from Renewing America

The Income Inequality Debate

Income inequality is generating high-level attention and debate in the United States, but the causes are complex and the policy remedies so far are modest, explains this Backgrounder.

Last updated February 03, 2014

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Income inequality in the United States, measured by the standard Gini coefficient, is substantially higher than that of almost any other developed nation, and even some developing countries such as Russia and India. Popular anger over inequality peaked in the autumn 2011 Occupy Wall Street protests, which catalyzed similar movements internationally. President Obama followed a December 2013 speech on economic mobility with further discussion of policy ideas in his 2014 State of the Union speech, titled "Opportunity for All."

There are many, complex causes of income inequality. Certainly, globalization and technological change have led to greater competition for lower-skilled workers—many of whom have also lost union membership—while giving well-educated, higher-skilled workers increased leverage. Changes to tax rates, including favorable treatment for capital gains, may also play a role.

Rising U.S. Income Inequality

According to the Congressional Budget Office (PDF), income inequality in the United States has been rising for decades, with the top echelon of earners rapidly outpacing the rest of the population. The average real after-tax household income of the top 1 percent rose 275 percent from 1979 to 2007. Meanwhile, income for the remainder of the top quintile (81st to 99th percentile) grew 65 percent. Income for the majority of the population in the middle of the scale (21st through 80th percentiles) grew just 37 percent for the same period. And the bottom quintile experienced the least growth income at just 18 percent.

Distribution of Household Income

Furthermore, in 1965, a typical corporate CEO earned more than twenty times a typical worker; by 2011, the ratio was 383:1, according to the Economic Policy Institute.

Still, this view is not universal among experts. An August 2012 paper by the Hoover Institution of Stanford argued that income inequality is not rising when noncash benefit programs are taken into account.

While many of the suspected drivers of rising income inequality—globalization, technological change and the rising value of education—affect other nations as well, few have seen as stark a rise in inequality as the United States. From 1968 to 2010, the share of national income earned by the top 20 percent rose from 42.6 to 50.2 percent, with gains concentrated at the very top. Meanwhile, the "middle class," the middle 60 percent, saw its share decline from 53.2 to 46.5 percent. This increasing income inequality is captured by the steady rise in the U.S. Gini coefficient, from 0.316 in the mid-1970s to 0.378 in the late 2000s. Today, the U.S. income distribution is one of the most uneven among major developed nations (PDF).

Income Inequality in OECD countries

Source: OECD Map: Hagit Bachrach

Globalization and De-Unionization

Economic forces underlie the growth of income inequality. Highly skilled workers have greatly benefited from worldwide opportunities, from the star actor whose movies reach a global audience to the entrepreneur who can quickly and cheaply bring a new product to market through Chinese contract manufacturing.

Meanwhile, globalization has brought tough competition to other American workers who have seen jobs move overseas, wages stagnate, and unions decline. The median union member earns roughly a quarter more than a non-union counterpart. Forty years ago, a quarter of private sector workers were represented by unions, but today it is only 6.9 percent. Despite a workforce one-fifth of the size, the public sector has more union members (PDF).

Immigration likely pays a role in stagnant wages, especially among workers without a high school degree, of which immigrants make up about half. One study found that a 10 percent increase in the local immigrant population correlated with a 1.3 percent decline in the price of labor-intensive services, but it is difficult to disentangle this competitive effect from others on the labor market (PDF).

Free-trade advocate Alan Blinder says that while beneficial for the United States as a whole, the increased labor competition from globalization will be painful for many Americans. He advocated for helping displaced workers through a stronger safety net, reforming education, and encouraging innovation and entrepreneurship. Fellow Princeton economist Paul Krugman believes that "we need to restore the bargaining power that labor has lost over the last thirty years, so that ordinary workers as well as superstars have the power to bargain for good wages."

Education and Technological Change

Most high wages come from high-skill jobs that require a commensurate level of education. After decades of gradually narrowing, the college wage premium has grown dramatically since 1980, as the annual growth in the college-educated workforce (2 percent) failed to keep pace with rising demand (3.27 to 3.66 percent) driven by technological change. In 2011, the median earnings of a worker with a bachelor’s degree were 65 percent higher than a high school graduate’s; holders of professional degrees (MD, JD, MBA) enjoyed a 161 percent premium. Higher educational attainment correlates both with higher earnings and lower unemployment.

However, college degrees do not guarantee good jobs. Falling costs in communications and computers are leading to the offshoring and automation of some jobs that were once the purview of well-paid professionals, from scientists in pharmaceutical labs to finance and accounting jobs. There is a widening wage premium between those with advanced degrees and those with a bachelor’s degree only. Since the 2000s, the wage premium for those with only a four-year degree has remained flat, while it has continued to grow for those with advanced degrees.

Gary S. Becker and Kevin M. Murphy of the University of Chicago see education as the major driver of rising income inequality: "In the United States, the rise in inequality accompanied a rise in the payoff to education and other skills. We believe that the rise in returns on investments in human capital is beneficial and desirable, and policies designed to deal with inequality must take account of its cause". To address income inequality, they argue for policies that would increase the percentages of American youth who complete high school and college, and against making the tax code more progressive.

In a 2012 survey, 80 percent of economic experts agreed that a leading reason for rising U.S. income inequality was that technological change has affected workers with some skillsets differently than others, but not all prominent economists agree. James K. Galbraith believes that "the skills bias argument—the notion that inequality is being driven by technological change and education and the supply of skills—is comprehensively rebutted by the evidence." He argues instead that the credit cycle has concentrated income in specific sectors, such as finance, tech, and real estate.

