Driving Forces Behind Rising Income Inequality: Tracking the Internet Debate

To a good neoclassical economist, the statement that the relative price of a factor of production--like the labor of the elite top 1% of America's wage and salary distribution--has risen is the same thing as the statement that the relative productivity of that factor of production has risen. But we need to distinguish between these statements in order to make sense of the ongoing argument between Andrew Samwick on the one hand and Paul Krugman and Mark Thoma on the other.

In a nutshell: Is the statement that there is a higher return to education today merely an assertion that the rich today earn more in relative terms than their counterparts in the past? Or is it also a statement that the rich today are more productive in relative terms than their counterparts in the past?

Andrew Samwick takes the first definition, and concludes that rising inequality is the result of a higher return to education. By his lights, he is clearly correct.

Paul Krugman and Mark Thoma take the second definition and conclude that that rising inequality is not primarily the result of a higher return to education but instead primarily the result of socio-political factors that have raised the relative price of what the rich and well-educated do. And they too have a strong case. Piketty and Saez's latest numbers estimate that top 13,000 American households have multiplied their relative real incomes nearly fivefold since the 1970s. Then they received some 0.6% of national income. Now they receive nearly 2.8% of national income--an average of $25 million each, compared to roughly $5 million each had the relative income distribution remained at its 1970s levels. What are the CEOs, CFOs, COOs, elite Hollywood entertainers, investment bankers, and the very highest levels of professionals doing differently now in their work lives that makes them, in relative terms, worth five times as much as their predecessors of a generation and a half ago?

Andrew Samwick writes:

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

But [Treasury Secretary Paulson]... [argued] 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...

[Samwick writes:] I'll even agree with [Krugman] 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... he is part of that top 1 percent... 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.... [T]his explanation 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.

Mark Thoma fires up his Paul Krugman emulation program inside his own brain and produces an answer that's very good. According to Mark, what Paul might say is:

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?

Which leads Andrew Samwick to respond:

Vox Baby: Krugman on Paulson's Speech: 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.... 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."... 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.... 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.... [I]t 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....

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?... [H]e cites no evidence to link the policies of the ruling political ideology to the income gains for the top 1 percent....

In the race between these two arguments, Paulson is way out in front of Krugman.... 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.... [T]o 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.

For Samwick, the key thing is that people today are willing to pay Paul Krugman much more for what he does than they were willing to pay Jim Tobin for what he did--therefore Paul is richer because "the [income] returns to being educated are higher." For Paul, the key thing is that Jim Tobin was a better economist--was more productive--therefore Paul's riches cannot be the result of a higher productivity return to being educated.

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Mark Thoma writes further:

Economist's View: The Debate over Inequality: Factors like top marginal income tax rates and social norms are connected to the political environment.... A lot of the change is driven.... [F]actors such as the New Deal's very large tax increases on the wealthy, both directly on income and indirectly on corporate profits are an important factor connected to the political environment at the time. It's an open question how much of the change in inequality that might explain by itself.

Unions are also worth taking seriously, with union membership nearly tripling to about a third of the workforce from the mid 1930s to the mid 1940s. This would affect all wages, not just those in sectors where unions are prevalent. The decline of unionization after the 70s is also a factor to consider, and there's a strong case to be made that this was made possible by a political environment that allowed union busting to occur. In any case, I don't think this is a settled question and I hope to follow up with more later...

Greg Mankiw says:

Greg Mankiw's Blog: Samwick on Krugman: I agree with Andrew that Paul is on shaky ground when trying to explain rising income inequality by politics (as opposed to technology, demography, and so on). Policy choices such as tax rates and minimum wages have not been the main causes of increasing inequality. At least that is the consensus, as I understand it, of the professional labor economists who study the issue...

Matthew Yglesias writes:

The Influence of Politics | TPMCafe: By Matthew Yglesias: Paul Krugman writes that politics matters for the income distribution, citing the long-term trends in inequality and their close correlation with long-term political trends. Brad DeLong says he thinks this is wrong, political changes can and do have a large impact on after-tax income distribution but the trends show up strongly in pre-tax income. "I can't see the mechanism by which changes in government policies bring about such huge swings in pre-tax income distribution."

I note for the edification of readers that one thing I've learned since arriving in DC is that a difference of opinion on this subject is a major divide within the progressive economic policy community. Most mainstream economists -- including most liberals -- agree with DeLong. Politics and policy affect the secondary distribution (after tax and transfer) and what happens with the primary distribution is just out there. Leftier economists tend to say this is mistaken.

