(This essay was published in Hong Kong Economic Journal on 28 May 2014)

 

Income inequality has grown in the United States and other developed economies since the early 1970s due to the combined effects of two different phenomena. The first was an increase in the incomes of the richest 20% at the top end of the income distribution. The second was a drop in the incomes of the less well-off 80% at the middle and bottom end of the income distribution. Figure 1 illustrates how these two phenomena have stretched out the income distribution.

 

The first phenomenon relates to the observation that the only group to experience real economic gains during this period has been those in the top 20%, with gains heavily concentrated in the top 10%, 5% and — most famously — 1%. The second phenomenon relates to a different observation that the middle income class is being hollowed out and descending into the lower income class. Together these two phenomena have lowered the median income level and expanded the gap between the top and bottom of the income distribution.

 

This essay discusses the first phenomenon only. I shall discuss the second one on another occasion.

 

Inversion of the “U-Shaped” Inequality

 

Two French economists, Thomas Piketty and Emmanuel Saez, working on tax data in the US and other developed economies, have confirmed the widespread intuition that income inequality has been increasing – that one of the key regularities of post-World War II economics has fallen apart.

 

This regularity was highlighted in 1955 by Simon Kuznets, then of Johns Hopkins University, who observed that inequality in developing countries tended to describe an “inverted-U”, rising substantially for a time as workers moved from farms into industrial cities, then steadily diminishing as output grew and gains from increased productivity were more evenly distributed.

 

Piketty and Saez demonstrate that the “U” has turned decisively right side up in the developed economies – that inequality has been rising steadily since the 1970s instead of falling (see Figure 2).

They found that families making up the top 10% of the income distribution have been steadily increasing their share of all income.

 

This top 10% of earners had a heyday in the “Roaring 1920s”, when their share reached nearly 45 percent of national income.  There they remained until about 1940, when the fallout from World War II apparently knocked them down to around 33 percent of the total.

 

Their share remained at this level – about one third of national income – for a remarkably stable three decades, until the mid-1970s. Then it began to climb again, surpassing 50 percent of national income in 2012, higher than any year since 1917 and higher than the heyday of 1928.

 

Piketty and Saez also found the same “U” pattern among the top 1% of earners (see Figure 2). Their share of national income reached a peak level of 25 percent in 1928. It fell off during World War II to about 10 percent, but since the early 1980s it has crept back to more than 20 percent.

 

Piketty and Saez’s response to their findings on income distribution is entirely predictable given both are socialist in their political persuasions. They have called for the imposition of a higher marginal tax rate at the top end of income distribution to reduce income inequality – specifically, a marginal tax rate of 83% on the top 1%.

 

There are two fallacies in their reasoning. The first is that they assume the rich are getting richer, while the poor are falling behind. The second is they assume that the real income of the majority of families has not risen significantly for decades. The latter has to do with why the middle-income class is descending into the lower-income class – an issue we will discuss next week.

 

Social Mobility is Alive

 

But is it the case that the top 1% in the income distribution includes the same people year in and year out? Or, for that matter, the top 5%, 10% and 20%? To what extent do everyday Americans experience these levels of affluence, at least some of the time?

 

In Chasing the American Dream, Mark Rank, Thomas Hirschl, and Kirk Foster looked at 44 years of longitudinal data regarding individuals aged 25 to 60 to see what percentage of the American population experienced these higher levels of affluence during their lifetimes. The results were striking.

 

It turns out that 12% of the population will find themselves in the top 1% of the income distribution for at least one year. What’s more, 39% of Americans will spend a year in the top 5% of the income distribution, 56% will find themselves in the top 10%, and a whopping 73% will spend a year in the top 20% of the income distribution (see Figure 3).

 

So a majority of Americans experience at least one year of affluence at some point during their working lives. This is just as true at the bottom of the income distribution scale, where 40% and 54%, respectively, of Americans will experience poverty or near poverty at least once between the ages of 25 and 60.

 

The picture drawn from reading Saez and Piketty’s work is that the top 1% is a static population, just as the other 99% is often portrayed as unchanging. There is a line drawn between these two groups, and never the two shall cross. As a consequence, inequality is considered to be entrenched without mobility – as something to be combated by ever-higher taxes. But this is simply not warranted. It is clear that the static image of 1% versus 99% (or 10% versus 90%) is largely incorrect.

 

The empirical evidence showing that Americans move up and down the income distribution during their lifetimes casts serious doubt on the notion of a rigid class structure in the United States based upon income. If an 83% marginal tax rate were to be imposed, then it would rob most of the rich of the only opportunity they will have in their lifetime of enjoying the fruits of making it to the top 1%. This would be a negative incentive on work effort.

