Is U.S. inequality special?

In this post, Greg Mankiw argues that the U.S. is not the only country to see an increase in inequality over the past 40 years. Referring to a plot of the top income shares in the U.K., Mankiw notes:

“The figure suggests that the explanation of growing inequality over the past several decades cannot be U.S.-specific but must have broader applicability... You find a similar U-shaped pattern in Australia, Canada, Ireland, and New Zealand but much less so in France, Germany, Japan, and Sweden.”

Mankiw uses the impressive “Top Incomes Database,” compiled by (among others) Thomas Piketty and Emmanuel Saez. It is a fantastic resource; it enables you to plot data on income shares and inequality for a wide-range of countries over more than one-hundred years. Perusing the data, one finds that, in fact, many countries have seen an increase in inequality. But Mankiw seems to be implying that, since this is a global phenomenon, that shifts in U.S. policy aren’t driving the increase in inequality.

Using the database, I generated the following graphs: (1) comparing the U.S. with other rich English-speaking countries; and (2) comparing the U.S. with rich, but non-English speaking countries. I chose the countries Mankiw cites as examples in his post. The data covers the period between 1950 and 2007:*

As Mankiw notes, the changes in the top share of incomes for other rich English-speaking countries largely track those of the U.S. It is worth noting the discontinuous jump in the U.S. series in the mid-1980s, coinciding with the reform of the tax system during the Reagan administration.

In contrast, the rich non-English-speaking countries do not see much of a change in their top income shares. For example, the share of the top 1% in France was 8.98% in 1950 and 8.94% in 2007. The corresponding numbers for the U.S. are 11.60% and 18.29%. It takes a lot of motivated reasoning to detect an upward trend in the non-English-speaking countries.

To explain the difference between the two groups, Mankiw offers the following idea:

“Might the rising share of the top 1 percent be related to the increasing use of English as a global language?”

I’m not exactly sure what this means or what the causal mechanism here would be. I would suggest a simpler explanation: English-speaking countries have tended to follow an economic model (often referred to as the “Anglo-Saxon Model”) that is more market-driven and relies on a smaller welfare state than the rest of Europe. Thus one should expect those countries to have higher levels of market-income inequality. Further, like the U.S., these countries have reformed their tax systems and de-regulated much of their economy, leading to even greater inequality. So while it’s true that increased inequality is not solely a U.S. phenomenon, it does not follow that policy changes aren’t an important part of the explanation. In fact, countries that have followed similar policies to the U.S. have seen increases in inequality, while those that haven’t, well, haven’t.

*I chose the years based on data-availability. I encourage people to play around with the database if they are curious about other countries, years or variables.

It is also worth mentioning that the data presented here is pre-tax gross income. Given that other countries have more progressive tax/transfer systems than the U.S., this is likely an underestimate of the difference in inequality between the U.S. and the rest of the rich world.

Why care about inequality?

This is a follow-up post to a previous discussion about economic inequality.

Emmanuel Saez, the UC Berkeley economist, recently produced a fascinating chart on income distribution in the US, depicting the share of national income held by the top 10% of Americans over time:


As you can see, the top 10% of families accounted for roughly 50% of national income in 2007, a level not seen since the time of Jay Gatsby. Though this is only one of numerous measures of income inequality, it clearly shows that the distribution of income in America is more skewed now than at any point since before the Great Depression.

Why should we care about this? There are good economic reasons for discounting measures of inequality. First, economics is not, in general, a zero-sum game. We can all do better even if some gain more than others. And conversely, while some poor societies are highly equal, equal poverty is no great virtue.

Second, there are good reasons why some people make more than others. People who make great innovations (eg the founders of Google) or who have specialized skills (eg neurosurgeons) have every right to be compensated for what they do, since they provide value for society. Bill Gates is enormously wealthy, but he didn't get that way by stealing from others; he became wealthy by providing valuable products to society, making everyone better off (Vista notwithstanding). The carrot of great individual wealth has done much to improve human welfare.

However, there are equally good economic reasons to care about inequality. First, sometimes inequality does result from zero-sum interactions. As Harvard labor economist Larry Katz notes,

"Much of the growth of high-end incomes stemmed from market forces, like technological innovation... But a significant amount also stemmed from the wealthy’s newfound ability to win favorable government contracts, low tax rates and weak financial regulation".

If government is captured by narrow interests, then we are likely to see the growth of policies that privilege one group and do nothing to help (or sometimes even hurt) other groups. A less regressive tax code, for example, helps the wealthy but can hurt the poor.

We should also care about changes in inequality because it can indicate how well the economy is functioning for different groups in society. For this reason it is important to understand what is driving inequality. For example, Katz and co-author Claudia Goldin have argued that inequality has increased because of a decline in the relative supply of highly skilled workers. This suggests that increasing college enrollment (and completion rates) for lower-income groups would stem the growth in inequality and increase incomes for poorer Americans.