I would side with Krugman on this. The trend data is too striking to be ignored. If you have a phenomenon and are having trouble identifying the cause, the thing to do is to try harder to identify the cause, not assert that the phenomenon isn't happening. But what is the cause? I can think of some plausible stories.

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. All this, I think, makes a big difference. Then the other factor to note is probably unionization which is much more impacted by policy decisions than people often seem to realize.

I opined:

The problem that I have with Paul Krugman's argument here is that the shifts in income inequality seem to me to be too big to be associated with anything the government does or did. Yes, Roosevelt and company were pushing in the right direction. Yes, Reagan, Gingrich, Bush, and company have been pushing in the wrong direction. But what they did and do affects (I think) after-tax income inequality much more than the before-tax income inequality numbers, and the before-tax numbers show the trends remarkably strongly. And I can't see the mechanism by which changes in government policies bring about such huge swings in pre-tax income distribution.

In response, in comments on my weblog, we have:

PaulC: I have no idea if Krugman is right, but it seems clear to me that the effect of government over long periods of time has the potential to be that significant. First off, small effects often have multipliers, particularly in winner take all scenarios. E.g., in an olympic race, the runners are all excellent to begin with, with the actual difference in ability often fractions of a percent. But only a few get medals; they have some chance at fame. The almost-as-goods are forced back to their day jobs. I'm not saying this is a good model for the economy, but it just illustrates how even a small advantage can pay off disproportionately.

Second, if you look at government policy over time and conclude they're not doing much, I wonder what you're using as a baseline. Maybe it's only a radical government that lets inequality get out of hand by doing nothing, while a moderate one would consider it a disaster that needs action. I think there are two premises (counter-premises) that need to be considered. One is the idea that growing inequality is socially disastrous (a normal, natural situation). The other is that private wealth in a growing economy can be tapped up to a limit for public good (is absolutely sacrosanct and should only be touched as sort of a necessary evil for supporting some minimal governmental duties--e.g. defense and law enforcement).

If you look at these premises and ask what a government would do in response to trends over a long period of time, I think it is reasonable to consider that a government with conservative premises would let inequality get out of hand, while one with liberal premises would be able to change the outcome using proportionately small changes assuming multipliers.

Or to recast my previous comment as a metaphor (with unfortunate allusions to the movie Being There, but so be it) suppose I am observing two gardens: one apparently well-maintained and productive, the other overgrown with crabgrass and dandelions. I might conclude that whatever happened isn't the gardener's doing. They both planted roughly the same crops, used the same fertilizers, watered them about as much. The plots were similar in size and received the same amount of sunshine. Whatever happened is the result of some mysterious external factors. When pressed, I might add that in fact the gardener with the better results did something else, spending a little extra time each day pulling out some plants. But they were just little seedlings, barely noticeable. If were to weigh the mass of weeds against those seedlings, it would be clear to any reasonable person that there is simply no way that those small actions could account for the difference between these gardens.

Graydon: The kicker is what kinds of corporate organization are permitted, not tax policy. The relentless push for de-regulation and for restructuring law related to markets has converted a machine intended to secure the general prosperity into a machine to concentrate wealth. (This started around 1970, with the creation of the formal obligation for a corporation to maximize monetary returns to the exclusion of all other considerations.) Organizational patterns and structures matter. Tax policy is not even vaguely important compared to, frex, what banks are allowed to do, and that is often both governmental and policy set by non-legislative means. The general conflation of wealth and virtue isn't any help, but the core problem is that profit is legally regarded as an excuse to do almost anything.

Blissex: «Inequality in America starts with COMPLACENCY at the bottom» Yes, this is something that has struck me quite a bit -- the ''let's bend over'' attitude of american workers. The Economist has commented that this is due to something like 60% of Usians thinking that they will become rich before their retire, even if class mobility is actually quite low.

«polls show 50% would prefer to be in a union -- but there is no inexorable groundswell because there is fundamental understanding of the desparate need.» Perhaps there is some, but then there is terror. Employers apparently rather dislike hiring ex-union workers. In the past unionization battles were sometimes fought with rifles and explosives (both sides) and like in other countries the Army was occasionally brought in to machine gun strikers. Perhaps it could not happen again, but now that there are national databases, and big employers routinely refuse to hire people who don't have a perfect credit history nationally, it is hard to be the one who sets the ball rolling.

