The great lending reversal

Historical stereotypes show that the rich owed a great share of their incomes to leverage. They invested borrowed money in remunerative enterprises and leveraged it to raise their incomes. In contrast, the middle-class and poor were seen as debt-averse and relying on debt only when forced into it. However, as this IMF study indicates, the roles, atleast in terms of the debt-aversion of the non-rich, appear to have changed. Sample this evidence from the US,

In 1983, the top 5 percent had 80 cents of debt for every dollar of income, while the remaining 95 percent had 60 cents for every dollar. By 2007, after decades in which an increasing share of income flowed to the top, the situation had reversed. The top 5 percent had 65 cents of debt for every dollar of income, while the remaining 95 percent had $1.40 in debt for every dollar.

The authors use cross-country data and develop models that try to simulate changes in income distribution and household debt to GDP ratios and its impact on the economy. Their DGSE model, where workers income shares decline at the expense of investors, show,

Loans to workers from domestic and foreign investors support aggregate demand and result in current account deficits. Financial liberalization helps workers smooth consumption, but at the cost of higher household debt and larger current account deficits. In emerging markets, workers cannot borrow from investors, who instead deploy their surplus funds abroad, leading to current account surpluses instead of deficits.  

In other words, the only way to sustain high levels of consumption and national aggregate demand growth in the face of stagnant incomes was for poor and middle-class households to borrow. And its result is widening inequality and eventual debt-default which brings down the whole economic edifice. 

They therefore argue that the only sustainable way to reduce this is to address the critical issue of stagnant incomes. It is now well-established that markets do not generate efficient outcomes with income distribution. The prevailing balance of power in the economic structure and its hand-maiden political establishment, are too skewed to generate the desired level of income distribution.

To address the immediate challenge of debt-reduction among households, an "orderly debt reduction" wherein the process takes a few years may be the most appropriate method. In the medium to long-run, given the skewed distribution of incomes between labour and capital, this market failure will have to be addressed through an institutionalized mechanism that restores some element of collective bargaining. 

The long-term economic impact of growing inequality

Inequality has been widening across the world. A recent ADB report expressed concern at the rapid rise in inequality in emerging economies and warned that it puts at risk the spectacular recent economic progress of these economies. In this context, Paul Krugman points to an exploration by Lawrence Mishel of the various causes of this widening inequality.  

Mishel attributes the growth in income inequality over the last 30 years in the US to three dynamics - rising inequality of labor income (wages and compensation), rising inequality of capital income, and an increasing share of income going to capital income rather than labor income. More specifically, he argues that divergence between pay and productivity can go a long way towards explaining this widening of income inequality,

Productivity growth has risen substantially over the last few decades but the hourly compensation of the typical worker has seen much more modest growth, especially in the last 10 years or so. The gap between productivity and the compensation growth for the typical worker has been larger in the “lost decade” since the early 2000s than at any point in the post-World War II period. In contrast, productivity and the compensation of the typical worker grew in tandem over the early postwar period until the 1970s.

He has two illuminating graphics that highlight the magnitude of its contribution. The first graphic illustrates the cumulative growth in productivity per hour worked of the total economy (inclusive of the private sector, government, and nonprofit sector) since 1948 and the cumulative growth in inflation-adjusted hourly compensation for private-sector production/nonsupervisory workers (a group comprising over 80 percent of payroll employment). Notice that after 1973, productivity grew strongly, especially after 1995, while the typical worker’s compensation was relatively stagnant.

The next graphic disaggregates the productivity-pay disparity from 1973 to 2011 by charting the accumulated growth since 1973 in productivity; real average hourly compensation; and real median hourly compensation of all workers, and of men and of women. This figure clearly shows the divergence, especially since the early nineties between productivity and different categories of compensation. In simple terms, the share of income received as wages by workers is disproportionately small when compared to the share received by the owners of capital.