On the other hand, Arnold Kling and others have argued that inequality has been driven by changes in technology and the growth of "winner take all" markets, as well as changes in family structure. People today are more likely to marry someone of a similar economic and educational background than they were 50 years ago. This re-enforces inequality among now and in the future, as successful, highly educated parents are likely to have successful, highly educated children. If these are the causes, Kling argues, then there is little government policy to can do to stop them, since we are obviously not going to put restrictions on technological progress or prevent wealthy people from marrying each other.

Inequality is not something that the government can directly set, like interest rates or the budget deficit. It is the product, of complex economic, political and social forces. It is important to recognize that inequality has many causes and that by understanding those causes, we can understand fundamental structures in the economy. We should care about inequality because we should care about an economy that satisfies the needs of everyone in society. By understanding what causes inequality, we can better understand how to get there.

Poverty and income inequality over time

Justin Wolfers posted this graph at Freakonomics, showing income growth by quintile since the 1970s:

His analysis was that economic growth has done little for the poor, accruing mostly (almost entirely) to the upper incomes.

Russ Roberts, however, takes issue with this analysis. In two separate posts (here and here), he criticizes Wolfers' interpretation:

"This alas, is a meaningless chart. It tells you nothing about who got the gains of the last 35 years. Why? Because they're not the same people in the quintiles. Starting in 1973, and it's not a coincidence, the divorce rate in the United States began to rise. The number of families increased dramatically simply because of divorce. There was also an increase in the number of families headed by single women with children. The quintile breaks-points changed, not because the economy was growing or shrinking but simply because of changes in the types of families."

In a sense, Roberts is not wrong. Looking at static graphs of quintiles does not account for differences in composition. If people move up the income ladder, then we will mistake static income growth among the groups for static income growth among individuals. The key here is the degree of social mobility. Basically, what are the odds that a person who is poor today will be poor next year, or in ten years?

Emmanuel Saez, the most recent winner of the John Bates Clark Medal, looks at this question in depth. Using Social Security data, Seaz tracked individuals over time to assess income growth and social mobility in the US over time. He concludes:

"We found that changes in short-term mobility have not substantially affected the evolution of inequality, so that annual snapshots of the distribution provide a good approximation of the evolution of the longer term measures of inequality. In particular, we find that increases in annual earnings inequality are driven almost entirely by increases in permanent earnings inequality with much more modest changes in the variability of transitory earnings. However, our key finding is that while the overall measures of mobility are fairly stable, they hide heterogeneity by gender groups. Inequality and mobility among male workers has worsened along almost any dimension since the 1950s: our series display sharp increases in annual earnings inequality, slight reductions in short-term mobility, large increases in long-term inequality with slight reduction or stability of long-term mobility.

Against those developments stand the very large earning gains achieved by women since the 1950s, due to increases in labor force attachment as well as increases in earnings conditional on working. Those gains have been so great that they have substantially reduced long-term inequality in recent decades among all workers, and actually almost exactly compensate for the increase in inequality for males."

Certainly, some longitudinal studies have found larger amounts of social mobility, but the bulk of the literature has not found the degree of mobility that Roberts implies.

So while the graph posted by Wolfers is static, there is evidence that it is a good approximation of reality. Income growth has accrued largely to wealthier individuals and families over the past 30 years, and it has not been sufficiently counterbalanced by social mobility.

Curiously, Roberts says that liberals lack a causal mechanism for changes in inequality and stagnant incomes among the poor. However, Wolfers was explicitly citing one of the most powerful arguments for this phenomenon, namely "skill-biased technological change". As Harvard's Larry Katz and Claudia Goldin explain, technological change has raised the productivity of skilled workers relative to less skilled workers, causing changes in relative incomes. In manufacturing, for example, advanced machinery has decreased demand for assembly line workers, but increased demand for engineers and mechnical operators. At the same time, the supply of educated workers has not kept up, resulting in large income gains in the upper half of the income distribution and much lower gains at the bottom.

Roberts is correct, however, in asserting that there is a difference between income inequality and absolute well-being. A rising tide can lift all boats, even while it lifts some faster than others. But it's important not to minimize slow income growth among lower income Americans; they may be better off than they were 30 years ago, but they are still struggling.

In a follow-up post, I'll delve more into the measurement, economics and politics of inequality.

Let my rich people go!

Ed Glaeser wonders if the new, higher marginal tax rates in New York State will lead to an exodus of the rich:

The problem with a tax on millionaires is that the economic success of a region is closely tied to its ability to attract highly skilled workers. The figure shows that a 10 percent increase in the share of a metropolitan area’s adult population with college degrees in 1980 is associated with a 7 percent increase in that area’s income between 1980 and 2000.

Any policy that makes a place less attractive for workers with high skill and education levels, including millionaire’s taxes, carries risks since localities that are dependent on skilled workers for long-run economic success. If all states simultaneously taxed the rich, then this would be essentially a national policy with little geographic consequences, but if some states raise taxes more than others, then economic activity will respond to those taxes.

