Inequality is more relevant than ever this election
The issue of inequality doesn’t usually feature in U.S. presidential debates. Compared with those in Europe, Americans are more relaxed about seeing higher pay as the reward for effort and ability.
This time it is different. The Occupy movement reflected the general anger toward Wall Street bankers who raked in millions during the boom years and then got bailed out in the bust that they helped to create. Income inequality has been quietly rising in the United States for almost four decades. President Barack Obama plans to increase taxes on those with high incomes and Governor Mitt Romney is against such “class warfare.”
One of the main differences between the two candidates in this election is whether or not to raise taxes on the rich. But rather than talking about the underlying causes of increased inequality, the presidential candidates have focused on dealing with its consequences, particularly over taxes and welfare.
President Obama has pledged to keep all the 2001 Bush tax cuts, except for those households with income over $250,000 a year, and to restrict tax loopholes for millionaires. For example, the top rate of income tax for the rich will increase from 35 percent to 39.6 percent under Obama’s plan.
Governor Romney’s criticism of Obama’s plan is that these tax increases will mean lower incentives for entrepreneurs and wealthier individuals to work hard, and the result will be a drag on growth.
But what about the “American Dream?” What matters, Americans typically say, is equality of opportunity, not equality of outcomes. Although the United States has greater inequality than other wealthy countries, there is a notion that it is easier to rise up the ranks through hard work and the spirit that a free enterprise society allows.
Surprisingly, the effect of being born rich affects one’s future more in the United States than in almost every other rich country. The correlation of a son’s earnings with his father’s earnings at the same age is notably high.
Research shows that countries with higher inequality tend to have lower mobility. Some of this lower intergenerational mobility is because poor American kids struggle to get an education good enough that makes them competitive in the marketplace. If the rungs of the income ladder are as far apart as they are in the United States, then it is much harder to climb to the top. The “Great Gatsby” curve in the figure below is evidence of this: countries with higher inequality have less intergenerational mobility.
Since the late 1970s, the shares of total income (labor and investment) held by the top 1 percent and top 0.1 percent of Americans have dramatically risen (see the figure below). In 1975, the top 1 percent had nearly 8 percent of the ‘income pie,’ but by 2007 this number had risen to nearly 24 percent. The last time inequality was so high was in 1928 on the eve of another great crash.
In 1970, the richest tenth of men earned about 3.2 times as much as the poorest tenth; by 2010, this ratio had risen to 5.2. These differences are caused by what happened in the labor market (see the figure below).
Economic productivity as measured by real GDP per hour has increased over the past four decades, but average labor compensation has fallen behind since the early 2000s. This means that company profits are an increasing share of the income pie.
Median wages rose by a measly 20 percent between 1972 and 2010, less than average compensation, which grew by 71 percent. The upward march of wage inequality means that average wages have increased much faster than median wages. Also, non-wage parts of compensation, especially healthcare costs, have dramatically risen in that time.
Workers in the middle of the pay-scale have fallen behind those in the top 10 percent for over 40 years, but in the last 15 years they have also lost ground to the bottom 20 percent. Since it’s usually the middle that decides elections, this squeeze must be felt by politicians this election.
There is reliable evidence that technological change may be the main culprit for these inequality trends by massively increasing the demand for skills. Since the 1970s, the growth in job seekers’ average years of school has slowed. With not enough skilled labor entering the workforce, the premium for education has increased.
As well as education another challenge that faces American workers is trade with low wage countries like China. Both candidates want to impose tougher restrictions on imports from China. Governor Romney has vowed to label China a ‘currency manipulator’ and President Obama has been increasing trade sanctions. However, China joined the global economy long after inequality began to widen in the United States. China-bashing can only damage growth.
Clearly, Soviet-style levels of equality would stifle individual incentives to succeed, but the United States is a long way from that. Indeed, some argue that high inequality in the United States squanders the potential of poor but talented children, as in the Great Gatsby curve. It is plausible that extremes of both equality and inequality will damage growth — and the United States seems to be moving into extreme inequality territory. A better focus would be on restoring America’s place as a world leader in public education, and tackling the human capital deficit that is at the heart of the inequality challenge.
GRAPHS: Sources are Atkinson, Piketty and Saez (2012) World Top Incomes Database; and Machin, Murani and Van Reenen (2012), calculations from March Current Population Survey, full-time full-year workers aged 18-60.