Income Tax Rates

One tool for addressing income inequality is a more progressive tax code (PDF). While some argue that shifting some money from the rich to the poor means that money can be used to create more social utility—the economic concept of declining marginal utility—other see this shift as unfair and unwise because it reduces the ability of more productive citizens to reinvest in the skills and businesses responsible for their higher relative income, thus retarding overall growth. While economic models and theories can attempt to quantify the relationship between inequality and growth, the optimum balance cannot be empirically determined.

The United States has generally cut top income tax rates over the past half century. When John F. Kennedy entered the White House in 1961, the top ordinary income tax bracket, applied to wages and savings interest, was more than 90 percent. Ronald Reagan slashed the top rate from 70 percent in 1981 to 28 percent after 1986. Tax increases under the first President Bush and President Clinton brought the top rate to 39.6 percent, but tax cuts signed by President George W. Bush and reauthorized by President Obama set it to 35 percent.

Tax rates on investment income in the form of capital gains taxes and dividends have also declined, with the current rate of 15 percent the lowest since 1933. Investment income ultimately is derived from the after-tax profits of corporations, whose tax rate has also declined since the Eisenhower era from more than 50 percent to today’s marginal rate of 35 percent. Corporate income tax has declined steadily as a share both of corporate profits and as a percentage of GDP over the past half century.

The Social Security payroll tax, which funds both old age pensions and Medicare, is regressive because it is a flat rate that only applies to the first $110,100 of wages (as of 2012). On the other hand, roughly half of U.S. taxpayers pay no additional federal income tax.

A Tax Policy Center analysis of all federal taxes found overall progressive taxation, with each quartile paying a successively higher rate and the top 0.1 percent paying an effective rate of 30.4 percent. While higher than the 14.1 percent borne by the middle quartile, 30.4 percent is lower than the historical rates paid by this small group, which is earning its largest share of national income since the Great Depression.

Social Program Support

The poverty rate tends to generally follow the economic cycle (PDF). As the economy reached new heights in 2000, the poverty rate fell to 11.1 percent—a rate not seen since 1973—but in 2010 the poverty rate had risen to 15.1 percent.

Under President Lyndon Johnson’s Great Society, most assistance was in the form of cash benefits to needy families. Through the 1970s and 1980s, noncash benefit programs were created or accelerated, including college grants, food stamps, and housing assistance. The 1990s ushered in welfare reform, replacing federal cash assistance with TANF block grant to states (PDF), with work requirements and time limits. The refundable earned income tax credit, (created in 1975) was greatly expanded at this time, providing extra cash to workers in an effort to "make work pay."

Today, record numbers receive food stamps, and one in five Americans struggle to afford food. The five-year farm bill passed in late January 2014 by the House—with Senate approval expected—contains a 1 percent cut to the food stamp program ($8 billion over 10 years), through tighter restrictions on heating assistance. The number of Social Security Disability Insurance recipients has surged by more than 22 percent since the recession began in 2007; that program effectively acts as a long-term unemployment benefit for some.

From Medicaid to unemployment benefits, many social support programs are driven by decisions at the state level. States have less flexibility to run deficits, and many have cut programs to needy citizens. Pennsylvania recently joined other states in eliminating its general assistance program.

Bred for Success?

Many Americans take pride in the belief that everyone has a chance to "make it big," and rags-to-riches stories are almost legends. But today, more than 40 percent of those born into the lowest income quintile will stay there, and less than 30 percent will make an above-average income.

U.S. Economic Mobility

Harvard’s Equality of Opportunity Project issued a paper based on tax record data for taxpayers born between 1971 and 1993, and determined that there has not been a significant change in intergenerational mobility (PDF). The researchers found that while stable, the level of upward mobility in the United States is not uniform; some regions consistently offer less economic mobility. Common factors that correlated with regions with more mobility were: less segregation, less income inequality, better schools, greater social capital, and more stable families (PDF). Still, while income mobility may be stable in a relative sense, inequality is growing in an absolute sense. The gaps between the median incomes in each quintile have grown as higher incomes grew at a faster rate (PDF).

Among developed countries, only the United Kingdom has less class mobility than the United States; in 2006, the Brookings Institution found that 47 percent of U.S. parents’ income advantages are passed to their children, greater than in France (41 percent), Germany (32 percent) or Sweden (27 percent). The countries with the highest mobility were Canada, Norway, Finland and Denmark, where less than 20 percent of economic advantages are passed to children (PDF).

Political Impact

President Obama’s 2014 State of the Union address did not use the term "income inequality," and his proposals focused on broadly expanding economic opportunity. His plan to raise the federal minimum wage to $10.10 an hour for all workers would require Congressional action; economists still debate whether minimum wage increases do more harm than good by lowering employment as wages rise. Many of the president’s ideas concerned accelerating economic growth as a way to increase opportunity. For instance, he stressed the importance of access to a quality education by highlighting programs such as universal pre-K and universal broadband access, and proposed efforts to get universities to improve access for low-income students.

The Pew Research Center found the percentage of adults self-identifying as middle class has declined from 53 percent in 2008 to 44 percent in 2014. While large majorities of both major political parties say the gap between rich and poor has increased in the last ten years, there is sharp disagreement over whether the government should act to reduce the gap. International investors and economists see income inequality as a drag on economic growth.