The following is an excerpt from Economics21’s new inequality primer, Income Inequality in America: Myths and Facts.
requires proper measurement of both income and consumption, along with an understanding of the ever-changing determinates of income and its distribution. These determinates have changed significantly since the 1950s.
Information technology has opened an enormous window of investment opportunities and changed the nature of investment—from labor and capital-intensive manufacturing carried out by large companies, to idea-intensive opportunities like WhatsApp and Instagram. These opportunities require little unskilled labor and capital, and can be created and owned by individuals.
The rewards for properly trained talent have risen despite a large productivity-driven increase in their supply. This indicates investment opportunities have grown even faster than the productivity-enhanced supply of talent.
At the other end of the pay scale, circumstances that increased middle class pay have run their course. We saturated the population with education and discovered a large pool of talented but uneducated workers whose productivity and pay rose substantially once educated. Today, the potential for further saturation is smaller. When technology hollowed out agriculture, it drove the rural population to the cities where they became much more productive. That one-time migration is over. And while the capital intensity of manufacturing continues to rise, it is no longer increasing the productivity of a growing proportion of unskilled workers.
At the same time, the United States has moved from a shortage of unskilled workers to a surplus. A lack of births during the Great Depression gave way to the baby boom after World War II and increased participation of women in the workforce. Over this period, a growing trade deficit exported jobs and massive migration to the U.S. added to the supply of domestic workers. Today, the United States has 37 million foreign-born adults and 16 million native-born adult children of foreign-born parents. This growth in supply put pressure on the wages of unskilled workers.
Nevertheless, it is inaccurate to conclude that the middle and working classes have not benefited from innovation. The U.S. economy has grown about 75 percent since 1991; U.S. employment grew 50 percent since 1980. Over these same periods, the French and German economies grew by less than half that amount, Japan by less than a third. The U.S., moreover, achieved this growth with median incomes that were already 25 to 30 percent higher. In addition, had the United States not contributed a disproportionate share of global innovation—which helped Europe and Japan grow faster than they otherwise would have—the latter’s growth relative to the U.S. would have been even slower.
Indeed, with a more restricted supply of labor, wages in the U.S. likely would have grown more. Yet even so, median incomes have grown nearly 40 percent since 1979— when healthcare and government benefits, like social security, are properly counted, and proper adjustments are made for family size.
Given this pronounced growth differential, it is far-fetched to claim rising “crony capitalism” in the United States accounts for growing income inequality. Had a misallocation of resources been the driver of greater U.S. income inequality, U.S. growth should have slowed relative to Europe and Japan, with more equally distributed incomes. Relative growth, however, accelerated.
Nor is there any credible evidence that U.S. income mobility has declined (another possible symptom of crony capitalism). In fact, U.S. mobility is identical to countries such as Denmark (with more equally distributed incomes)—except for the country’s bottom 20 percent, where we see lower test scores, higher dropout rates, and much greater decimation of the family (factors which probably transcend economics).
More likely, incomes have risen because we have seen a rise in the opportunity cost of deploying a scarcity of properly trained talent. CEO pay has risen, for example, but not relative to the pay of the 0.1 percent, or relative to the pay of CEOs of privately owned companies.
In the United States, we also find that growth in the share of GDP earned by the one percent has largely come at the expense of the share of GDP earned by capital and not the share earned by the 99 percent. In both the United States and Germany, for example, the 99 percent earns about half of GDP, despite the fact that the one percent in the United States earns a larger share of GDP than does the one percent in Germany. In the United States, however, capital earns a smaller share of GDP than it earns in Germany. This may indicate that properly trained talent in the United States, which is more productive than its counterparts in Germany and elsewhere, may rightly have more negotiating leverage over investors. Regardless, the relative success of the one percent does not seem to have significantly affected the share of GDP earned by the 99 percent.
If circumstances have benefited the one percent disproportionately, why not tax and redistribute their good fortune? The slow growth of Europe and Japan should give one pause for concern. Nevertheless, there are two opposing theories. One side argues that Americans are inherently entrepreneurial and will continue to innovate, no matter the payoffs. The other side claims payoffs drive risk-taking like any game of chance; as such, culture is largely a byproduct of incentives.
Proponents of tax increases often point to the 1990s as evidence that taxes don't affect entrepreneurialism. They forget, however, that the invention of the Internet drove the NASDAQ from 800 to 4500. The resulting increase in the payoff for risk-taking—and we saw a large increase in entrepreneurialism—thus trumped any increase in the tax rate.
Proponents similarly point to the growth of Silicon Valley in California, where higher tax rates reign. Again, however, the payoffs for working in such a community of experts likely trumps any difference in state tax rates. (Where the payoffs are higher, we consistently see more entrepreneurialism.)
Consider, further, the “compounding effect” on state lotteries. When the size of the pool rises, ticket sales increase exponentially. The U.S. has undoubtedly benefited from the compounding effect on the payoffs for risk-taking.
Success is relative: one person's success raises the bar for others. Our most talented workers are working longer hours than their counterparts in Europe, and with higher productivity than their counterparts in Japan. Our best students no longer want to be doctors and lawyers. They are going to business school.
Their success creates companies such as Google and Microsoft, as well as communities of experts, like Silicon Valley, which give our workers far more valuable on-the-job training. That training increases their chances of success and, in turn, the payoff for prudent risk-taking.
Meanwhile the success of these companies puts equity into the hands of successful entrepreneurs, who are more willing to underwrite the risks that produce innovation, and who are more skillful at choosing which risks to underwrite. It is no coincidence that the United States has more equity per employee and per dollar of GDP, while also growing faster than both Europe and Japan.
But this process is gradual and compounds slowly over time. The resulting increase in payoffs is affected by far more than just the tax rate. Without these compounding benefits, it is not as though Europe—absent similar infrastructure—can slash tax rates and immediately start growing as fast as the United States.
The financial crisis increased the importance of equity and risk-taking. With a finite capacity for bearing risk, when the economy eventually reawakened to the fact that banks were more unstable than expected, the economy, accordingly, dialed back risk-taking elsewhere to compensate. As a result, growth slowed, unemployment rose, and incomes declined.
Risk-averse savings sat unused for want of more equity to underwrite the risks of putting such savings back to work. Unconventional monetary policy, a growing level of public debt relative to GDP, and an increased regulatory burden, also added to the risks faced by our economy. Going forward, unless we mitigate some of these risks—or accumulate more equity per dollar of GDP and per employee—economic activity will, in the future, likely grow more slowly from a permanently lower base of demand.
Taken from the Economics21 issue brief, Income Inequality in America: Myths and Facts.
Edward Conard is a visiting scholar at the American Enterprise Institute. You can follow him on Twitter here.
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