Category: income inequality

Via Kash and Greg Mankiw, I read a fascinating piece in Fortune about the source of some of the anti-ultra-rich sentiment, the merely rich. The key excerpt:

Here's my outlandish theory: that economic resentment at the bottom of the top 1 percent of America's income distribution is the new wild card in public life. Ordinary workers won't rise up against ultras because they take it as given that "the rich get richer."

But the hopes and dreams of today's educated class are based on the idea that market capitalism is a meritocracy. The unreachable success of the superrich shreds those dreams.

As Kash, says, he may be onto something, but it's a different thing than the author suggests. Here is a rewrite of the last part of the excerpt that I think is more accurate: "... the hopes and dreams of today's educated class are based on the idea that society is not the meritocracy of market capitalism but the meritocracy of a social democracy."

I don't disagree with the article's diagnosis: the educated trade classes of doctors, lawyers, authors, accountants, engineers, and professors (among others) have lost ground in the last decade or so compared to the entrepreneurs and financiers. Market capitalism rewards these innovators and risk takers above all others.

I think the educated trade classes resent that the contributions they make through their intellect and efforts are not valued by the market as highly as the returns to innovation and risk taking in product markets. The amenities that would accrue to them under (their idealized notion) of a more socialist system are becoming more expensive. They want their dachas by the lake, but the ultra-rich have already bought them up. And it didn't used to be that way.

And, of course (and as suggested in the article), every nurse, public school teacher, fireman, and other worker with lower education-based credentials, who works just as hard or harder and receives even less compensation for it, could rightfully tell them to get over themselves.

Kash closed his post with the question, "Who knows what such resentment could cause?"

My suggested answer: Senator Ned Lamont.

For some earlier ideas in this topic, see these two posts.

Matthew Yglesias is disheartened by my need to praise his theory:

Meanwhile, I was sad to read this comment from Andrew Samwick on my theory that tax policy affects pre-tax income distribution:

I hadn't fully appreciated that a progressive tax system might be used to give lower-income workers a leg up in competing for the marginal unit of production. It remains an empirical question as to how important this might be over the last 25 years. I would have thought the effect to be small, compared to things like increasing global competition in product markets.

I would have thought that lots of people would have thought of that already. It doesn't seem like it should be too hard to model, right? Indeed, at first I thought I should be able to model it myself but actually I can't. Some of what I'm thinking, though, goes below.

Here's some clarification of what I meant by "fully appreciated."

Progressive tax systems reduce the inequality in the after-tax distribution of income, conditional on the pre-tax distribution of income. Got it.

High marginal tax rates on the rich discourage further work by the rich, lowering their pre-tax income. Got it.

With the rich discouraged, there is more demand for the poor to do that work. They work more, and their pre-tax income goes up. Hadn't thought about the impact of the lower marginal tax rate for poor people on their willingness to work to meet that extra demand until I read Matt's theory.

So here's the next question, which has been asked in different ways by different people: are the poor better off if the rich are idle? I suppose they could perceive some direct benefit of a lower income gap, but I wouldn't presume. The answer, I think, depends on how the rich and poor interact in production and consumption. What if Tiger Woods plays one fewer golf tournament? What if Paul Krugman writes one fewer book? What if Bernie Marcus had opened a hundred or so fewer Home Depots?

It's the last one--the effect on entrepreneurs--that might make us think twice about the answer.

Brad DeLong does the public service of recapping the blogosphere's discussion of Krugman's "Wages, Wealth, and Politics" column. I blogged about it in the last two posts.

Krugman argues that the dominant political ideology is the main cause of changes in inequality. I want him to show a mechanism by which that occurs. Brad notes that Krugman has a book coming out on the subject--I guess we'll have to wait for it to see whether his criticism of the Treasury Secretary's remarks can be validated.

Others in Brad's recap have speculated about such mechanisms. There are a few different groups of them. Here's my quick take on them.

1) Weaker bargaining positions for labor, exacerbated by government policy

In this group are factors like less vigorous enforcement of laws protecting unions and opposition to increases in the minimum wage. A commenter named "Dark Helmet" at Matthew Yglesias's blog offered the following hypothesis:

The notion of putting more economic risk on the middle class -- in Orwellian, the "Ownership Society" -- reduces the bargaining power of middle-income employees. The more risk people bear, the more they cling to the remaining hedges against uncertainty. Which usually means the job that they have. This shows up most starkly in the "job lock" problem with health care. Want to quit your job and start a business? Better not have any preexisting conditions.

Interesting idea. I think it's plausible that these factors are inhibiting workers to press for higher wage growth. But wages are not everything. Greg Mankiw has noted, not all of the observed weakness in wage growth is the result of total compensation not growing. Compensation includes wages and fringe benefits, and the fraction of compensation taken up by wages is falling. So while these factors may be at work, we've got to insist on a better comparison before assessing their importance.

