The Pattern of Growth in Income Inequality

Greg Mankiw notes:

Greg Mankiw's Blog: Lazear vs Krugman: NY Times columnist Paul Krugman yesterday:

There's a persistent myth, perpetuated by economists who should know better -- like Edward Lazear, the chairman of the president's Council of Economic Advisers -- that rising inequality in the United States is mainly a matter of a rising gap between those with a lot of education and those without...

And he questions why economist Paul Krugman, a high-ranking candidate for this year's Nobel Prize, writes this.

The reason, I think, is contained in this graph:

from Thomas Piketty and Emmanuel Saez (2006), The Evolution of Top Incomes: A Historical and International Perspective (Cambridge: NBER Working Paper No. 11955, January 2006).

The big rise in inequality in the U.S. since 1980 has been overwhelmingly concentrated among the top 1% of income earners: their share has risen from 8% in 1980 to 16% in 2004. By contrast, the share of the next 4% of income earners has only risen from 13% to 15%, and the share of the next 5% of income earners has stuck at 12%. The top 1% have gone from 8 to 16 times average income, the next 4% have gone from 3.2 to 3.7 times average income, and the next 5% have been stuck at 3 times average income.

It's hard to attribute this pattern to a rise in the premium salary earned by the well-educated by virtue of the skills their formal education taught them. Such a rise in the education premium would produce a much smoother rise in relative incomes among the whole top tenth of the income distribution. The cross-percentile pattern doesn't fit.

It is especially hard because most theories of the rising education premium attribute it to skill-biased technological change generated by the high-tech computer industrial revolution. But the high-tech boom's effects on overall productivity became large only in the second half of the 1990s, well after the biggest increases in inequality. The timing doesn't fit either.

Something else is going on.

If the New York Times were smarter, it would give Paul Krugman 2000 words every two weeks, rather than confining him to the straightjacket of 700 words twice a week, so that he could explain background issues like this more adequately...

Comments

[John Emerson]

I've frequently heard something like "Education is the best single factor deciding lifetime earnings". So if we want to increase equality, we should promote education, and if we want our kids to do well, we should send them to school.

Counterargument 1. If education is being used as a selector, then increasing the educational level of the populace will just raise the bar. Already a lot of jobs require schooling which once were taught on-the-job, and a lot of jobs require MAs that used to require only BSs.

Counterargument 2. While education is the single biggest factor, that's partly because it aggregates a lot of other factors which correlate with education, such as family income, personal character, and talent. Many without educations either lack family support or else have personal problems.

So even though education is the best single selector for lifetime income, that doesn't necessarily mean that a talented, problem-free kid from a prosperous family needs to go to college. He already has several of the reasons why college-educated kids do better. (I'm not saying that college per se has no effect, just that the "best single factor" argument exaggerates that effect.)

If public money paid for education, it would amount to erasing some of the difference deriving from parental income. But fronting money to start a small business would do that too.

I really think that the big argument is whether kids should go to tech schools or to four-year colleges. Humanities degrees in four-year colleges are not very practical, especially for kids whoise parents can't afford further education. Whereas one-year or two-year tech programs often are very practical.

I am strongly in favor of the humanities, but think that maybe it should be mostly an adult-education replacement for TV. You really can't justify letting a talented kid from a marginal family to go $20,000 into debt in order to get an English BA from a second-rank school.

[Delicious Pundit]

OT to the main topic, but I don't see why the NYT is smarter having better Krugman less often; when he's in the paper twice a week then he's a real draw, if he's only in the paper once every two weeks not so much.

It'd be a little like, "Why don't they just run the Sunday crossword? That's the interesting one."

[Devil's Advocate]

Is there any good reason for why the income of the top 1% surged during the years 86-88 and 94-99?

[J]

Let's compromise and have Krugman write the longer pieces twice a week. I'm pretty sure the limiting factor is the NYT column inches, not Krugman's ability to write enough.

In other countries (France, Taiwan, Mexico) you will often see fairly lengthy think pieces by major intellectuals in the daily paper. Call me a hate America firster, but our way of making journalism an autonomous profession with a separate career track makes our newspapers stupid. (And when someone from outside journalism is given a slot, usually it's a Republican speechwriter chosen for "balance": Noonan, Buchanan, Safire, Will, and as I remember there are more.

