Opinion

The Great Debate

A shrinking middle class means a shrinking economy

By Alan Krueger
January 13, 2012

The following is an excerpt from a speech Alan Krueger, chairman of President Obama’s Council of Economic Advisers, gave at the Center for American Progress on Thursday. The full text is available here.

Although I have done much research on inequality, I used to have an aversion to using the term. Indeed, the Wall Street Journal ran an article in the mid-1990s that noted that I prefer to use the term “dispersion.” But the rise in income dispersion – along so many dimensions – has gotten to be so high, that I now think that inequality is a more appropriate term.

President Obama summarized the rise of inequality very succinctly in his Osawatomie, Kansas speech, when he said, “over the last few decades, the rungs on the ladder of opportunity have grown farther and farther apart, and the middle class has shrunk.”

These trends are well documented but worth reviewing. My first figure shows the annualized growth rate of real income for families in each fifth of the income distribution over two periods. The figure shows that all quintiles (fifths) of the income distribution grew together from the end of World War II to the late 1970s, but since the 1970s, income has grown more for families at the top of the income distribution than in the middle, and it has shrunk for those at the bottom.

I should point out that the pattern in the post-1970s period is not monolithic. As this next chart shows, the period from 1992 to 2000 was an exception, when strong economic growth and the policies of the Clinton administration led all quintiles to grow together again. Indeed, all income groups experienced their fastest income growth in years.

I could also note that there is no sign in these data that the tax increases in the early 1990s had an adverse effect on income growth.

This next chart shows the level of income earned by the median household each year, after adjusting for inflation. You can see that the median household saw a decline in real income in the 2000s. If in the first decade of the 2000s the income of the median household had grown at the same rate as it did in the 1990s, middle-class households would have an extra $8,900 a year to spend on their mortgages, rent, cars, food and clothing, or to add to their savings.

The next chart shows how much after-tax income has grown for different parts of the income distribution since 1979, after adjusting for inflation. As the Congressional Budget Office noted in a recent report, the top 1% of families saw a 278 percent increase in their real after-tax income from 1979 to 2007, while the middle 60% had an increase of less than 40 percent.

Because of these trends, the very top income earners have pulled much further ahead of everyone else. The following chart shows the share of all income earned by the top 1 percent and 0.1 percent of households. Not since the Roaring Twenties has the share of income going to the very top reached such high levels.

A consequence of the momentous shifts in the income distribution is that the middle class has shrunk. The next chart illustrates this development by showing the percentage of households whose income falls within 50 percent of the median. We have gone from having just over 50 percent of households with incomes within 50 percent of the median in 1970 to 44 percent in 2000, and 42.2 percent last year.

A handy statistic for summarizing the connection between parents’ and children’s income is the Intergenerational Income Elasticity (IGE). Recent studies put the IGE for the U.S. around 0.4. This means that if someone’s parents earned 50 percent more than the average, their child can be expected to earn 20 percent above the average in their generation.

Recent work by Miles Corak finds an intriguing link between economic mobility and inequality. Countries that have a high degree of inequality at a point in time also tend to have less economic mobility across generations. We have extended this work. This next figure shows a scatter diagram of the relationship between income mobility across generations on the Y-axis (measured by IGE) and inequality in the mid-1980s (measured by the Gini coefficient for after-tax income) on the X-axis. Each point represents a country. Higher values along the X-axis reflect greater inequality in family resources roughly around the time that the children were growing up. Higher values on the Y-axis indicate a lower degree of economic mobility across generations.

I call this the “Great Gatsby Curve.” The points cluster around an upward sloping line, indicating that countries that had more inequality across households also had more persistence in income from one generation to the next.

The U.S. has had a sharp rise in inequality since the 1980s. If the Great Gatsby Curve holds in the future, we would expect to see a 25 percent rise in the persistence in income across generations in the U.S. It is hard to look at these figures and not be concerned that rising inequality is jeopardizing our tradition of equality of opportunity.

There have also been important institutional changes that have contributed to the rise in income inequality, including the decline in union membership and fall in the real value of the minimum wage.

Tax policy has played a role in rising inequality. Although our tax code is still progressive, tax changes in the early 2000s benefited the very wealthy by much more than other taxpayers, compounding the widening gap in pre-tax earnings.