2) Tax policy leading to higher pre-tax incomes disproportionately at the high end, Part I

In this group are explanations based on the higher incentive to realize income when marginal tax rates are lower. For example, if capital gains tax rates are high, then investors hold their gains rather than realize them. When capital gains tax rates are lower, the same investors realize the gains, paying the smaller tax rate, and then reinvest. Reported income goes up, and it does so disproportionately at the high end. I don't think this is a valid explanation of some fundamental economic shift. It is a criticism of using reported income, rather than accrued income, to compare income distributions at different points in time.

3) Tax policy leading to higher pre-tax incomes disproportionately at the high end, Part II

This one comes from Matthew Yglesias. Part of it belongs in (2) above, so I've emphasized the elements that wouldn't just be a measurement issue:

One thing to say is that tax policy impacts pre-tax distribution. When the top income tax rate was very high -- 70 percent or above -- this not only meant that rich people paid a lot in taxes, it also meant that there were a broad range of circumstances where it didn't necessarily make much sense to offer well-compensated people even more compensation. When you have a very progressive rate structure, an employer can get a lot more bang for his buck by directing his employment budget at middle-income people than at rich people. As
you flatten the tax structure, this becomes less-and-less the case.

Similarly, very high tax rates encourage high income people to engage in more leisure and less work whereas right now we have the somewhat odd situation where highly compensated people tend to work more than do the moderately compensated.

I think that's fascinating. I hadn't fully appreciated that a progressive tax system might be used to give lower-income workers a leg up in competing for the marginal unit of production. It remains an empirical question as to how important this might be over the last 25 years. I would have thought the effect to be small, compared to things like increasing global competition in product markets.

4) Lax enforcement of laws that should prevent the rich from stealing from others

This group is basically organized around the notion that CEOs and other top corporate officers have seen their pay grow tremendously over this period, and some of that, the theory goes, must be due to illicit activities. Hard to argue that none of it is ill-gotten, though I am not in the camp that suggests it is very high. As food for thought, here is the abstract of a new paper by Xavier Gabaix and Augustin Landier, "Why Has CEO Pay Increased So Much?"

This paper develops a simple equilibrium model of CEO pay. CEOs have different talents and are matched to firms in a competitive assignment model. In market equilibrium, a CEO’s pay changes one for one with aggregate firm size, while changing much less with the size of his own firm. The model determines the level of CEO pay across firms and over time, offering a benchmark for calibratable corporate finance. The sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies during that period. We find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The data broadly support the model. The size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.

Another interesting hypothesis. The part I've emphasized suggests that the rise in CEO pay is the passive result of growth in market capitalization.

The last post was focused on Krugman's status in the top 1 percent of the income distribution and what it implies about the quality of his argument. Some readers, including Mark Thoma at Economist's View, misconstrued it as suggesting that if Krugman is in the top 1 percent, then he is being dishonest if he advocates policies that would reduce the income of the top 1 percent.

Obviously, I don't believe that. As just one example, consider that I am in the group that would bear the full brunt of the tax increases in the Liebman-MacGuineas-Samwick plan to reform Social Security. As PGL points out at Angry Bear, I am not calling Krugman dishonest. I am saying that his own experience should suggest to him how silly his argument is.

Krugman begins by criticizing Treasury Secretary Paulson for "falsely implying that rising inequality is mainly a story about rising wages for the highly educated." You can read the full text of Paulson's speech to determine whether Krugman excerpted him accurately. (The relevant passage starts with "The final challenge I will touch on today ...")

In order for Krugman to validate that criticism, he has to show us that "rising inequality is mainly a story about ... something else." His choice for that something else is a thesis that "it matters a lot which political party, or more accurately, which political ideology rules Washington." So he's got to show us how the political ideology ruling Washington over the last 25 years has generated the following outcomes:

Between 1980 and 2004, real wages in manufacturing fell 1 percent, while the real income of the richest 1 percent — people with incomes of more than $277,000 in 2004 — rose 135 percent.

Here is what he says about that 25-year period:

Finally, since 1980 the U.S. political scene has been dominated by a conservative movement firmly committed to the view that what’s good for the rich is good for America. Sure enough, the rich have seen their incomes soar, while working Americans have seen few if any gains.

By the way: Yes, Bill Clinton was president for eight years. But for six of those years Congress was controlled by hard-line right-wingers. Moreover, in practice Mr. Clinton governed well to the right of both Eisenhower and Nixon.

Now, this chronology doesn’t prove that politics drives changes in inequality. There were certainly other factors at work, including technological change, globalization and immigration, an issue that cuts across party lines.

But it seems likely that government policies have played a big role in America’s growing economic polarization — not just easily measured policies like tax rates for the rich and the level of the minimum wage, but things like the shift in Labor Department policy from protection of worker rights to tacit support for union-busting.

It is only in the last paragraph that he describes any specific mechanisms whereby ideology might drive the outcomes. He mentions the level of the minimum wage and the tacit support for union-busting. Let's just grant him that those are relevant for the 1 percent decline in real wages in manufacturing.

