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.”

21 comments

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I’d like to see some more current graphs, showing how after 6 years under Obama the middle class is shrinking faster and the lower class is growing faster.

Posted by Sophia99 | Report as abusive