All else being equal, people will seek to live in states with lower tax rates. Of course, all else is not equal. Many northeastern states have higher tax rates (New York, New Jersey, Massachusetts), but they also have other amenities that attract highly educated and productive workers. People are attracted to the culture, vibrancy and dynamism of cities like New York and Boston, and probably wouldn't choose Fort Lauderdale just because of the tax rate.

However, as Glaeser points out, if there are lower cost alternatives within commuting distance (such as Greenwich, Conn in the case of New York City), then high income workers may choose to relocate. Given the fact that the rich are more able to afford moving, this is a completely plausible story.

It's a tough spot for cash-strapped states, but they may face situations where raising tax rates will actually lower tax revenues (yes, in very rare cases, supply-side economics does work!). However, if there are no lower tax alternatives within communiting distance, then states might be able to tax the rich without creating an exodus. If Colorado raised its income taxes, high skilled workers in Denver or Boulder will probably not move to Wyoming just to take advantage of the tax break.

Capping corporate compensation: cathartic, but not efficient

Former Merrill Lynch CEO John Thain probably isn't getting invited to too many parties these days. While his company collapsed and was ultimately bought out by Bank of American a few months ago, Thain contended that he deserved a bonus--a $10 million bonus, that is. Yes, after public outcry he withdrew his request. But his grandiose sense of entitlement has rubbed a recession-addled economy the wrong way.

Executive pay is a hot topic now. With so many people losing their jobs and seeing their savings melt away, the salaries of corporate heads (especially those in the financial industry) seem obscene; so much so, that President Obama has advocated capping executive pay for companies receiving bailout money, and has generally decried the level of corporate compensation.

It's hard to argue with the emotional appeal of corporate salary cuts. Do people really deserve to make tens (or hundreds) of millions of dollars a year? But the economic case for these cuts are not so straight forward. Reed Hastings, CEO of NetFlix, advocates a "tax, not shame policy" towards executive compensation:

"The reality is that the boards of public companies hate overpaying for anything, including executives. But picking the wrong chief executive is an enormous disaster, so boards are willing to pay an arm and a leg for already proven talent. Putting limits on the salaries at public companies, or trying to shame them into coming down, won’t stop this costly competition for talent.

Of course, it’s galling when a chief executive fails and is still handsomely rewarded. But with the concept of “tax, not shame,” a shocking $20 million severance package would generate $10 million for the government. That’s a far better solution than what we have today, not least because it works with the market rather than against it."

Economists generally favor taxes over price caps on the basis of efficiency. Surely some CEO's are worth a lot of money and companies should be allowed to spend extra to attract them. In fact, there is evidence that CEO salaries are tied to improvements in their company's market capitalization, implying that companies (at least sometimes) are getting what they're paying for. This, however, does not explain why US managers do so well relative to their European and Japanese counterparts.

But the larger fallacy in the pay cap argument is that the distribution of gains is between CEOs and shareholders, not CEOs and workers. Capping management salaries will simply put more money in the hands of the corporate board. This may be desierable in and of itself; but it won't do much for the average worker.

The "tax, not shame" policy would certianly do more for the budget deficit than a cap on pay. According to E.J. McMahon, a senior fellow at the (admittedly conservative) Manhattan Institute:

"From a New York perspective, it’s ironic that the Obama administration chose to reveal its bailout compensation cap on the same day that Sheldon Silver, the speaker of our state Assembly, moved closer to endorsing a bigger new “millionaire tax” to help close Albany’s $13 billion budget gap.

If New York’s weakest financial institutions (and who knows what future bailout recipients in other industries) are forced to hold pay to $500,000, Mr. Silver and his colleagues will have fewer million-dollar incomes to tax. This is the sort of unintended consequence that could almost persuade a free-market conservative to embrace the president’s policy. Almost."

As I've written before, the second fundamental welfare theorem says we can use lump-sum transfers (e.g. progressive taxation) to reach a desirable allocation of income. It's a lot less galling to think these gigantic salaries are funding "our soldiers, schools and security".

Emotional skills and inequality

James Heckman provides some useful insights into economic inequality:

"...an emerging literature shows that much more than smarts is required for success in life. Motivation, sociability, the ability to work with others, the ability to focus on tasks, self-regulation, self-esteem, time preference, health, and mental health all matter. In an earlier time, these traits were part of what was called “character.” A substantial body of research shows that earnings, employment, labour force experience, college attendance, teenage pregnancy, participation in risky activities, compliance with health protocols, and participation in crime are all strongly affected by non-cognitive as well as cognitive abilities."

He is referring to "social-emotional skills", which are often only taught implicitly, if at all, in schools. What is particularly interesting is the return on investment on early intervention programs. In particular, he discusses the Perry preschool program, which yielded a 10% return per dollar of cost. In contrast, later interventions (such as high school programs or job training) yield much lower returns.

As Heckman says, "skills beget skills". If we want to address inequality, we have to address it early in life.