Income and/or wealth inequality has become a hot topic. This post presents two views on this: a quick summary of the conventional wisdom widely disseminated by the media and a much different viewpoint by John Mauldin.
The gap between the rich and poor continues to grow. The wealthiest 1 percent held 8 percent of the economic pie in 1975 but now hold over 20 percent. This is a striking change from the 1950s and 1960s when their share of all incomes was slightly over 10 percent. A study by Emmanuel Saez found that between 2009 and 2012 the real incomes of the top 1 percent jumped 31.4 percent. The richest 10 percent now receive 50.5 percent of all incomes, the largest share since data was first recorded in 1917. The wealthiest are becoming disproportionally wealthier at an ever increasing rate.
Most of the literature on income inequalities is written by professors from the sociology departments of universities. They have identified factors such as technology, the reduced role of labor unions, the decline in the real value of the minimum wage, and, everyone’s favorite scapegoat, the growing importance of China.
Those factors may have played a role, but there are really two overriding factors that are the real cause of income differentials. One is desirable and justified while the other is the exact opposite.
In a capitalist economy, prices and profit play a critical role in ensuring resources are allocated where they are most needed and used to produce goods and services that best meets society’s needs. When Apple took the risk of producing the iPad, many commentators expected it to flop. Its success brought profits while at the same time sent a signal to all other producers that society wanted more of this product. The profits were a reward for the risks taken. It is the profit motive that has given us a multitude of new products and an ever-increasing standard of living. Yet, profits and income inequalities go hand in hand. We cannot have one without the other, and if we try to eliminate one, we will eliminate, or significantly reduce, the other. Income inequalities are an integral outcome of the profit-and-loss characteristic of capitalism; they cannot be divorced.
Prime Minister Margaret Thatcher understood this inseparability well. She once said it is better to have large income inequalities and have everyone near the top of the ladder, than have little income differences and have everyone closer to the bottom of the ladder.
Yet, the middle class has been sinking toward poverty: that is not climbing the ladder. Over the period between 1979 and 2007, incomes for the middle 60 percent increased less than 40 percent while inflation was 186 percent. According to the Saez study, the remaining 99 percent saw their real incomes increase a mere .4 percent between 2009 and 2012. However, this does not come close to recovering the loss of 11.6 percent suffered between 2007 and 2009, the largest two-year decline since the Great Depression. When adjusted for inflation, low-wage workers are actually making less now than they did 50 years ago.
This brings us to the second undesirable and unjustified source of income inequalities, i.e., the creation of money out of thin air, or legal counterfeiting, by central banks. It should be no surprise the growing gap in income inequalities has coincided with the adoption of fiat currencies worldwide. Every dollar the central bank creates benefits the early recipients of the money—the government and the banking sector — at the expense of the late recipients of the money, the wage earners, and the poor. Since the creation of a fiat currency system in 1971, the dollar has lost 82 percent of its value while the banking sector has gone from 4 percent of GDP to well over 10 percent today.
The central bank does not create anything real; neither resources nor goods and services. When it creates money it causes the price of transactions to increase. The original quantity theory of money clearly related money to the price of anything money can buy, including assets. When the central bank creates money, traders, hedge funds and banks — being first in line — benefit from the increased variability and upward trend in asset prices. Also, future contracts and other derivative products on exchange rates or interest rates were unnecessary prior to 1971, since hedging activity was mostly unnecessary. The central bank is responsible for this added risk, variability, and surge in asset prices unjustified by fundamentals.
The banking sector has been able to significantly increase its profits or claims on goods and services. However, more claims held by one sector, which essentially does not create anything of real value, means less claims on real goods and services for everyone else. This is why counterfeiting is illegal. Hence, the central bank has been playing a central role as a “reverse Robin Hood” by increasing the economic pie going to the rich and by slowly sinking the middle class toward poverty.
Janet Yellen recently said “I am hopeful that … inflation will move back toward our longer-run goal of 2 percent, demonstrating her commitment to an institutionalized policy of theft and wealth redistribution.” The European central bank is no better. Its LTRO strategy was to give longer term loans to banks on dodgy collateral to buy government bonds which they promptly turned around and deposited with the central bank for more cheap loans for more government bonds. This has nothing to do with liquidity and everything to do with boosting bank profits. Yet, every euro the central bank creates is a tax on everyone that uses the euro. It is a tax on cash balances. It is taking from the working man to give to the rich European bankers. This is clearly a back door monetization of the debt with the banking sector acting as a middle man and taking a nice juicy cut. The same logic applies to the redistribution created by paying interest on reserves to U.S. banks.
Concerned with income inequalities, President Obama and democrats have suggested even higher taxes on the rich and boosting the minimum wage. They are wrongly focusing on the results instead of the causes of income inequalities. If they succeed, they will be throwing the baby out with the bathwater. If they are serious about reducing income inequalities, they should focus on its main cause, the central bank.