I could see why someone could support tax cuts for top income earners if they had materially benefited the U.S. economy, but the macro evidence is clear that the economy did not perform better after last decade’s tax cuts than it did after taxes were increased on top earners in the early 1990s. Income growth was stronger for lower- and middle-income families in the 1990s than it was in the last 40 years over all. This next chart shows that there was more job growth in start-ups in the 1990s than in the 2001-2007 period. Across all businesses, job growth was much weaker in the 2000s than in the 1990s. There is little empirical support for the claim that reducing the progressivity of the tax code has spurred income growth, business formation or job growth.

Support for equality of opportunity should be a nonpartisan issue. It is hard not to bemoan the fact that, because of rising inequality, the happenstance of having been born to poor parents makes it harder to climb the ladder of economic success. There is a cost to the economy and society if children from low-income families do not have anything close to the opportunities to develop and use their talents as the more fortunate kin from better-off families who can attend better schools, receive college prep tutoring and draw on a network of family connections in the job market.

One would think it inexcusable that public policy has exacerbated this trend. But that is exactly what has happened over the last decade. As I mentioned, income tax changes have made the distribution of after-tax income more unequal, not less. Moreover, the drastic cut in the estate tax will reduce economic mobility in the U.S. going forward, as the tremendous resources accrued by the wealthy can now be transferred to their heirs at much lower tax cost.

While the potential drag on aggregate demand from the shifts in the income distribution are hard to document, the following back-of-the envelope calculation makes clear that it could be substantial. The share of income going to the top 1 percent increased by 13.5 percentage points between 1979 and 2007, the equivalent of about $1.1 trillion a year in 2007 income. Research on the saving behavior of families at the top of the income distribution is scarce, but according to research by Karen Dynan and coauthors, the top 1 percent of households saves about half of the increases in their wealth, while the population at large had a general savings rate of about 10%. This implies that if another $1.1 trillion had been earned by the bottom 99% instead of the top 1%, annual consumption would be about $440 billion higher.

To conclude, I want to emphasize that restoring more fairness to the economy would be good for all parts of American society. This is not a zero-sum game. The evidence suggests that a growing middle class is good for the economy, and that is a more fair distribution of income would hasten economic growth. Businesses would benefit from restoring more fairness to the economy by having more middle-class customers, more stable markets, and improved employee morale and productivity.

President Obama said this much better than I ever could: “This isn’t about class warfare. This is about the nation’s welfare. It’s about making choices that benefit not just the people who’ve done fantastically well over the last few decades, but that benefits the middle class, and those fighting to get to the middle class, and the economy as a whole.”

Comments
20 comments so far | RSS Comments RSS

Great article. Nice to see someone from the government who recognizes that a great wealth disparity is bad for the nation

Posted by jjmciny | Report as abusive
 

Ssssh…according to Mitt Romney this topic should only be discussed in “quiet rooms”. Thanks, Mr. Krueger, for ignoring Romney’s directive and publishing an excellent article on a topic that goes to the heart of the American economy and one which Americans really need to be encouraged, not discouraged, to discuss at length. How anyone can consider supporting a candidate who wants to dictate to the American people what they should and shouldn’t be discussing is beyond me, especially a topic as crucial to our economy as how the economy is distributed and how that disproportionate distribution is destroying the great American Middle Class.

Posted by doggydaddy | Report as abusive
 

Excellent summary!

Our goose is cooked if another Republican gets into the the White House this year.

Posted by jrpardinas | Report as abusive
 

The question is whether we are a single people, or not. If we have something in common besides Interstates and the IRS, then we should care about the fate of our fellow countrymen. If not, then why do we tolerate one another? Is it all simply about getting from others, and then snuffling at the notion of “zero sum” economics?

Perhaps it is a matter of who takes what from whom. Perhaps it is also a matter of not permitting your enemies, those who wish you ill, to sell to you, or to control what your children are taught, or to order you off to fight for them. We are either all under the tent, or not. Which is it?