 

The Rich as Superstars

 

A brief look at the Forbes 400 list provides little support for the idea that fortunes are patiently accumulated through reinvestment of old wealth. When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members from 1982 would have qualified in 2012 if they had accumulated wealth at a real rate of even 4% a year. They did not, given propensities to spend, donate, or misinvest their wealth. In a similar vein, the data also indicated that the share of the Forbes 400 who inherited their wealth was in sharp decline.

 

The gains in income of the top 1% substantially represent labor rather than capital income. The official data probably underestimate this aspect — for example, some large part of Warren Buffet’s reported capital income is really best thought of as a return on his entrepreneurial labor.

 

So why has the labor income of the top 1% risen so sharply relative to the incomes of everyone else? No one really knows. Certainly there have been changes in prevailing mores regarding executive compensation, particularly in the English-speaking world. It is conceivable that as tax rates have fallen, executives have gained. But then why would hard-nosed boards and shareholders agree to exorbitant executive pay?

 

There is plenty to criticize in existing corporate-governance arrangements and their lack of resistance to executive self-dealing. There are certainly abuses. Nevertheless, the idea that productivity does have something to do with compensation should be taken seriously. The executives who make the most money are not for the most part the ones running public companies who can pack their boards with friends. Rather, they are the executives chosen by private equity firms or large family shareholders to run the companies they control.

 

The rise of income among the top 1% also reflects the extraordinary levels of compensation in the financial sector. While one has to worry about over-leveraging in the financial sector, much of the income earned in finance does reflect some form of pay for performance; investment managers are, for example, compensated with a share of the returns they generate.

 

And there is the basic truth that the late Professor Sherwin Rosen of the University of Chicago taught us in 1981 about the rise of superstars. Technology and globalization have given greater scope and opportunity to those with extraordinary entrepreneurial ability, luck, or managerial skill. Think about the contrast between George Eastman, who pioneered fundamental innovations in photography, and Steve Jobs. Jobs had an immediate global market, and the immediate capacity to implement his innovations at very low cost, so he was able to capture a far larger share of their value than Eastman.

 

This type of situation is becoming pervasive. Most obviously, the best athletes and entertainers benefit from a worldwide market for their celebrity. But something similar is true for those with extraordinary gifts of any kind. The idea that superstars in today’s digital networked economy can command audiences of millions has certainly altered reach and compensation. This phenomenon is already spreading to education, sermons, gaming and so on.

 

The opening of the Hong Kong Coliseum in 1983, with a seating capacity of 12,500 and an unobstructed view of the stage, has been instrumental in advancing the careers (and incomes) of Canto-pop stars and bringing unprecedented access to live entertainment to the local audience. Our Hung Hom Coliseum was the “technology” that “globalized” our local entertainment market.

 

Success in the English-speaking World

 

It is interesting to note that the U-shape of the top 1% of income shares is found only in the English-speaking countries (see Figure 4). In Continental Europe and Japan, the income shares are L-shaped (see Figure 5).

Why haven’t the non-English speaking countries in the developed world produced as many superstars, entrepreneurs, innovators and high compensation executives? The largest transnational companies have also been from the English-speaking economies. Perhaps the English-speaking market is a better-integrated part of the global economy. And perhaps society outside the English-speaking world is less upwardly mobile.

 

Rank, Hirschl and Foster also found in their study that nearly 80% of the population would experience significant economic insecurity at some point between the ages of 25 and 60. Moreover, the risk of economic vulnerability has been increasing substantially over the past four decades. But the surveyed Americans remained upbeat about achieving the American Dream at some point during their lifetimes.

 

Last November, five months before their book’s April 1 publication date, lead author Mark Rank wrote a New York Times editorial stating that roughly 40 percent of Americans will experience poverty at some point between the ages of 25 and 60. Days later, the Atlantic Monthly picked up on the story, and on December 4, President Barack Obama alluded to this same startling figure in a speech on economic inequality.

 

In emphasizing this point, Obama failed to tell the other side of the story and gave a very partial portrayal of poverty and upward mobility in America. My essay in the HKEJ 30 April 2014 reported that recent research on upward mobility in the US (by Chetty et al.) showed it has not changed for the generations who were born in the 1970s to the 1990s. America has frequently been referred to as the land of opportunity. It still is!

 

References

 

Raj Chetty, Nathaniel Hendren, Patrick Kline, Emmanuel Saez, and Nicholas Turner, Is the United States still a land of opportunity? Recent trends in intergenerational mobility, Working Paper 19844, National Bureau of Economic Research, January 2014

 

Mark R Rank, Thomas A Hirschl, and Kirk A Foster, Chasing the American Dream: Understanding What Shapes Our Fortunes, Oxford University Press, 2014

 

Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States, 1913-1998,” Quarterly Journal of Economics, February 2003 (more recent figures updated by authors).

 

Sherwin Rosen, “The Economics of Superstars,” American Economic Review, December 1981.

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