In addition, he also finds that workers suffered from adverse terms of trade. In other words, the prices of things they buy (i.e., consumer goods and services) have risen much faster than that of what they produce (consumer goods but also capital goods).

I will leave Mishel to conclude,

Productivity in the economy grew by 80.4 percent between 1973 and 2011 but the growth of real hourly compensation of the median worker grew by far less, just 10.7 percent, and nearly all of that growth occurred in a short window in the late 1990s. The pattern was very different from 1948 to 1973, when the hourly compensation of a typical worker grew in tandem with productivity. Reestablishing the link between productivity and pay of the typical worker is an essential component of any effort to provide shared prosperity and, in fact, may be necessary for obtaining robust growth without relying on asset bubbles and increased household debt. 

Much the same forces are active across the world, including countries like India. The only difference is in its magnitude or severity. 

Galbraith on inequality

Here an interview with Jamie Galbraith on his new book. An important point about inequality is that it peaked around 2000 and in the first decade of this century it has improved. That is often missed by economists. According to Galbraith:

"Worldwide, inequality rose sharply from 1980 to 2000. This is a pattern you find in my data, which measure pay inequalities within countries, and also in measures of inequality between countries and in measures of the profit share in the rich countries. It's well-confirmed at this point. The pattern closely tracks the evolution of the global debt crisis: first in Latin America and Africa, then in Central and Eastern Europe, finally in Asia.

Worldwide, as in the U.S., the peak appears to have come in 2000. Since then, with lower interest rates and rising commodity prices, conditions have improved, especially in South America where inequality has declined quite a bit. Even in China we observe a peaking of inter-regional inequality in the mid-2000s, although inequality between sectors (for example, inequalities related to the rising power of the banks) continued to increase."

Prices of commodities and higher growth in the periphery are a crucial element of the reduction in inequality in certain parts of the world. The burst of the bubble too reduces inequality in developed countries, but of course it remains (both in the center and in the periphery) at very high levels.

Recovery with a human face

There have been many fora for discussions about the crisis, and its consequences on the more vulnerable around the globe. The electronic debate moderated by United Nations was among the more interesting. Topics ranged from the impacts of the crisis to policy responses and alternative options for socio-economic recovery. Now a summary of the debates is avaliable here:

A Recovery with a Human Face? Summary of a UN e-discussion

A more thorough analysis of the issues debated can be found in the recent publication A Recovery for All: Rethinking Socio-Economic Policies for Children and Poor Households, which can be downloaded for free here.

Thanks go to Isabel Ortiz for sharing the information, and for her commitment to the whole project.

Inequality and taxation in the US

America's deep fiscal hole and spectacular income growth at the top of the income ladder has ignited a debate on increasing the marginal tax rates, especially for the richest.

This striking graphic from Thomas Piketty and Emannuel Saez brilliantly captures the stunning magnitude of concentration of wealth at the top over the past quarter century. In order to mitigate the effects of this, they propose a "much higher top marginal tax rates on the rich, up to 50 percent, or 70 percent or even 90 percent, from the current top rate of 35 percent". Peter Diamond and Emmanuel Saez have estimated that the optimal tax rate on the highest earners is in the vicinity of 70%.


In fact since the mid-eighties, income gains at the topmost part of the income ladder dwarf those elsewhere. As the after-tax incomes of the top 1% households rose 277% in the1979-2007 period, those of the bottom quintile just nudged up 18%.

An important contributory factor to this rise in income inequality has been the declining marginal tax rates. As David Leonhardt points out, the effective tax rates - including income, payroll, and all other federal taxes - have declined dramatically in the last 50 years for the very rich. The US tax code while still progressive, is not nearly as progressive as it used to be.

See also this excellent series of graphics from Derek Thompson.

Update 1 (29/4/2012)

The Times has this graphic which shows how as corporate profits have exploded, effective tax rates have fallen. 

