Q. Why should we worry about income inequality?
A. Because it erodes trust -- the social capital on which on well-being and economic growth depends.
Q. Isn't income inequality the natural result of our free-market system?
A. Some level of income inequality is motivational and is not only to be expected, but a positive force in society. But current levels in the U.S. are unprecedented and dangerous.
Q. Has inequality really gotten worse?
A. The Congressional Budget Office recently took a comprehensive look at household after-tax incomes for the period between 1979 and 2007. Both years reflected similar economic conditions, each coming before a recession. In addition to wages, bonuses, dividends, interest, capital gains, and other forms of earned income, the CBO auditors took into account government payments such as social security and welfare. They also subtracted all federal taxes paid, including payroll taxes. And they adjusted all data to account for inflation.
After crunching the data, the CBO concluded that after-tax income for households at the higher end of the income scale rose much more rapidly than income for households in the middle and at the lower end of the income scale.
- For the 1 percent of the population with the highest incomes, average real after-tax household income grew by 275% between 1979 and 2007.
- For the 20% of the population with the next highest incomes (those in the 81st through 99th percentiles), average real after-tax household income grew by 65% over that period.
- For the 60% of the population in the middle of the income scale (the 21st through 80th percentiles), the growth in average after-tax household income was just under 40%.
- For the 20 percent of the population with the lowest income, average after-tax household income was about 18% higher in 2007 than it had been in 1979.
Q. What accounts for these differences?
A. The CBO concluded that the principal reason is that all major sources of income became more highly concentrated in the very highest-income households.
- Wages and bonuses are by far the largest source of income, accounting for about three-fourths of total income across all households in 1979 and two-thirds in 2007. But whereas in 1979, 60% of wages and bonuses went to people in the lowest 80% of incomes, in 2007 less than 50% did.
- There are different theories to account for this, ranging from the impact of salaries paid to a relatively small number of superstar athletes and entertainers, to the outsized compensation given to corporate CEOs, and the increasing concentration of the economy in higher-paying financial, legal, and medical industries, as well as the general increase in jobs requiring higher levels of education and technical skill.
An important secondary cause of increasing income disparity is that non-wage income became a larger piece of the total income pie over this period. Capital income (i.e., interest, dividends, and rents), business income (i.e., an owner or partner's share of busines profits), capital gains (i.e., profits realized on prior investments), and private pensions became a larger piece of the total income pie over this period.
All of these sources tend to be concentrated in the upper income households. But the biggest change in this period was the share of business income concentrated in the top one percent of households.(Business income increased partly because business earnings increased in this period. But it was also due to tax changes that caused many businesses to redefine themselves as "S Chapter" corporations that pass their earnings on to their owners or partners, avoiding double taxation at the corporate and individual levels.)
But an unexpected reason, at least to me, is that government transfers across most income groups declined as a share of total income.
- For example, Medicare payments -- which are not means-tested -- grew, shifting more government payments to middle- and upper-income households.
- On the other hand, spending on federal means-tested programs like Aid to Families with Dependent Children declined. As a result, households in the lowest-income quintile received 54 percent of federal transfer payments in 1979 and only 36 percent in 2007.
Finally, average federal tax rates went down by two percentage points in the period, but payroll taxes increased. The result was a less progressive federal tax system.
Taken together, nearly all households' share of income after government payments and federal taxes either went down (for the bottom 80%) or stayed the same (next 19%), while the share to the top 1% more than doubled.
According to the CBO, higher after-tax incomes for the top 1% of households accounted for more than half of the increase in income inequality.
In sum, it seems that income inequality is due to a less progressive tax system, decreases in government benefits for lower income groups, higher compensation for occupations requiring more education and technical skill, and CEO compensation that has grown faster than the economy.
Q. So what can we do about income inequality?
A. I think at least part of the solution requires action on four fronts:
- Restore the progessivity of our tax system, especially on the 0.1% highest-income households,
- Apply more means-testing to government benefits, including Medicare and Social Security,
- Improve corporate governance to get more control over executive compensation,
- Make major investments in education to equip people with the skills needed to compete for higher-paying jobs.
Q. What are the chances of any of this happening?
A. It all depends on people like us deciding to do something about it.
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