Thursday, November 15, 2007

Rising Inequality: Why is the rising tide not lifting all the boats?

The global economy is enjoying an age of unprecedented growth, but unfortunately inequality appears to be growing even faster. Why is the Gilded age, with its goldilocks economies and stable and high economic growths, not resulting in equitable outcomes? Why is the rising tide not lifting all the boats?

There are different views on the causes for the widening inequality

1. The major share of increasing inequality is accounted for by the sharpening wage divide. Lawrence Katz argues that the major portion of the rising wage inequality since 1980 can be attributed to the increasing educational wage differential. This school highlights a trend of increasing returns to investments in skills - an increasing wage premium on more school education, more training and greater skills and capabilities set.

In 1980, people with college degrees made on average 30 percent more than those with only high school diplomas. That disparity has widened to 70 percent. In the same year, the average earnings of people with advanced degrees were 50 percent more than those with only high school diplomas; today it is more than 100 percent.

2. The emergence of IT and its tools helped companies capture the performances of employees and their contribution to the company more accurately, thereby enabling them to differentiate between employees with differring capabilities and skills. Professor W. Bentley MacLeod of Columbia University, Thomas Lemieux of the University of British Columbia and Daniel Parent of McGill University found that performance based pay accounted for 25% of the increase in wage inequality in the 1976-1993 period. They also found that the proportion of jobs with a performance-pay component rose to 40 percent in the 1990s from 30 percent in the late 1970s. In 2003, the authors note, 44.5 percent of workers at Fortune 1000 companies received some form of performance-based pay, up from 34.7 percent in 1996. “Since companies are better able to measure precisely what an employee contributes, we’ve seen a greater range of incomes among people doing roughly the same jobs,” says Professor MacLeod.

3. Another view attributes this trend to the increasing share of profits and dividends in national income, and the corresponding decline in the shares of wages. Unlike payroll tax, capital gains and dividends (most famously the "carried interest" of hedge fund managers and private equity partners) are taxed only at 15% in the US.

However Emmanuel Saez of the University of California at Berkeley and Thomas Piketty of the Paris School of Economics, argues that the the share of top incomes coming from capital is much lower now than it has been historically. He claims that for the richest Americans — those in the top 0.01 percent of the distribution — the percentage of income derived from capital fell to 25 percent in 2004 from 70 percent in 1929. But their data clearly shows that this income share is rising steeply in the US, since 1980. They however argue that "the decline of progressive taxation observed since the early 1980s in the United States could very well spur a revival of high wealth concentration and top capital incomes during the next few decades." Prof Greg Mankiw claims, "The leisure class has been replaced by the working rich."

It is a different matter that this "working rich" is a miniscule minority and have emerged as the "new leisure class", and are pulling away from the rest of the society. This is a sleight of hand, as the "working rich'" also includes a very small but extremely rich category of managers, who are by any yardstick more than mere employees of their companies. To make a more meaningful analysis, we will need to separate them from the regular working rich, who are ordinary employees of their companies.

In fact, in the same study, Saez and Piketty also reveal that the share of gross personal income of the top 1 percent of American earners rose to 17.4 percent in 2005 from 8.2 percent in 1980. This is a more pertinent piece of information, which clearly points towards incresing inequality.

4. An excellent NBER working paper by Professors Frank Levy and Peter Temin, of the MIT, Inequality and Institutions in 20th Century America, lays the blame on public policies and says that "income distribution in each period was strongly shaped by a set of economic institutions." They argue that in the period 1955-80, was dominated by "unions, a negotiating framework set in the Treaty of Detroit, progressive taxes, and a high minimum wage - all parts of a general government effort to broadly distribute the gains from growth". This grand bargain between labor and corporate America involving New Deal-era protections for workers and high marginal tax rates (the top rate was 90 percent in the 1950s) led to the Great Moderation. The middle class grew dramatically, income inequality decreased, and corporations generally enjoyed labor peace.

"The stability in income equality where wages rose with national productivity for a generation after the Second World War was the result of policies that began in the Great Depression with the New Deal and were amplified by both public and private actions after the war. This stability was not the result of a natural economy; it was the result of policies designed to promote it. We have termed this set of policies the Treaty of Detroit."

Since 1980, due in part to the Reagan era shift in political environment, unions have weakened, minimum wage hasn’t come close to keeping up with inflation, and marginal income tax rates have been cut (the top marginal rate is now 35 percent, down from 70 percent in 1980). They argue that "the recent years have been characterized by reversals in all these dimensions in an institutional pattern known as the Washington Consensus, whose effects have been amplified by the skil based technical change" of recent years. This has resulted in declining bargaining power for workers and the rise of a winner-take-all environment.