 

Buffett rules

Brief comment by Jamie on Buffett's rule, that is a minimum tax of 30% on millionaries (annual income above a million). His point is that it would be only symbolic, from the point of view of additional revenue, but it would be important for pushing the debate on income distribution. Hey, anytime we talk about millionaires rather than 'job creators' I'm happy!

PS: More here, where he also talks about his proposal to increase the minimum wage to US$ 12.

America's income inequality in a graphic

The graphic strikingly captures the nature of income growth and resultant contribution to widening inequality in the United States. Though median income grew from $8,734 in 1970 to $49,445 in 2010, almost all the real income gains were captured by those at the top 10%. The contrast with economic growth in the previous half-century could not have been starker.

In fact, as Emmanuel Saez has documented, during the 2010 recovery, the top 1 percent captured 93 percent of the income gains, while the incomes of the 99 percent essentially remained flat.

Inequality and economic instability

Jamie Galbraith's new book  is out. The main thesis in the book is that the inequality of the past three decades, driven fundamentally by financialization, led inexorably to boom and bust instability. A recent interview about his book and the current economic situation can be found here.

Why redistribution matters?

John Sides in The Monkey Cage has an excellent post that points to the distinction between the progressivity of taxation and the level of inequality.

This paper by Moinca Prasad and Yingying Deng has an excellent graphic of the progressivity of direct taxes, as measured by the Kakwani index of taxation (a measure of the progressivity in the distribution of taxes among different categories that controls for the impact of income concentration on the concentration of the tax burden), in many advanced countries.



However, given its relatively higher Gini coefficient, America's progressivity of taxation does not translate into lower income inequality. So what gives? The aforementioned paper shows that the high progressivity in America's taxation system is matched by the low level of income redistribution through welfare policies. In simple terms, it is America's welfare policy that needs immediate attention than its taxation policy. The graphic below highlights the role played by income redistribution in lowering inequality.



The Scandinavian countries achieve twice as much inequality reduction (as measured by the lowering of their respective Gini coefficients) by redistributive policies than the Anglo-American nations. It is not a coincidence that these countries have much higher levels of taxation as measured by their higher tax-to-GDP ratios. It appears that higher redistribution goes hand-in-hand with higher levels of taxation.



Interestingly, the association between tax progressivity and overall re-distribution through taxation across countries is negative.



Though the study speculates on several political economy reasons, none of them are satisfactory enough to provide a good explanation for this surprising inverse correlation.

These graphics are an excellent empirical illustration of the importance of enlightened public policy in lowering inequality and poverty. It is also a strong reminder to free-market evangelists that unfettered markets fail to achieve the desired conditions necessary to promote growth and reduce poverty and inequality.

Income inequality and educational outcomes

Widening income inequality is arguably one of the biggest challenges facing the economy and society in both developing and developed countries. Addressing it assumes greater significance given the dynamics of forces shaping global economic trends. For a variety of factors, these forces institutionally favor children from families with higher incomes.

Children from more well-off families have numerous socially institutionalized advantages that put them well-ahead of those from poorer families. One, they are most likely to attend the best or better schools. Two, their parents can afford to spend more time and resources with them and show much greater interest in their education. Three, their social and family environment is much less likely (than that of children from poorer backgrounds) to be detrimental to the child's learning process. Four, they attend good early childhood education centers and other learning institutions, which gives them a head start when they join school. Finally, they are more likely to have exposure to various other non-school based, formal and non-formal literacy related platforms.

The Times has an excellent article that points to a sharp spurt in learning achievement gap over the past few decades between children from rich and poor family backgrounds.

A Stanford University study has found that the gap in standardized test scores between affluent and low-income students had grown by about 40% since the 1960s, and is now double the testing gap between blacks and whites. It analyzed 12 sets of standardized test scores starting in 1960 and ending in 2007 and compared children from families in the 90th percentile of income and children from the 10th percentile. It highlights the increased role of family incomes in determining children's learning levels,

"The relationship between parental education and children’s achievement has remained relatively stable during the last fifty years, whereas the relationship between income and achievement has grown sharply. Family income is now nearly as strong as parental education in predicting children’s achievement... a given difference in family incomes now corresponds to a 30 to 60 percent larger difference in achievement than it did for children born in the 1970s."