Of course, in fairness I must name the Democratic militants in the media: Susan Estrich, George Stephanopolous, Chris Mathews, Tim Russert. With people like these out there fighting for us, it would be silly for us to complain about media bias.

[anne]

There is a considerable advantage in realizing income as capital gain, but the wealthiest have a far more than proportional ability to take income as capital gains, so a period in which there is an international bull market will mark an increase in income concentration. We are in such a period now, but tax law has increasingly favored taking income as capital gain so the concentration effect is becoming more pronounced yet will be even more pronounced.

[vtcodger]

I think that Delicious Pundit is onto something here. I'm in no way, shape or form an economist, but the fact that almost all the growth in asset differential takes place in two relatively short time intervals seems indicative of something.

It'd be easy to attribute the growth in differential to booms (or maybe bubbles) in equities and property prices. But it that is the case, surely the 95-99 percentile group which have large investments in property (often on 80% margin), and substantial equity holdings in IRAs, 401Ks, and directly ought to be doing better relative to the very wealthy (and the poor for that matter).

With all due respect to Anne, I don't think the Capital Gains tax advantage by itself can account for this chart. In fact, many of the assets held by the wealthy are long term investments (e.g. coastal property in Malibu or the Hamptons) where the eventual capital gains surely won't have been subtracted from the current value in drawing the chart. The capital gains tax break may be lousy public policy (surely indexing would be fairer and better), but I don't see how it can account for this hyper concentration of wealth. Maybe I'll try some modelling if I ever get a bunch of other projects out of the way.

Anyway, we know something odd and probably not healthy is going on. I think we ought to be more concerned with why.

[anne]

Actually, realization of capital gains or losses in the critical reason for the pronounced changes in income concentration. Turnover in holding of assets, especially stocks, is startlingly high, no matter the wealth level, and concentration of wealth is startlingly high. David Cay Johnston has pointed to this several times, but there is more to think through and your comment as ususal is important :)

[Blissex]

«I've frequently heard something like "Education is the best single factor deciding lifetime earnings". So if we want to increase equality, we should promote education,»

This is just a way of saying that income inequality depends on objective factors, and since people with less education tend to be ashamed of that, it is a way of making them feel guilty for being poorer.

«If education is being used as a selector, then increasing the educational level of the populace will just raise the bar.»

Well, one could advance the idea that rewards flow to the top 5%, irrespective of the absolute educational level. Let's look at graduates...

When only 5% of the population got a degree, 100% of graduates had it very good, as their degree had scarcity value.

Now that 40-50% of the population has a degree, not having one sucks; but having one is not awesome either, unless it is from the same institutions (Ivy league, Oxbridge) that graduate the top 5%, and once granted all degrees...

Mass education as you say does not much affect the _distribution_ of the pie, because it does not much change the bargaining power of employees vs. employers. It does not even affect much the absolute level of compensation, according to the data, as all productivity gains go to asset holders (and the top 1% of income earners are really asset holders).

More education has sure and immediate costs and uncertain (for those not in the top 5%) and long term benefits. Then what matters is who captures the benefits if any...

With mass education the benefits are largely captured by _employers_, because increased competition among employees reduces the scarcity value and pricing power of ''bulk headcount'' credentials.

Mass education also has wonderful side effects: it considerably reduces the reported rate of unemployment (a very important factor for many OECD governments), and makes employees more desperate to get a job and afraid of losing it because of university debt.

No wonder that the ''more education'' line is so common among certain advocates...

As to productivity, a good high school education is usually all that's needed to obtain the productivity benefits in a modern economy. Degrees are really only necessary for the professions and for access to the elite jobs.

[bakho]

Didn't Reagan whack the top income tax rate? Would this have an effect on after tax income of the top 1%?

[Blissex]

«Is there any good reason for why the income of the top 1% surged during the years 86-88 and 94-99?»

First, we are talking not about the *income*, but the *share of income* of the top 1%. Two very different things.

Seconds, there can be two different reasons...

Also note that the share of income to the top 1% surged *permanently* which is quite impressive.

Fixing on specific dates thus seems less important than looking at long term trends, and the remarkable fact that the top 1% share oscillated stably within 8-9% through 40 years even if quite a few disruptions happened in those years.

However as economics teaches :-), the truth can only be that in those 40 years the (rate of growth of) marginal productivity of the top 1% somehow halved, and it doubled instead in the past 20 years.