"The elements of the Washington Consensus were adopted in the name of improving economic efficiency. But there is growing recognition that the current free-market income distribution – the combination of large inequalities and stagnant wages for many workers – creates its own “soft” inefficiencies as people become disenchanted with existing economic

"Only a reorientation of government policy can restore the general prosperity of the postwar boom, can recreate a more equitable distribution of productivity gains where a rising tide lifts all boats."

Update 1
Temin and Levy's article from Vox, Inequality and institutions in 20th century America. They write, "Rising American inequality stems from efficiency-enhancing policy changes in the 1970s and 1980s. There is growing recognition that the current free-market income distribution – the combination of large inequalities and stagnant wages for many workers – creates its own “soft” inefficiencies as people become disenchanted with existing economic arrangements."

Update 2
A recent NYT article says that Report Says That the Rich Are Getting Richer Faster, Much Faster. The poorest fifth of households had total income of $383.4 billion in 2005, while just the increase in income for the top 1 percent came to $524.8 billion, a figure 37 percent higher. On average, incomes for the top 1 percent of households rose by $465,700 each, or 42.6 percent after adjusting for inflation. The incomes of the poorest fifth rose by $200, or 1.3 percent, and the middle fifth increased by $2,400 or 4.3 percent. It says, "Much of the increase at the top reflected the rebound of the stock market after its sharp drop in 2000, economists from across the political spectrum said. About half of the income going to the top 1 percent comes from investments and business."

Update 3
Paul Krugman explores how hedge fund managers, the top 25 of whom made more than $14 bn in 2006, are contributing to the widening inequality.

Update 4
It is often argued that measures of income inequality are misleading because an individual's income is, at best, a rough proxy for his or her real economic wellbeing. Because we can save, draw down savings, or run up debt, our income may tell us little about how we're faring. They argue that on the contrary, consumption surveys, which track what people actually spend, sketch a more lifelike portrait of the material quality of life. Again consumption numbers, too, conceal as much as they illuminate. They can record only that we have spent, but not the value—the pleasure or health—gained in the spending. According to one 2006 study, by Dirk Krueger of the University of Pennsylvania and Fabrizio Perri of New York University, consumption inequality has barely budged for several decades, despite a sharp upswing in income inequality.

Update 5
Income and wealth have become more concentrated than at any time in the past 80 years, and those at the top are now taxed at lower rates than rich Americans have been taxed since before the start of World War II. Taxpayers who bring home over $5 million annually now pay less than 22 percent of their incomes in federal tax, on average. Managers of hedge funds, private-equity partners, and many venture capitalists are paying no more than 15 percent -- since their earnings are, absurdly, treated as capital gains. This means that America's wealthiest, who have been receiving most of the economy's bounty, are paying a smaller percentage of their income in taxes than are middle-class Americans. Financiers who are raking in hundreds of millions -- last year, each of the 25 highest paid hedge-fund managers took in an average of $560 million -- are paying at a lower rate than many of America's working poor who barely clear $20,000 annually.

Here is an arguement that claims inequality may not be as bad as the income figures show, since consumption differences between the top and bottom quintile are not so marked. The share of national income going to the richest 20 percent of households rose from 43.6 percent in 1975 to 49.6 percent in 2006, and families in the lowest fifth saw their piece of the pie fall from 4.3 percent to 3.3 percent, or a 1:15 ratio. The top fifth of American households earned an average of $149,963 a year in 2006 and spent $69,863 on food, clothing, shelter, utilities, transportation, health care and other categories of consumption, with the rest going largely to taxes and savings. The bottom fifth earned just $9,974, but spent nearly twice that — an average of $18,153 a year, sources of spending money that doesn’t fall under taxable income - portions of sales of property like homes and cars and securities that are not subject to capital gains taxes, insurance policies redeemed, or the drawing down of bank accounts. This means a consumption ratio of only 1:4.

Here is Bernie Saffran Lecture by Frank Levy, where he examines the role of social, political and economic institutions that contributes towards widening income inequality. He argues how the institutions – unions, the minimum wage, the tax system, accounting conventions and ultimately the tone set by the government – have the power to either moderate or reinforce the underlying market. He describes how "U.S. institutions abandoned a moderating role sometime after 1975, when market forces were already tending toward greater inequality."

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