Another study by University of Michigan researchers that uses data from nearly 70 years finds the imbalance between rich and poor children in college completion — the single most important predictor of success in the work force — has grown by about 50 percent since the late 1980s.

"Wefind growing gaps between children from high- and low-income families in college entry, persistence, and graduation. Rates of college completion increased by only four percentage points for low-income cohorts born around 1980 relative to cohorts born in the early 1960s, but by 18 percentage points for corresponding cohorts who grew up in high-income families. Among men, inequality in educational attainment has increased slightly since the early 1980s. But among women, inequality in educational attainment has risen sharply, driven by increases in the education of the daughters of high-income parents. Sex differences in educational attainment, which were small or nonexistent thirty years ago, are now substantial, with women outpacing men in every demographic group."

Times points to the critical importance of early childhood education which gives children from better economic circumstances a head-start in the education race.

"Meredith Phillips, an associate professor of public policy and sociology at the University of California, Los Angeles, used survey data to show that affluent children spend 1,300 more hours than low-income children before age 6 in places other than their homes, their day care centers, or schools (anywhere from museums to shopping malls). By the time high-income children start school, they have spent about 400 hours more than poor children in literacy activities."

Economix points to this intuitive explanation from a behavioural psychology perspective about the relationship between income deprivation and parenting outcomes. The implication is that well-off parents, being less likely to be hassled by their daily chores, are therefore more likely to have enough emotional energies to concentrate on their child's educational needs. They write,

"Good parenting requires psychic resources. Complex decisions must be made. Sacrifices must be made in the moment. This is hard for anyone, whatever their income: we all have limited reserves of self-control, and attention and other psychic resources... Low-income parents... face a tax on their psychic resources. Many things that are trifling and routine to the well-off give sleepless nights to those less fortunate."

Tax and transfer to reduce inequality

I have blogged repeatedly about the critical role played by government transfers in reducing inequality and the unsustainability of economic growth in conditions of high inequality. However, transfers require tax revenues. This highlights the importance of taxation in addressing poverty and creating conditions for sustainable economic growth. The graphic below from The Economist draws attention to this.



In most European nations, the poverty rates are lower only because of the significant role played by government transfers. Transfers nearly halve poverty rates in these countries. Contrast this with the United States where the lower extent of transfers are responsible for keeping poverty rates high.

The role of taxes and transfers is even more pronounced with inequality measures. Similar trans-Atlantic trends persist with inequality reduction due to taxes and transfers. In case of many developing countries, as the cases of Mexico, Brazil, and Chile show, the low levels of transfers contribute towards their poverty and high inequality rates.

Inequality and mobility

The so-called Great Gatsby diagram that Alan Krueger presented recently shows that there is a positive correlation between inequality and lack of social mobility. The graph below shows a full version.

Note that the only African and the four Latin American countries are on the higher end of the graph, while the four Nordic and the three British off-shoots in the sample are at the other end of the Gatsby curve. The US uncomfortably close to the higher end of the curve. No particular observation. Graph does all the job. The source for the graph is Miles Corak here.

Why taxes are important to reduce poverty and inequality?

Free market conservatives oppose big government and favor reduction in taxes as the preferred route to the achievement of economic growth. They argue that governments are inherently ineffective in efficiently allocating resources and therefore should give way and facilitate private enterprise to achieve the same objective.

They claim that economic growth, thus achieved, will "trickle down" to benefit everyone by way of more jobs, higher wages, and better living standards. They therefore advocate that government's role should be confined to unshackling the restraints to private enterprise and providing everyone with the basic opportunities - health care, education, and skills - to compete in the market.