«I very undramatically chalk it all up to an accident of culture: we have this belief in the self-reliant individual and no information to tell us otherwise (the great compression and decades of galloping productivity misinformed us otherwise).» I agree that this is a large part of the story; the business interests are marxian to a fault (they tend to believe in most of what Marx said, reserve labor army and all, just see it from the other side :->), and seem to have understood well the gramscian concept of ''cultural hegemony''. But it is also because the unions at some point in the 70s-80s became widely perceived, and correctly, as exploitative and brutal guilds in their own right, and the left as a bunch of dreaming crazies. There is a very nice book on the subject, "The right nation", by Micklethwait and Wooldridge. The left and the union have dug themselves in a deep hole... Almost as deep as the right and the chambers of commerce dug themselves in the 1930s.

«[ ... ] never picked up even a hint that, by now, 25% of workers are earning less than the minimum wage under Lyndon Johnson, $9.50/hour even though average income doubled since that same time -- or that middle and upper middle family income has grown half as fast as average income for over 30 years -- or that the missing growth has almost all gone to the top 1%.» Well, few people talk about these things because they know which side their bread is buttered on, and talking about these things means being classified as a promoter of the politics of envy or of class hatred.

«Not that I blame the top 1% for doing what they are supposed to do in a capitalist economy: bargaining hard for the best deal.» Ah you see class warfare is when the bottom 99% want a bigger slice of the pie, but when it is the 1% doubling theirs that's justly rewarding higher productivity. :-)

«The solution is for someone to alert the bottom to the money they are missing out on and on how easily they could recoup it by modernizing labor organizing legislation and then get out of their way. All so simple if somebody would just tell us.» But that would require going up against vested interests for the sake of a few dozen million poor suckers. :-) To give you an idea of how dire the intellectual and practical situation is, some unions are trying to organize day laborers, but are afraid that their members would complain, which is beyond moronic: http://SeattlePI.NWSource.com/business/281097_daylaborunion14.html «However, Jerry Hunter, former general council for the National Labor Relations Board, said unionized construction workers might balk if their unions recruit illegal immigrants. "Members could start asking themselves, 'Whose interests are you representing?' " Hunter said.»

«Small changes for example in the climate to make hostile and asset stripping takeovers easier» Perhaps I have mentioned this already, but I think Milken and Drexel have had a far greater influence that I thought. When debt fueled hostile takeovers were rare, management had long term careers and their self interests were to pursue corporate empire building. Now that it is easy and cheap to fund with debt a takeover, management self interests are to make as much money as possible as possible in as short time as possible. Their profile has switched from a long term to a short term sharecropper, and now they work the assets they are temporarily leasing a lot harder. Which is not in the interests of shareholders either. But the incentive is there. While Milken was the enabler of the asset stripping fashion, perhaps they were not the ultimate cause; I suspect the increase in takeovers was largely based on reductions in capital gains tax, which also gave an incentive to corporations to stop distributing dividends and gross up the capital value of the company, via ''virtual'' earnings.

Robert Waldmann: I think prevailing ideology has direct effects in addition to affecting public policy. Heartened by the fact that you think you have discovered an intelligent sociologist (who is in fact a physicist) I'd say that social norms are critical, and that firms have to respect their workers perceptions of what is fair. It is no longer fatal to a firm for the top 5 officers to have incomes that you and I consider obscene. Thus such firms are not crippled by the anger of their other employees. More generally I think the ideas that greed is OK and that grabbing lots of money demonstrates intelligence not corruption have become stronger resulting in increased inequality. In a word Akerlof.

And Paul Krugman, in email, promises more:

There's actually a lot more behind this than I could put in the Times; it will ultimately be a chapter in my next book...

Falling value of the minimum wage. Shift in the personnel at the National Labor Relations Board and the role of that shift in the decline of unions. Loosening up on the regime that regulates Wall Street and the consequent shift from the Berle-Means technostructure corporation to the modern takeover game, plus institutional corruption via IPOs and compensation subcommittees of boards of directors. Declining marginal tax rates on the rich making it less unreasonable for your CEO to demand compensation in cash rather than in a fancy executive dining room. Trade. Immigration--which has a powerful effect on the American income distribution even if it does little to shift the income distribution among the native born.

How much bang can these politically-driven changes have? And how much is the politics the result rather than the cause of rising inequality? And what is the role of the factors identified by McCarty, Poole, and Rosenthal's Polarized America in all this?

I'm skeptical--I think it's more likely than not that politics are a reinforcing factor rather than the driving force--the moving crest of the tsunami and the froth on top of that rather than the originating earthquake, which I would see as probably in society and technology--but it's an open question, and now I have another reason to eagerly look forward to Paul Krugman's next book.