In 1923, Germany returned to its pre-war currency and the gold standard with essentially no gold. It did it by pledging never to print again. We should do the same.
John Mauldin’s Thoughts From The Frontline of March 29 offers a very different understanding of income inequality. The whole piece is well worth your time but here’s an abridged version:
(…) We have spent three letters (so far) dealing with the topic of income inequality. The topic is everywhere in our daily conversation and in economic research. (…) We’ve discovered so far that income inequality is a fact; however, income mobility has remained roughly the same over the last 40 years. That is, a person’s chances of rising from a lower stratum of wealth distribution to a higher stratum is approximately the same as it was in 1975. (…)
This week we will look at some of the actual causes of income inequality (…).
The most significant factor in income inequality, which some research suggests is close to 75% of the problem, is that human beings get older. And the older you get, the more money you make and the more net assets you typically have. (…)
At every point across the net worth curve, the older you are the more likely you are to be wealthier, up until the time you cross into serious retirement and begin to consume your savings.
Furthermore, your income tends to rise the older you get (again, up until retirement age). The data shows that the peak earning period stretches between ages 45 to 65. This is not a shocking revelation, but it doesn’t get mentioned often enough in the debate about income inequality.
I think you can make the case that rising income inequality is significantly attributable to Baby Boomers reaching their peak income years. There are other factors, of course, but the demographics are what they are. Boomers are reaping the rewards from investing time and money in themselves and their businesses over 40+ year careers. (…)
It therefore seems logical that income inequality should be rising as the pig in the US population python reaches age 45-65. (…)
Academic scholars are beginning to argue that conclusions about income inequality should be adjusted for age-related reasons. (…)
While it may be inconvenient for those who want to blame income inequality on factors deemed politically correct, it should not come as a shock that much of the inequality can be attributed to characteristics that most people hold as positive values.
A report from the American Enterprise Institute gives us a good summary. Notice in the chart below that while the income of the highest fifth of the US population is almost 18 times that of the lowest fifth, there is only a 3.5x differential when it comes to the average earnings of the people actually working and making money in the household. It is just that high-income households have more than four times as many wage earners (on average) as poor households.
And married and thus two-earner households make more than single-person households. That seems obvious, of course, but it is a significant factor in income inequality. That doesn’t make the plight of the single working mom any better or easier, but it does help explain the statistical difference. And it does make a difference in lifestyle. Marriage drops the probability of childhood poverty by 82%.
And as we noted in previous letters on income inequality, education is an important factor, too. The relationship between families with higher incomes and the educational attainment of their children is also quite statistically significant.
The AEI report ends on this positive note:
“Bottom Line: Household demographics, including the average number of earners per household and the marital status, age, and education of householders are all very highly correlated with household income. Specifically, high-income households have a greater average number of income-earners than households in lower-income quintiles, and individuals in high income households are far more likely than individuals in low-income households to be well-educated, married, working full-time, and in their prime earning years. In contrast, individuals in lower-income households are far more likely than their counterparts in higher-income households to be less-educated, working part-time, either very young (under 35 years) or very old (over 65 years), and living in single-parent households.
The good news is that the key demographic factors that explain differences in household income are not fixed over our lifetimes and are largely under our control (e.g. staying in school, getting and staying married, etc.), which means that individuals and households are not destined to remain in a single income quintile forever. Fortunately, studies that track people over time indicate that individuals and households move up and down the income quintiles over their lifetimes, as the key demographic variables highlighted above change…. (…)
It’s highly likely that most of today’s high-income, college-educated, married individuals who are now in their peak earning years were in a lower-income quintile in their … single younger years, before they acquired education and job experience. It’s also likely that individuals in today’s top income quintiles will move back down to a lower income quintile in the future during their retirement years, which is just part of the natural lifetime cycle of moving up and down the income quintiles for most Americans. So when we hear the President and the media talk about an “income inequality crisis” in America, we should keep in mind that basic household demographics go a long way towards explaining the differences in household income in the United States. And because the key income-determining demographic variables change over a person’s lifetime, income mobility and the American dream are still “alive and well” in the US.”
Now let us turn to to a fascinating if lengthy article from the Manhattan Institute. The report is by Diana Furchtgott-Roth, and it’s a treasure trove of data. It is exceptionally well footnoted and uses the same data available to all researchers from government sources. It just offers the data up in a manner that doesn’t play to a progressive/liberal narrative that is looking for an excuse to increase taxes and engage in income redistribution. Let’s look at her introduction:
“Published government spending data by income quintile show that the ratio of spending between the top and bottom 20 percent has essentially not changed between 1987 and 2012. In terms of total spending, inequality is at the same level as 1987.