However, as Lane Kenworthy (see also this earlier) points out with empirical evidence, reality is not as simple. In fact, examining the trends in income levels among those at the lower end of the income ladder in the advanced economies since the 19760s, he finds that it was not trickle down but direct transfers that kept incomes growing. He writes,

"In almost all of these countries (Ireland and the Netherlands are exceptions) the earnings of low-end households increased little, if at all, over time. Instead, increases in net government transfers — transfers received minus taxes paid — tended to drive increases in incomes when they occurred."

The graphic below captures the average household income in the bottom decile of the posttransfer-posttax income distribution. Group 1 is Denmark, Finland, Ireland, Netherlands, Norway, Sweden, and United Kingdom, while Group 2 includes Australia, Canada, Germany, Switzerland, and United States.



Clearly, incomes have increased substantially after transfers for those in Group 1. In fact, Kenworthy goes further and argues that jobs and higher wages cannot produce the same trickle down effect on those at the bottom end. He writes,

"At higher points in the income distribution, they do play more of a role. But for the bottom 10 percent there are limits to what employment can accomplish. Some people have psychological, cognitive, or physical conditions that limit their earnings capability. Others are constrained by family circumstances. At any given point in time, some will be out of work due to structural or cyclical unemployment. And in all rich countries, a large and growing number of households are headed by retirees. We surely can do better at helping able adults get into (or back into) employment, but we shouldn’t pretend that paid work is a realistic route to guaranteeing rising incomes for everyone."

He also points to the importance of keeping income transfers dynamic enough to ensure that its share of incomes do not fall appreciably with time. He draws attention to the fact that in most affluent nations, including the Scandinavian ones, while transfers have increased, it has not done so at the rate required to keep its share of the GDP from falling. He writes,

"In most of these affluent nations... increases in the share of GDP allocated to public transfers largely stopped after the 1970s. In recent decades, the distinction has been between countries that kept transfers rising in line with GDP versus those that did not. Sometimes doing so requires no explicit policy change, as benefit levels tend to rise automatically as the economy grows. This happens when, for instance, pensions, unemployment compensation, and related benefits are indexed to average wages. Increases in other transfers, such as social assistance, typically require periodic policy updates. That’s true also of tax reductions for low-income households."

In particular about the US, his suggestion is,

"What the income data tell us is that the United States has done less well by its poor than many other affluent nations, because we’ve failed to keep government supports for the least well-off rising in sync with our GDP... Modest, regularized increases in the inflation-adjusted benefit levels of existing social programs — the Earned Income Tax Credit, unemployment compensation, social assistance (TANF and SNAP), housing assistance, and disability benefits — would yield significant improvements in the incomes of America’s least well-off."

Kenworthy's findings carry important lessons for policy makers in India. It clearly establishes that economic growth alone cannot address the problems of poverty and inequality, all the more so in regulated and under-developed markets like India. Government transfers are more important in achieving poverty reduction objective, especially for those at the bottom of the income ladder. However, there are two points of qualification.

One, transfers can be meaningful only when the the fiscal balance is in order and governments have the resources to carry out such transfers. Robust economic growth is the only route to keeping public finances in good strength. Two, it is important to ensure that these resources are utilized to deliver bang for the buck. The most effective strategy to optimize public spending is to channel it towards those activities which address market failures and enables equality of opportunity to all citizens in accessing the market. This requires a very scarce commodity - far-sightedness in public policy making.

Graphic linkfest from 2011

Excellent graphics from the Wonkblog, BBC, and the Atlantic. All graphics below highlight important economic and social trends in a most striking manner.

It is no secret that any meaningful attempt to rein in America's debts has to involve addressing the burgeoning public health care expenditure. The graphic below makes this clear. Relentlessly rising health care costs coupled with demographic changes are driving the growth of these programs, while the open-ended structure of these programs is responsible for much of the increase in health care costs.



This graphic captures the extent of political polarization in the US. In the late 1960s, the most conservative Democrats in the House and the most liberal Republicans voted together frequently enough (as shown by the overlap between the two distributions) to make centrist legislating successful. By the late 1980s, that overlap was dwindling and today, it is largely gone.