But what is the mechanism for ideology driving outcomes in the top 1 percent? The only factor he mentions is tax rates for the rich, but that won't work here. His evidence for widening inequality was the growth in real income, not (from his description) real after-tax income. And if he is suggesting lower tax rates generated the boom in the top 1 percent's real income, then he's more of a supply sider than he lets on. (There may be some relation between capital gains realizations and lower tax rates, but Krugman would have to acknowledge that this reflects not differences in inequality but differences in the importance of including realized versus accrued capital gains.)

So he cites no evidence to link the policies of the ruling political ideology to the income gains for the top 1 percent. And for that, I'm supposed to accept his claim that the Treasury Secretary made false implications, by saying:

But we must also recognize that, as our economy grows, market forces work to provide the greatest rewards to those with the needed skills in the growth areas. This means that those workers with less education and fewer skills will realize fewer rewards and have fewer opportunities to advance. In 2004, workers with a bachelor's degree earned almost $23,000 more per year, on average, than workers with a high school degree only. This gap has grown more than 60 percent since 1975.

This trend dates back many years, and was evident in the recovery of the 1990s. It is simply an economic reality, and it is neither fair nor useful to blame any political party. It stems from a number of factors, including technology and U.S. integration with the global economy. Rather than playing the blame game, we must focus on helping workers move up the economic ladder.

In the race between these two arguments, Paulson is way out in front of Krugman. In my post, I suggested that Krugman's own experience would suggest how invalid his thesis is compared to Paulson's. Krugman is a perfect example of someone whose real income is high because the returns to being educated are higher, not because the dominant political ideology has conspired to increase his earnings capacity in some pernicious way.

Mark Thoma, ghost-writing a response on Krugman's behalf, suggests the following:

I'm sure that I earn a lot more than James Tobin did (I use him as an example because of how modest his lifestyle was), but it's not because I'm a better economist; it's the system that has changed.

And what I'm talking about is the system, not whether individuals have earned their places in it. Why is that so hard to understand?

Fair enough, but in order for that to support Krugman's thesis rather than Paulson's, Mark would have to tell us how the dominant political ideology, rather than simply a higher return to education, has changed that system. That's the part where Krugman needs some real ghost-writing help.

UPDATE: Related commentary by Brad DeLong and Greg Mankiw.

Paul Krugman, a highly educated man, leaves himself out of his own column today in "Wages, Wealth, and Politics." The excerpt:

But he [Treasury Secretary Paulson] quickly reverted to form, falsely implying that rising inequality is mainly a story about rising wages for the highly educated. And he argued that nothing can be done about this trend, that “it is simply an economic reality, and it is neither fair nor useful to blame any political party.”

History suggests otherwise.

I’ve been studying the long-term history of inequality in the United States. And it’s hard to avoid the sense that it matters a lot which political party, or more accurately, which political ideology rules Washington.

Since the 1920’s there have been four eras of American inequality:

• The Great Compression, 1929-1947: The birth of middle-class America. The real wages of production workers in manufacturing rose 67 percent, while the real income of the richest 1 percent of Americans actually fell 17 percent.
• The Postwar Boom, 1947-1973: An era of widely shared growth. Real wages rose 81 percent, and the income of the richest 1 percent rose 38 percent.
• Stagflation, 1973-1980: Everyone lost ground. Real wages fell 3 percent, and the income of the richest 1 percent fell 4 percent.
• The New Gilded Age, 1980-?: Big gains at the very top, stagnation below. Between 1980 and 2004, real wages in manufacturing fell 1 percent, while the real income of the richest 1 percent — people with incomes of more than $277,000 in 2004 — rose 135 percent.

What’s noticeable is that except during stagflation, when virtually all Americans were hurt by a tenfold increase in oil prices, what happened in each era was what the dominant political tendency of that era wanted to happen.

I'll forgive him the odd switches between real wages and real wages in manufacturing, as well as the comparisons of wages for one group with income for another group. I'll even agree with him about his (later) discussions of where Republican Eisenhower and Democrat Clinton fit in their respective eras. I'll even forgive him the seemingly obvious point that in the "New Gilded Age," the income gains do seem to be at the high end, refuting his critique of Paulson's first point (under the very reasonable assumption that the top 1 percent is on average "highly educated.")

What always puzzles me about Paul Krugman and his claims about inequality is why he doesn't seem to realize how silly he sounds when he refuses to acknowledge, and take some pride in the fact, that he is part of that top 1 percent. I find it hard to imagine that Paul Krugman's income in 2004 wasn't above $277,000, between his income from his university, his speaking engagements, his books, his columns, and his investments.

Now, does Paul Krugman think that he was just a tool of the "New Gilded Age" politicos? Does he owe his income gains to the people he despises, those nasty Republicans and that ridiculously centrist Clinton? I'd like to know. I suspect that if you asked him why his income grew to the point where he's in the top 1 percent, he would give some long answer, the shorter version of which is that he's "highly educated" and he's not lazy.

And the salient fact about this explanation is that it is accurate. Krugman's about as highly educated as you can get. He's got plenty of skills and occasionally (though not here) a good argument. People like what he does and he gets paid for it. Good for him. But good for Secretary Paulson as well, since Paul Krugman's own experience supports both parts of Paulson's assertion.