Posted by txgadfly | Report as abusive
 

America needs Barrack Obama in the saddle if they have to complete the task of putting America back on track. Reform of Direct Tax code, investment in R & D for future (even the greedy ones – big business’s will stand to gain on it),renewing infrastructure that is crumbling, getting back US on world diplomacy map after the Bush era debacles. The Big business will fall in line – come Jan 2013. These buggers are not going to wait another 4 yrs and will start behaving. In fact if the early trends show up they will fall in line much earlier – Sep. / Oct 2012 itself. It is time for American public to recalim their govt.back from the clutches of these greedy buggers – big business and GOP.

Posted by Purush | Report as abusive
 

Excellent article.

Posted by lhathaway | Report as abusive
 

Interesting article, but I’m a bit confused by the second chart/figure. Is the middle class defined by those occupying the lowest quintile of income? Or is it the next to lowest or middle quintiles?

Posted by 2bornot | Report as abusive
 

This is so far above the heads of the Tea Party and Republicons in general, you will never get them to understand the need to raise taxes on the wealthy.

Their mantra: If you ain’t rich, you ain’t workin’ hard enough.

As if the average ‘worker’ could overcome the deck that is so massively stacked against them.

Good luck America, your Republicons have sewn the seeds of your destruction.

Posted by NobleKin | Report as abusive
 

I agree with everything you say, except when you deliberately obfuscate by calling the problem “inequality”.

This is NOT a natural disaster — like a hurricane, tornado or earthquake — but MAN-MADE, which means there are specific people responsible for what has happened to our country, who should be punished for what they have done.

Please see my comments in the companion article running in today’s Reuters entitled “A corporate tax code for a different century” By David Cay Johnston January 13, 2012, in which I give a detailed explanation (spanning several comments) for what you document by graphs.

The president is WRONG in his comment that “This isn’t about class warfare. This is about the nation’s welfare.”

The nations welfare depends upon immediately beginning effective class warfare to regain what we have lost to the wealthy class.

We MUST reverse ALL the wealthy-oriented legislation the US government has passed regarding free trade and taxes over the past 30+ years.

THAT is what is responsible for ALL of this economic disaster we see.

THAT is the major problem we must first understand, before we can solve it.

“IT’S THE WEALTHY, STUPID!”

Posted by Gordon2352 | Report as abusive
 

Brilliant piece, is what it is all about.

We must avoid a new “french” revolution, then it was the court, nobility and the clergy, now it ios the financial economic top of society thast burns the bridges of the workers.

People are getting more and more agrivated, things are already heating up in Southern and Eastern Europe (and do noit forget the riots in England) Change is really overdue, regrettably the corrupt (lobbying) American political system has disabled Obama to do much about it.

I hope he will get the landslide victory in November that he needs to make his mark. God save our souls if the tewa party and it’s (non-) “ideals” win.

Posted by Checksbalances | Report as abusive
 

Thank you for further vindicating my blog article on a similar subject:
http://www.slyman.org/blog/2011/07/reaga nomics-and-prudent-taxation/

Posted by matthewslyman | Report as abusive
 

I’m concerned about the collapsed axes on some of your graphs, but generally, this is excellent information that goes right to the heart of why the US economy has been falling flat despite its enterprising and ambitious population.

Figure 5 is the one that worries me the most. Income inequality is close now to where it was at the start of the Great Depression, and we have nothing good to show for Reagan’s or Bush’s largesse toward the wealthy. Is it not time for this experiment to end, along with the pretenses of its proponents?

Will President Obama please join us in declaring that the old emperor Reagan has no economic clothes? Although Reagan can’t speak for himself from beyond the grave, He has plenty of advocates who evoke his image as a battle-standard, yet the data speak for themselves! Reagan had his good points, but economics WASN’T one of them.

Reagan’s greatest success? I heard from Republican-leaning folks that he bluffed the paranoid Soviet generals into overspending on their military (in Afghanistan, a land of the perpetual conflict; and in a phoney space-war). Long live the United States of America. May the USA NOT fall into the same trap that the Soviet Union did…

Posted by matthewslyman | Report as abusive
 

I agree with the article. But the truth is with the key players in the executive, legislative and judicial being millionaires, the chances of raising taxes on the top 1% let alone 10% of Amercan households is between nill and zero. The two party system is no longer adequate. We would be no worse off with a lottery system to select our president and fill the legislative branch with every tax paying, vote registered law abiding citizen entered in the lottery.

