have to deal with it because not dealing with it, courts a populist movement which could usher in a wave of really bad economic policies (think about a maximum wage policy or something similar). But the correct view is this: it’s a huge problem because none of us (even the most stoic Republican out there) wants to live in a country where we have people living in obscene opulence while at the same time, just a few miles away, we have people living in obscene poverty – the kind of poverty where basic health needs becomes an issue; the kind of poverty where food and heat become luxuries.  We aren’t dealing with this problem and we need to.  It’s as simple as that.

For Democrats, the challenge is realizing that the distorting problems of taxation and careless redistribution are real and must be properly confronted by policy makers.  We need to come up with aggressive policies (policies which make meaningful progress on inequality) but that don’t cause huge market inefficiencies.  These policies are not necessarily going to be politically popular and there are many ways of screwing things up if we don’t think carefully about how best to achieve our goals.  The recent article by the Harvard economist Sendhil Mullainathan is exactly right and every well-meaning liberal should take a moment to internalize these ideas.  Incomes in the United States really are substantially higher than incomes in Europe and it’s no accident.  (If you are a Democrat and you are thinking that the first thing we need to do is raise the minimum wage, you are confused.)  I suspect that many liberal concerns about market failures are really just stand-in’s for a concern about inequality. If income were very evenly distributed, would people really care about “predatory lending.”

[1] These figures all correspond to pre-tax income for individual tax units. After-tax measures will undoubtedly be better. In addition, the composition of the households will also matter. Joint filers will typically have more income than a single filer though this doesn’t really reflect income inequality. Correcting for these factors is important but it’s not going to undo the stark reality which is behind these figures.

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10 thoughts on “Needed: Meaningful Progress on Income Inequality

  1. Hi Chris,

    Great post. As a liberal I’d agree with you that the primary focus should be on fighting income inequality. Can you give me a starting point for what you believe to be well designed aggressive policies to fight income inequality?

    • The standard go-to policy is often an expended version of the EITC but I think this is still a bit too passive. I would like to see discussion of other possible policies for example:

      1. A ‘negative income tax’ through negative with-holding. That is, if your job pays you $100 you could get $120 after-tax. This would have to be phased-out over a substantial range of income but it wouldn’t require any tax filing on the part of the recipient. We could also make the means-testing depend on the tax bracket of the people filing on behalf of the workers. So children who work would benefit only if their parents income qualified the family as a whole. This policy would transfer income from general revenues (which are raised via progressive taxation). It would also ‘encourage’ employment for low-income workers and potentially reward firms that hired these workers. This is in sharp contrast to the minimum wage proposal which penalizes firms if they hire low-wage workers.

      2. A more aggressive estate tax, particularly for extremely high wealth households. The current estate tax is actually fairly aggressive (I think the statutory rate is 55 percent above the cutoff – someone correct me if this is off). That said, we could make it even a bit more aggressive for households in the upper stratosphere.

      3. A government bequest at the start of life. This could be placed in a fund which could be accessed by children say when they turn 16 with the hope of using it toward education or other types of job training (or just making life a bit easier). If every child received $10,000 at birth which could grow at say 4 percent over the following 15 years, the child would have enough for a car or for collateral for a student loan, etc.

      These are just thoughts off the top of my head — I haven’t given any of them serious attention as to their budget impact or anything but it would seem that we should try to attack the problem directly if we want to get anywhere.

      Do you have any ideas?

      • “This is in sharp contrast to the minimum wage proposal which penalizes firms if they hire low-wage workers.”

        This would be correct if low-wage workers earned what they produced. Given that median real wages stagnated in the US and low real wages actually fell during the last three decades, i.e. roughly since the Reagan-Thatcher revolution that ended the short realm of social democracy / moderated capitalism and pushed all Western economies back on a path towards unfettered capitalism (when folks talk about income inequality they often compared the current state to the Gilded Age) it is safe to claim that a significant part of wages is not influenced by fundamentals but by political economy.

        This is the theoretical reason why a higher minimum wage will not lead to significant negative employment effects and the empirical literature does after all also report fairly moderate employment effects.
        Of course it depends upon the company. For example Walmart workers could probably be paid 50%-100% more of what they earn right now while the managers earn less and no competitor would drive wages down (i.e. it is mainly a distributional game between labour and managers/capital) but in the case of small companies folks with low wages probably earn more or less what they produce so a higher minimum wage would have detrimental effects on employment.

  2. “For Democrats, the challenge is realizing that the distorting problems of taxation and careless redistribution are real and must be properly confronted by policy makers. We need to come up with aggressive policies (policies which make meaningful progress on inequality) but that don’t cause huge market inefficiencies.”

    Bullshit. Top marginal income tax rate in the US are at a historical low (http://upload.wikimedia.org/wikipedia/commons/thumb/9/97/Historical_Mariginal_Tax_Rate_for_Highest_and_Lowest_Income_Earners.jpg/350px-Historical_Mariginal_Tax_Rate_for_Highest_and_Lowest_Income_Earners.jpg) and when they have been above 90% during the oh-so-pinko-hippie-liberal Eisenhower administration GDP

    In simple model the costs of disincentive effects of taxation are quadratic in the tax rates so they should be historically low right now. And as I pointed out above, even if tax rates are high there is no evidence that the resulting disincentive effects are significant.

    There are market failures that caused all this mess and matter though, market failures in corporate governance. I am all for incentive contracts but CEOs getting paid large bonuses even when the company is not doing well are perverse incentives. The best solution would be to force managers to put some of their equity into the company such that they would actually lose money if they underperform.

    If we frame the issue not as income inequality but as market failure in corporate governance or socialism for the managers / managerialist wealth extraction / theft of shareholders we would realize that more income equality and more market economy would actually go hand in hand in this instance

    • This line should have been. “Top marginal income tax rate in the US are at a historical low and when they have been above 90% during the oh-so-pinko-hippie-liberal Eisenhower administration GDP growth has not been below average.”

  3. Income inequality is a maximization, not an optimization. A game theoretic view of income inequality is one of exceeding the value of the game, thus it is a cost, a negative use cost. As a cost it is bore by those maximizing the system. The problem is when are these costs borne. Later more than likely, as we always eat tomorrow and pay later. Today’s beneficiaries will pay tomorrow.

  4. Pingback: Watch what you Say in the Echo Chamber | Orderstatistic

  5. So, wait. Huge disparities in wealth just miles away cannot be tolerated, however much bigger disparities in wealth thousands of miles away can? Strange position, considering the massive global drop in inequality in the last 30 years.

    • You make a very good point — see the follow-up post “Inequality Redux” by the anonymous commenter who makes a similar case.

  6. Pingback: Warren Buffet: Fighting Income Inequality with the EITC | Orderstatistic

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