Inequality is already one of the most important concerns for the US economy. As the graphic shows, corporate profits have not only recovered their post-recession highs, they’ve surpassed it and are growing, even as workers compensation as a share of the economy is declining continuously.



Thomas Gallagher of Scowcroft Group points out from the graphic below that the steep bull market since the early 1980s and the fact that previous such bull markets were preceded by pretty severe bear markets, is reason enough to be minimize expectations for overall stock market gains over the next several years.



Given the extent of job losses during the Great Recession, this Hamilton Project graphic shows that it may be years before the US economy regains the pre-recession level of jobs. If the economy adds about 208,000 jobs per month, which was the average monthly rate for the best year of job creation in the 2000s, then it will take until February 2024 — over 12 years — to close the jobs gap.



The chart below shows the real GDP in the US and the level of total civilian employment from 2002-2011. Its trends are an indicator of the gravity of labour market problem facing the US economy. While the total output has regained the pre-crisis level, the labour market is stuck way below. In other words, the US economy is producing the same output as in Q4 2007 with 6.6 million fewer workers. This jobless recovery points to a combination of increased productivity and labour market shifts (towards jobs which employ fewer jobs).



The graphic below captures the true magnitude of the global macroeconomic imbalance. It highlights the explosion of current account surpluses and official investments of delveloping economies in foreign financial assets, especially US Treasury Bonds. The mirro image of this is the rise in current account deficits in the developed economies.



Tyler Cowen's book, The Great Stagnation, has drawn attention to the stagnation in the Total Factor Productivity (TFP) of the US economy since the early 1970s. TFP is a measure of how much the economy is receiving a boost from innovation and new ideas, as opposed to, say, people working longer hours or taking a second job.



The graphic below highlights the power of the Fed's monetary policy announcements. On August 9, 2011, the FOMC meeting minutes announced that the economic conditions were 'likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013'. The market reaction was impressive.



One of the most powerful measures of the depth of the Great Recession is the output gaps that have emerged in both sides of the Atlantic. Bridging them could take years.




The two illuminating graphics ought to clarify the source of America's current debt crisis. It clearly points to the Bush legacy - tax cuts and Iraq-Afghan wars - as the main drivers of the ballooning deficit. Further, the much maligned stimulus spending and bailout policies have contributed only marginally to the debt stock and deficit. However, the loss of revenues due to the economic downturn has had a very significant effect.

Framing the inequality debate

Widening inequality is arguably one of the most important socio-economic challenges facing societies, rich and poor, across the world. Unfortunately, despite the steep widening of inequality in recent years, it has not generated the anticipated level of social outrage.

In a recent article in the NYT, Ian Ayres and Aaron Edlinn, had called for a Brandeis tax, as a tax directly on inequality. The Brandeis Ratio is the average income of the richest one percent of household to the average median household income. This ratio has risen alarmingly from 12.5 in 1980 to 36 by 2006. The Brandeis tax be an automatic extra tax on the income of the top 1 percent of earners — a tax that would limit the after-tax incomes of this club to 36 times the median household income. It would therefore be an inequality capping tax.

In a series of posts in Freakonomics, they take their argument one step ahead and advocate that the debate on income inequality be framed in terms of "medians". They write,

"Framing income inequality in terms of "medians" is also part of a larger goal of making the median household incomes more salient... Part of our goal is to change the way politicians speak about income equality. Framing the income of the wealthy in relation to the median income will help us all keep in mind the relative success of the middle class.

It might even be useful to describe other things in terms of medians. A new Cadillac Escalade will run you 1.4 medians. A year’s tuition at Yale Law School is about .88 medians. We might even restructure government salaries so that they automatically adjust with the median... To raise the prominence of the median measure, government could standardize a "mi" symbol."

