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On income inequality

Slate.com presents a nice set of charts on the issue of growing income inequality. It seems there is a reasonable debate to be had about whether this is a good or bad thing. The political debate goes something like this. Republicans either disclaim the growing gap (e.g., the data, as seen below, excludes government transfers, which are large), tell an incentive story (i.e., if the inequality represents increasing returns from education, as it seems to in part, then growing inequality would be a strong incentive for individuals and society to invest in education), argue that income does not correspond to well being or happiness, or invoke Gerald Ford (“If the government is big enough to give you everything you want, it is big enough to take away everything you have.?). Democrats, on the other hand, note how wealth concentration can breed political tension and unhappiness. I have no idea which of these dominates, and I’d be persuadable in either direction.

But I want to put aside this debate to get at the question of why we’ve seen an increase in inequality. The Slate.com charts and accompanying article tell us one very interesting thing — tax cuts are not to blame. Money quote: “[I]t would be hard to argue, based on this data, [tax cuts] were a major factor.” This is a pretty startling admission. Everyone admits that taxes can reduce income inequality, but there is a significant political debate about whether tax policy caused the recent increase in income inequality. It seems the answer is “no.”

So what caused the increase in income inequality? I’m not an expert in this area, but I noticed something interesting about the income inequality curve presented in the article. It is here:

I noticed a striking parallel between the shape of this curve and the shape of the curve of executive compensation. Data on the top 1000 or so executives show a remarkably similar change in the early 1980s. For instance, here is a chart from a recent paper by Frydman and Saks:

The small number of executives cannot explain the change in income, but rather is some evidence of the underlying cause. But we need to know the cause of the change in executive compensation from 1980 to present in order to understand whether there is an underlying explanation that explains both charts. The cause of the change of executive compensation is well understood. Starting in the early 1980s, executives started to be paid like shareholders (that is, with stock options) instead of bureaucrats, and the rising curve of executive compensation is explained entirely by the growth of the stock market over the same period. Here is a curve from Kevin Murphy showing this:

So, in other words, it may be that the growth of income inequality is driven by the top 1 percent getting more income from investments. If this is the case, then policies like Social Security and defined-benefit pension plans (pushed by labor unions) are somewhat to blame for this trend not being experienced more widely. Policies that push ownership and investments down the income curve, like stock options for employees and 401(k) plans, may help reduce the problem of income inequality without more government intervention.

Filed under: taxes, truth on the market

Full post as published by Truth on the Market on September 08, 2010 (boomark / email).