Posted by nohereman | Report as abusive
 

Mr. Krueger,

You obviously believe that the federal government of these United States was given the power to collect and redistribute income among individuals by our founding fathers. I do not. The power to tax wages and not heads is NOT one of the specific powers granted the federal government by our Constitution, which specifically reserved ALL other powers to the respective States and to the People. The very idea of taxing income or redistributing tax dollars among the citizenry in any manner would have horrified each and every one of them.

An “Income Tax” applicable only to “the rich” adopted at a nominal rate at the beginning of the Twentith Century should today be a lesson to one and all of the dangers of letting a camel’s nose, or, in this case, the government’s “nose”, under the tent. Today that innocent, paltry little tax, together with it’s illegitimate brother, an “Alternate Minimum Tax” that intentionally ignores inflation’s ever-widening grasp, have metastasized into the primary sources of federal tax revenue.

Your period “observed”, from the end of WW II to 1980, is one of constant and significant flux absolutely unique in American history. Wartime material priorities led to an ever-increasing unsatisfied demand for consumer goods in short supply. Only War Bond sales tied up the “easy money” that otherwise would have fueled rampant inflation and a huge “black market”.
Wartime military manpower needs removed millions of our best and brightest young people from the civilian economy, thus creating jobs for our preexisting “underclass” and “stay-at-home wives and mothers”. “On-the job training” conveyed job skills and financial security without precedent as record numbers of citizens thus productively employed.

When the guns fell silent, the troops came home and got about the business or rebuilding lives derailed. Many of the “new jobs” disappeared as war production wound down. Many discharged Veterans reclaimed their old jobs. Many of those thus displaced were not happy with this “return to normalcy”.

Many Veterans went to college under the G.I. Bill as a grateful nation invested in the mental potential of a generation. As cars and refrigerators replaced planes and tanks coming out of the factories pent-up consumer demand and countless dollars tied up in War Bonds spilled out in a frenzy of spending. Times were good.

Levittown and it’s clones began creeping across the land near cities as construction switched from military bases to housing and new or expanding schools. As each area of the American economy caught up with demand and stopped growing or shrunk, activity would shift to other activities of promise. In the mid-fifties America “invested” in it’s Interstate Highway System. With many, many more college-educated people “in the economic mix”, America’s “middle class” grew to unprecedented size. Nobody planned it, it just happened; and it was the result of a convergence of circumstance that will not happen again.

As a professional paid to persuade, are you not disingenuous in offering this “smoothie” of unrelated but well blended data suggesting such major economic transitional periods as homogenous? Is it not even more so to suggest it somehow “proves” something is wrong with the American economy that needs “fixing”.

Everyone agrees something is wrong, but there is little consensus as to what it is and how to fix it. I think that’s because no one knows what the “new normal” will be for the American “middle class”.

Is it not obvious that today’s bloated, inefficient government comprised of hoards of unionized bureaucrats with high wages, lavish benefits and guaranteed pensions does not contribute to the American economy in reasonable measure to it’s cost in present and future taxpayer dollars? These people lay no track, brick or pipes. They shuffle paper, not make it. They ever more ensnarl business and workers in the workplace in more and more red tape. They are, by and large, more like sand in the wheels of progress than grease and oil.

With 20-20 hindsight is it not clear that professional economists were utterly clueless in seeing the economic warning signs preceding the collapse of our auto industry, our financial industry and our residential and commercial construction industry? A current commentary makes credible argument that the policies of Alan Greenspan almost exclusively brought about our economic implosion. No one is yet to be held meaningfully accountable for what has happened. In a bureaucracy, that’s almost always the case.

America needs to “restore itself” to a sustainable level of economic activity. That won’t be a “business as usual” recovery, but a reeducation and redirection with regard to what the country needs today and what it will need in the future. America is NOT about the “everyone gets a trophy” mindset. It is about “everyone has an opportunity to win a trophy”. A government can drag everyone down to a common level of misery, but those Americans usually emulate are not lifted by others but succeed by inspiration, preparation and perspiration.