Why do other measures show increasing inequality? First, many studies use measures of income before taxes are paid and before transfers, such as food stamps, Medicaid, and housing allowances. Including these transfers reduces inequality.
Second, many studies do not take into account demographic changes in the composition of households over the past 25 years. These changes include more two-earner households at the top of the income scale and more one-person households at the bottom. Studies that show increasing inequality are capturing these demographic changes.
Third, some of this increase in measured inequality is due to the Tax Reform Act of 1986, which lowered top individual income-tax rates from 50 percent to 28 percent, leading more small businesses to file taxes under individual, rather than corporate, tax schedules (Joint Committee on Taxation, “General Explanation of the Tax Reform Act of 1986” (H.R. 3838, 99th Congress, Public Law 99-514), May 4, 1987).
A superior measure of well-being that avoids these pitfalls is real spending per person by income quintile. Spending power shows how individuals are doing over time relative to those in other income groups. These data can be calculated from published consumer expenditure data from the government’s Consumer Expenditure Survey. An examination of these data from 1987 through 2012 shows that inequality has not changed. [Emphasis mine]
Is Inequality Increasing?
(…) measuring inequality is not simple. The choice of the measure of income, along with the measure of the household unit, substantially influences the results of the inequality measure. (…)
In order to measure inequality, disposable income is the most accurate measure. This is what Americans can spend to make themselves better off. Hence, income should be measured after taxes are paid because households cannot avail themselves of tax revenue for expenditures. Similarly, income should include transfer payments because those are available for spending.”
(…) As noted above, there is a high correlation between income inequality and single-person households. The data from the US Census Bureau shows that the number of single-person households has more than doubled in the last 50 years. Is it any wonder that income inequality in an absolute sense – as measured by household (which is the standard measure cited in the press and used in most academic economic studies) – has risen dramatically during that time? (…)
Another factor that can influence measures of inequality is changes in the tax code. The Tax Reform Act of 1986 lowered the top individual tax rate to 28 percent, and the corporate rate to 35 percent (…). In 1986, the top individual rate was 50 percent, and the top corporate rate was 46 percent, so small businesses would pay tax at a lower rate if they incorporated and filed taxes as corporations With the implementation of the Tax Reform Act of 1986, the top individual tax rate of 28 percent meant that small businesses were often better off filing under the individual tax code. Revenues shifted from the corporate to the individual tax sector. In the late 1980s and 1990s, that made it appear as though people had suddenly become better off and income inequality had worsened. This had not happened; rather, income that had been declared on a corporate return was being declared on the individual return. This makes any comparisons between pre- and post-1986 returns meaningless.
Finally, inequality appears greater because the cost of living varies substantially in different parts of the country. College graduates tend to move to locations with higher costs of housing, food, and services, such as New York, Boston, Washington, D.C., and San Francisco. College students prefer these cities because they have amenities such as museums, theaters, shopping, and restaurants. As more well-educated people move into these locations, they become more attractive.
What this means for the study of inequality is that high incomes are less valuable in high-cost locations. A $200,000 salary goes further in Mobile than in New York, for instance, and if more $200,000 wage earners move to New York, the distribution of income is more unequal.
Low-income individuals spend a higher proportion of their income on food and clothing, and high-income people spend more on services. The price of food and clothing, nondurables, has been rising more slowly than the price of services, which are disproportionately consumed by higher-income individuals. (…)
If you’re really serious about dealing with income inequality, you need to worry about equality of opportunity in education, and specifically about making sure that the education system is radically reformed by taking it out of the hands of bureaucrats and unions. We need to make sure the economic and legal playing field is level by getting government favoritism and bureaucratic meddling out of the way and making the pie larger for everyone. However, as I demonstrated a few weeks ago, a natural outcome of doubling the size of the economic pie over the coming 15 years will be that there is an even greater differential between those who have next to nothing and those who have accumulated the most. The only way to prevent such an outcome is to keep the total economic pie from growing, and that doesn’t seem like a very good economic policy. (…)
Income inequality will not be solved by taxing the rich at higher levels. At some point, that “solution” would reduce savings and therefore investment and thus shrink the total potential for economic growth. To argue any differently is to argue with basic economics and simple math. The goal should not be equality of income or wealth but equality of opportunity. The role of government should be to make sure the playing field is level and the rules are simple and fair.
What constitutes a level playing field will change over time as society becomes richer and technology progresses, but the principle should remain the same. There is a place for the governments of developed economies and their societies to establish safety nets, including healthcare. But these are safety nets, not substitutes for personal endeavor and achievement.
In summary, in the last four weeks we’ve seen that while income inequality is real, increasing taxes and redistributing income is not the answer if the true goal is to improve the incomes and lifestyles of everyone. If we do that, we will actually make the problem worse rather than better.