[Blissex]

«Didn't Reagan whack the top income tax rate? Would this have an effect on after tax income of the top 1%?»

All those statistics are before income tax... After income tax things are a little flatter (and as 'anne' says they are more than flat at the very top after all taxes), and as you say they have become less flat with time.

If you look at after income-tax income, the rise in inequality is even more pronounced, even as inequality overall is less so than before-tax.

For the full story, at least since 1979, check "Table 1C" in this spreadsheet:

http://WWW.CBO.gov/ftpdocs/70xx/doc7000/Spreadsheets.xls

[save the rustbelt]

Just did my weekly scan of a dozen Rustbelt newspapers.

Bad economic news all around, and especially in Ohio and Michigan.

Real incomes still sinking like the Titanic.

The rich still belly up to the banquet table and have their fill.

[Lord]

I think creativity would be a more important determinative factor, not that the rest of us can't be creative, but that being creative, being in a position to recognize an opportunity and be able to take advantage of it, is not that widely distributed. It takes knowledge, information, capital, contacts, and connections. It is almost necessarily narrow by definition.

[John Emerson]

I think that creativity per se has no value. Creativity combined with a skill level or a position can distinguish between otherwise similar individuals. But creativity isn't a very measurable quality and not very usable in econ.

[Movie Guy]

Mankiw has since responded to Brad's post (this one).

It's astonishing that he doesn't really understand the full scope of considerations that create income inequality.

Watching key economists stumble on basics such as income inequality is disappointing and embarrassing for the nation. Whether it's a lack of knowledge or intentional ideology misdirection remains in question.

I am with Paul Krugman on this issue. Paul has taken the time to think this through. My twenty plus additional manhours of research this past support his conclusions.

[Douglas Knight]

The chart *excludes* capital gains, so bull markets are probably not relevant in any simple way.

[anne]

http://economistsview.typepad.com/economistsview/2006/07/gilded_age_ii.html#c19833683

July 16, 2006

Krugman: Gilded Age II, Here We Come

Greg Mankiw asks Paul Krugman to explain his comments in his recent column. He does so in an email:

OK, ... here's some explanation.

First, the question of which dates to look at depends on the question you're trying to answer. If you're asking why the public doesn't feel good about the economic growth since 2003 - which was, after all, what my "Left Behind" column was about - pointing out that inequality fell between 2000 and 2003 is irrelevant; everyone felt lousy about the economy during those years. The point is to explain why most people don't feel better about performance since 2003 - and rising inequality since then is the explanation.

Second, the data aren't encouraging about the long-term trend. The slump in top income shares after 2000 gave us reason to hope that the extreme income concentration at the end of the 90s was an artifact of the bubble, and would not return. But 2004 data already show a return almost to 2000 levels of inequality, and other indicators suggest that the trend has continued since then. Gilded Age II, here we come.

Third, both Greg and Eddie Lazear have asserted not just that rising inequality is partly due to an increased skill premium, which is true, but that it's mainly due to skill, which is false. I don't see why this distinction is so hard to understand. The median income of college grads is up since 1980, but only modestly, around 1 percent per year; the big gains are for people at the 99th percentile and beyond.

[derrida derider]

Krugman's Slate articles - ~2000 words every fortnight - were far better than his NYT column. He seems to need some space to think up new arguments; that he doesn't have it is what makes him sometimes sound predictable.

I agree with Brad - he's just much better in a bit longer format.

[johnchx]

John Emerson wrote: "I've frequently heard something like 'Education is the best single factor deciding lifetime earnings'."

In addition to the caveats John raised in his comment, I'd point out that it's important to quantify *how much* of the variance in income is explained by education, how much by other factors, and how large the unexplained residual variance is. In other words, it's perfectly possible for education to be the single most powerful predictor of income while only explaining a fraction of the variance.

There's a paper in the June 2006 AER (by Thomas Lemieux from the University of British Columbia) that sheds some interesting light on this. He comments, "...explanations for the growth in wage inequality linked to standard human capital variables like experience and education are limited by the fact that these variables explain only about a third of the variance in wages."

One key observation is that as an individual's "human capital" (education + experience) increases, both the median wage *and* wage variance increases. As Brad commented elsewhere, every Master's degree comes with a lottery ticket. Increased education gets you a lottery ticket with a bigger jackpot...but it's still a lottery ticket, not a check.