Socialists forget that inequality is part of life. Life isn’t fair, and never has been; so we can’t “restore fairness”. Fairness is a “Will o’ the wisp”, a mirage of no substance that does not exist in the “real world”. For everyone above “average” there must be someone below “average”. That will never change. For everyone with income above “average” there must be someone with income below “average”. That will never change. For someone to “win”, someone must “lose”. That will never change. We all begin life earning nothing. Everyone’s journey is different. All will not “succeed”. That will never change.

Kids earning minimum wage today earn more as their skill and/or experience increases which increases their economic “value” to employers. It is common for what one earns to continue to increase until retirement in normal times. Accordingly, the people that comprise the low, middle and top groups are in constant flux.

Your presentation depicts a “static state” picture as artificial as it is useless. You ignore the significance of the “good” times and “bad” times that have originated throughout history from weather, climatological change, political or other stimuli. There are NO guarantees. In the overall, rulers and government have reacted to events more than they have brought them about. This administration has not filled me with confidence.

Posted by OneOfTheSheep | Report as abusive
 

I haven’t read OneOfTheSheep’s post (just skimmed a few paragraphs), but the length of it demonstrates the lengths that some people will go to, and the difficulties that people face, in trying to disprove the clear data that Mr. Krueger is sharing with us…

It’s simply not possible to write an economic analysis that covers all possible phenomena – and it’s simply not necessary to do so.

Why, if every time I turn up the central heating, the temperature of the house goes up and if the corollary is also true (irrespective of outside weather, wind, sunshine etc.); then I would be a fool to say there was no evidence of a link between my central heating and the temperature of my home!

No matter, that the absolute temperature is not directly proportional to the intensity of my heating. The empirical correlation is strong enough, and the mechanism is obvious enough for the phenomenon to be effectively proven…

Posted by matthewslyman | Report as abusive
 

I liked your article. Maybe a little more salt-of-the-earth type language to help hammer home your point, but thats it.

We need the rich to not make as much money.

We need the not-rich to make more money.

I see it all as tied into out-sourcing jobs to other countries. We need to make it more affordable for people to keep jobs here.

Then there’s Wall Street.. but i leave that discussion to another article.

Posted by RailBended | Report as abusive
 

Our economy had been evolving since the turn of the previous century. We started as an agricultural economy where people “moved” soil, seeds, and crops; Then it was the industrial economy where people “moved” metal, masonry, and plastics; Now we find ourselves in the information age where people “moved” equity (stocks, bonds, currencies, options, sub-prime mortgages, etc.). With each transition, the number of people we needed to sustain the “new” economy was drastically reduced. Such changes give rise to shrinking the number of haves and expanding the number of have-nots. Is it a good thing? Some obviously like the way it is. They would want even more. The rest of us just see life become harder and harder. If history is any indication, this will be the final phase. What comes next will likely be very ugly. Such cycles happened over and over in the past. We saw it with Ancient Egypt; the Roman Empire; more than a dozen Chinese dynasties; Louis XVI and Marie Antoinette; Tsar Nikolas II; just to name a few. At least this time around there is a raging debate. In the past, the vast majority were kept in the dark, or were fed a load of lies. Then when they suddenly realized the truth, blood flowed on the streets. Sure hope we’ve learned from history.

Posted by vwking | Report as abusive
 

The middle class is getting smaller because the higher income group is getting larger.

The US Census tracks long term household income (40+ years of data) and if you use this data to create 3 income groups (low $100k/yr) you’ll see a slow but steady drop in the number of low and middle income groups and an increase in the upper income groups. Bottom line, households are becoming more prosperous. See the August 21, 2010 article at http://unrepentantcapitalist.blogspot.co m/

Posted by jambrytay | Report as abusive
 

moderator, why do my posts get truncated? let me try again:

The middle class is getting smaller because the higher income group is getting larger.

The US Census tracks long term household income (40+ years of data) and if you use this data to create 3 income groups (low under $25k per year, middle $25k to $100k per year, and high over $100k per year) you’ll see a slow but steady drop in the number of low and middle income groups and an increase in the upper income groups. Bottom line, households are becoming more prosperous. See the August 21, 2010 article at http://unrepentantcapitalist.blogspot.co m/

Posted by jambrytay | Report as abusive
 

I’m wondering how much Federal and State tax revenue has been lost by 1) keeping middle class earnings flat and 2) shrinking the size of the middle class.

Posted by Bpops | Report as abusive
 

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