The Economic Policy Institute’s new report on trends in wages, earnings, and incomes, “Wage Stagnation in Nine Charts,” is a greatest-hits compilation of EPI’s attempts to show that the American middle class is in trouble because of rising inequality.
The first chart in EPI’s report is entitled “The cost of inequality to middle-class households.” It is intended to show how much greater the incomes of middle-class households would be if inequality had not risen, an income loss EPI dubs “the inequality tax.” The chart shows that, in 2007, the average American in the middle 60 percent of household income (adjusted for household size) had $17,867 less in household income (not adjusted for household size) than it would have “because of the growth of inequality.” That is an inequality tax of around 20 percent.
To construct the “Income with no change in inequality” trend—the dashed line in the chart—EPI assumed that the average household income within the middle three-fifths of Americans grew at the same rate as the average household income across all Americans between 1979 and 2007. The increase in the average for all Americans (67 percent) was higher than it was for the middle class (35 percent) because the dramatic income gains at the top have had the effect of pulling the overall average more sharply upwards. If income had grown at the same rate among the bottom fifth, the middle three-fifths, and the top fifth of Americans, that would have left the shares of aggregate income received by each group at their 1979 levels.
The EPI estimate is as high as it is partly because it is based on CBO’s pre-tax income figures. When social critics decry inequality, they generally advocate an increase in top tax rates to redistribute income. Thomas Piketty, for instance, in his surprise best-seller, Capital in the Twenty-First Century, advocated a top tax rate of 80 percent on all income over $500,000.
What middle-class Americans probably care most about is whether after-tax incomes are lower today because of rising inequality. The claim that the “middle class had $17,867 less income in 2007” because inequality rose loses its force if redistribution whittles that amount down significantly.
Conducting the EPI exercise using CBO’s after-tax income figures, the inequality tax falls to $12,802. In other words, through actual redistributive taxes, we manage to reduce the supposed “inequality tax” on middle-class families by 28 percent.
EPI’s analysis has a hidden assumption—that aggregate income growth would have been no slower if we had prevented the top from pulling away. Many social critics make EPI’s assumption—that the American economy is essentially a pie of fixed size, so that gains at the top must come at the expense of others. But higher inequality—at least to a point—can enlarge the economic pie, so that even if the slice enjoyed by the middle class becomes skinnier, the middle can still end up with more pie.
For the top fifth of Americans to have been kept to its 1979 share of pre-tax household income in 2007, it would have been necessary to hold its average income to a level 20 percent lower than its actual 2007 average. Since people in the 80th through 90th percentiles saw their share of income fall between 1979 and 2007 and those in the 90th through 95th percentiles saw essentially no change in their share, that 20 percent drop would have to have come entirely from the top five percent. That would have required that their incomes end up 39 percent lower on average in 2007 than what the top five percent actually received.
Would those who made it to the top have worked as hard, taken as many innovation-promoting risks, or invested as much if we had taxed them enough to reduce their payoff by 39 percent? Would we have been able to attract the best people to the most important positions in executive suites, in Silicon Valley, and on Wall Street? If not, then economic growth might have lagged, and the middle class might have suffered because of it.
Of course, it is also possible that reducing inequality would have increased growth. However, in a recent paper on cross-national differences in inequality and living standards, I find that, if anything, the research on inequality and economic growth offers more support for the conclusion that inequality strengthens growth than the claim that it hurts growth, at least in developed countries, but the effect is probably small either way.
EPI’s estimation of how much better off the middle class would be if incomes had grown at the same rate across the board (and economic growth had not suffered) is illustrative, but how relevant is it? EPI’s thought experiment amounts to asking how much better off the middle class would be if the income growth of the top five percent had diminished enough to “fund” the additional income growth in the bottom 90 percent necessary for keeping income shares fixed.
If we assume that overall income growth would not have been harmed (or helped), then in 2007 around $194,000 per person in the top 5 percent would have had to be redistributed to the bottom 90 percent to get back to the 1979 income shares. For the middle class to maintain its 1979 share of income, it would have needed just under $13,000 per person in 2007. That could have been accomplished by transferring 76 percent of the proceeds from the top 5 percent’s per-person $194,000 to the middle three-fifths. Another 8 percent would have been required to prop up the bottom fifth, and 10 percent would have gone to people between the 80th and 90th percentiles. (The remaining 6 percent is a residual from the imprecision in multiplying quite a few numbers, many of them rounded in the CBO data.)
This is a very specific thought experiment that is fine as far as it goes, but, as a practical matter, it is unlikely that the proceeds from slowing income growth in the top five percent—however achieved—would have been distributed in this fashion. Capping the gains at the top likely would have shifted a disproportionate amount of income to knowledge workers and professionals between the 80th and 95th percentiles rather than sending enough gains to the middle class to maintain its 1979 income share.
Consider the case of Mark Zuckerberg. The Facebook founder and CEO reportedly earned $2.3 billion in 2012 exercising stock options. Imagine he had never been granted those options or that they ended up being worth less than they were. In that event, the likely beneficiaries from Zuckerberg’s loss would have been not middle-class families, but Facebook’s other investors (who saw their own Facebook shares decline in value when Facebook issued the additional shares to compensate Zuckerberg). According to economist Edward Wolff, the stocks and mutual funds held by the wealthiest 10 percent of households amount to 91 percent of the total value of those securities. Zuckerberg’s money would have mostly gone into the pockets of the rest of the top fifth.
When EPI and others show modest income growth since 1979 or 2000 relative to the 1950s and 1960s, they rarely make much effort to show that the slowdown in income was caused by the rise in inequality. They simply contrast the low inequality and strong income growth of the Golden Age with the high-and-rising inequality and sluggish income growth we have experienced in recent decades. But these sorts of comparisons are easily abused. Other datasets show that while the slowdown in income growth below the top began in the 1970s—before the years EPI analyzes—incomes at the top did not take off until after 1980. Apparently, rising inequality after 1980 caused middle-class income growth to slow during the prior decade.
The left appears ready to bank its 2016 hopes on the idea that there is a “middle class squeeze” caused by inequality. The next two years are sure to feature myriad claims that rising income inequality has hurt the middle class, necessitating liberal policies to pull down the top. Invariably, these claims convey overly negative impressions of how the middle class is doing, omit important contextual details, exaggerate the extent to which inequality has risen, or otherwise present an inaccurate case that inequality is the source of all our troubles. These claims call for careful evaluation.
For more information see Did Inequality Rob Middle-Class Households of $18,000?
Scott Winship is the Walter B. Wriston Fellow at the Manhattan Institute for Policy Research. You can follow him on Twitter here.
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