international analysis and commentary

The features, and perils, of income inequality in America

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It is said that Washington D.C. is a political and cultural bubble hardly representative of the American heartland. Some people, in particular on the right, call it “elitist,” alongside other coastal hubs such as New York and San Francisco. Yet, there is at least one way in which the federal capital is a worthy ambassador for the United States: it leads the rest of the country in the level of income inequality.

It is a problem particularly visible here – with the posh, cosmopolitan northwest corner of the city populated by lobbyists, diplomats, and students attending expensive private universities, and the downtrodden south- and north-east of low-income, low-skilled workers.

According to a recent study by the DC Fiscal Policy Institute, between 1979 and 2009 the median wage of residents of the District of Columbia who held at least a college degree rose 30% (adjusted for inflation,) while people with only a high school degree have experienced a wage increase of approximately 1%. At the national level, only Atlanta and Boston display wider gaps between the well off and the not so well off.

But income inequality is real across America and has been growing. To prove it, a host of data has emerged since the recession. And now some recent research also explains how large levels of inequality risk undermining the foundations of a healthy market economy.

A 2010 analysis by the Center on Budget and Policy Priorities shows that, on average, the after-tax income of the wealthiest Americans – those who belong to the top 1% of earners – grew a whopping 281% between 1979 and 2007. During the same period, incomes for the middle fifth of households increased only 25% and for households in the bottom fifth an even smaller 16%. 

This growth in income inequality was halted by the recession, but only temporarily. A study by Professor Emmanuel Saez of the University of California-Berkeley, found that, between 2007 and 2009 the share of national income controlled by the top 1% went from 23.5% down to 18.1%.  But in 2010, when the recovery is considered to have begun, the income of the top percentile grew by 11.6% while the other 99% saw an increase of only 0.2%.

“The pay of corporate executives has grown dramatically since the recession and the stock market has gone up, so if you make your income from the stock market, or from being a corporate executive, it’s almost like the recession never happened,” says Mark Schmitt, a senior fellow at the Roosevelt Institute. “Whereas everybody else, the 99%, took a significant hit in one form or another, some people lost their jobs while others were foreclosed on.”

The reasons of such growing gap have been widely discussed. Experts disagree on the main culprit, whether it has been the process of globalization, or technological innovation, or fiscal policy. More likely, this trend is the result of a combination of factors simultaneously at play. “On one side the top earners have specialized skills.  That includes star athletes, rock musicians, skilled surgeons, trial lawyers, and businessmen and women who run large, multinational corporations,” says Professor Allan H. Meltzer of Carnegie Mellon University. “Additionally, the growth of manufacturing jobs in China and India added hundreds of millions to the world’s work force.  That slows or halts incomes of middle-income earners in the rest of the world.  And the low quality of education prevents mainly low-income workers from developing marketable skills.”

Other economists have been looking at the role of America’s growing financial sector. Data shows that people in the highest 0.1% of earners have been pulling away from everybody else even faster than the 1% as a whole. According to a study by the non-partisan Congressional Budget Office, between 1979 and 2005 their after-tax income grew by an astonishing 400%. This is even truer for individuals at the very high end of the income distribution, those in the top 0.0001%. Financial workers comprise an increasingly large share of this group. According to a study by Steven N. Kaplan and Joshua Rauh of the University of Chicago, among people making more than $100 million in 2004, there were nine times as many Wall Street financiers as chief executives of publicly traded companies. The authors calculated that, in that year, the 25 highest-earning hedge fund managers combined brought in more than all of the CEOs at the helm of S&P 500 companies.

“In normal years the financial sector is flush with cash and high earnings,” George Mason University economist Tyler Cowen wrote in The American Interest. “In implosion years a lot of the losses are borne by other sectors of society. In other words, financial crisis begets income inequality.” It doesn’t help, at least in terms of net income, that taxes on capital gains (from which investors on Wall Street derive much of their income) have been greatly reduced in the last decade (Republican contenders in this year presidential race are proposing to cut them further from today’s rate of 15%.)

Political scientists, especially on the left, have long worried about the potentially devastating consequences of growing income inequality on democratic societies. “There is a very strong case that inequality is not only a problem in itself, but it also creates a more fragile economic system,” says Schmitt of the Roosevelt Institute. “It widens the sense of social divisions. And it makes it harder to have a democracy.”

Now economists are also looking into the question, trying to assess how inequality might affect private sector debt, public finances and economic growth. 

“The increase in private- and public-sector leverage and the related asset and credit bubbles [before the crisis] are partly the result of inequality,” writes economist Nouriel Roubini in a column for Project Syndicate. “Mediocre income growth for everyone but the rich in the last few decades opened a gap between incomes and spending aspirations.” According to Roubini, countries such as the United States and Great Britain responded to this problem by providing easy credit to middle class households so that they could borrow to bridge the gap between available income and aspirations. In Europe, instead, governments stepped in, providing services that, it turns out, were not entirely being paid for by tax collection. In both cases, private and public borrowing became unsustainable and helped trigger the crisis.

There is also another way to look at the relationship between inequality and debt. Marina Azzimonti of the Federal Reserve Bank of Philadelphia, Eva de Francisco of Towson University and Vincenzo Quadrini of the University of Southern California are the co-authors of an independent working paper on the subject. According to their analysis, growing income inequality along with the progressive liberalization and integration of global capital markets have made it more attractive for OECD countries to sell their debt, which have then skyrocketed. “When countries liberalize their financial markets, they perceive the cost of borrowing to be less sensitive to their own actions, due to the fact that the total size of the market increases relative to the size of their country,” explain Azzimonti and De Francisco. Simultaneously, growing income inequality also works in the same direction. “The way we think about inequality is that individual incomes change more drastically over time, translating into more risk for individuals, who, in turn, want to save more and allocate the savings to assets that are considered safe,” says, in a separate interview, the paper’s other co-author Quadrini. “Government bonds are considered one of the safest investments.” In short, governments find it more convenient to sell their debt both because they have access to more buyers in larger capital markets: this is the case of Greece, which, at the creation of the common currency, suddenly was able to sell high-in-demand, Euro-denominated debt,). But also because there is increased demand for safe assets: in the U.S., for example, interest rates on Treasury bonds are near zero despite the fact that the country’s public debt has been mounting and its credit rating was downgraded this past summer.

Finally, Andrew G. Berg and Jonathan D. Ostry, of the International Monetary Fund’s research department, found that income inequality might have adverse effects on growth. They focused their research not so much on factors that kick-off growth in the first place, but on those that sustain it in the long run. “Many of even the poorest countries have succeeded in initiating growth at high rates for a few years,” the two authors write in a 2011 paper. “What is rarer—and what separates growth miracles from laggards—is the ability to sustain growth.” Looking at extended periods of high growth in economies across the world, they discovered that these “were much more likely to end in countries with less equal income distributions,” a problem often experienced across South America. 

Although some inequality is considered integral to the correct functioning of a market economy, data show that the gap between the haves and the haves-not has been growing tremendously all over the world in the last three decades. New research now also highlights the economic impact implicit in rising levels of income inequality. All in all, economists and policy makers have plenty of reasons to worry.