Behavioural psychologists have long pointed to the power of framing in re-orienting the human mind. In the instant case, absolute income numbers are not very effective in signalling about the degree of inequality. However, when the same is framed in terms of "mi", the extent of inequality becomes cognitively striking.

Similar framing can be an effective strategy in the various conservation (water, electricity etc) and environmental awareness campaigns. Water closets could be rated based on the number of buckets of water used. Air conditioners can be rated by describing their energy consumption as a multiple of that of a fan. In all these cases, the message is framed in a language that is readily graspable and therefore cognitively salient.

In this context, economist Robert Frank has constructed a Toil Index to more evocatively highlight the middle-class squeeze. It represents the number of monthly hours of work required to rent a house in an area served by a school of average quality. And it has just shot up vertically since the last decade.

Income inequality and sustainable growth

Eduardo Porter points to the work of IMF economists Andrew Berg and Jonathan Ostry that questions the sustainability of economic growth in conditions of widening inequality. They argue that "sustainable economic reform is possible only when its benefits are widely shared".

They found that in high-inequality nations spurts of growth ended more quickly, and often in painful contractions. They find that a 10 percentile decrease in inequality (represented by a change in the Gini coefficient from 40 to 37) increases the expected length of a growth spell by 50 percent.





They also found that income distribution contributes more to the sustainability of economic growth than does the quality of a country’s political institutions, its foreign debt and openness to trade, the level of foreign investment in the economy and whether its exchange rate is competitive.



The graphic below highlights why widening inequality is a much greater cause for concern in the US



Extreme inequality and its rapid widening is especially bad for developing economies like India, which are even otherwise vulnerable to supply and demand-side business cycle shocks. As Porter briefly mentioned, such widening inequality has implications which go beyond economic stability. It threatens political stability and forces democratic governments down the slippery slope of political populism.

I am inclined to believe that the rapid explosion of competitive populism in India in recent years is in no small measure due to the rapid rise in income inequality and the perceived need for governments to placate increasingly alienated and disgruntled voters who have come to believe that they are being short-changed in the sharing of benefits of liberalization and globalization. As the inequality gap widens further, the propensity for competitive populism will only increase.

This creates a policy gridlock, a low-level equilibrium, from where governments find it difficult, fiscally constrained, to meaningfully address the critical issues that determine sustainable economic growth. Among other things, it contributes to the stifling of reforms and the weakening of governance.

Inequality and the "Big Sort"

Peter Orszag has a scholarly op-ed in Bloomberg where he points to the pernicious consequences of widening inequality,

"To a stunning degree, Americans are increasingly moving into neighborhoods with other people who have similar incomes and share their political views. Bill Bishop and Robert Cushing... and others have documented the way Americans increasingly live near people with similar political views. This residential sorting by political party has occurred despite an ongoing overall decline in housing mobility."

He points to a new study by Sean Reardon and Kendra Bischoff who find that Americans are increasingly choosing to live near people in their own income bracket. They find that whereas almost two-thirds of American families lived in middle-income neighborhoods in 1970, it declined to just 44% by 2007. Further, the share of those living in a poor neighborhood, in the same period, more than doubled, from 8% to 17%, and those living in an affluent neighborhood rose from 7% to 14%. Another study by Tara Watson concluded that trends in income inequality can fully explain recent increases in economic segregation.

More worryingly, these trends are also impacting voting patterns. Orszag points to Andrew Gelman who has shown how "within any given state, higher-income people are much more likely to vote Republican". Orszag writes,

Gelman finds that although, in any state, higher- income people are more likely to be Republican, the link between income and party affiliation in blue states is less dramatic than it is in red ones. In other words, as you move up the income scale in a Democratic state, the proportion of Republicans rises, but not as much as it does in a Republican state. That higher-income people in red states are so much more likely to vote Republican helps explain the blue state-red state conundrum. My personal experience is consistent with this: It is rare to meet a high-income Democrat in a red state.

His conclusion is instructive,

Residential segregation by income has been increasing markedly, and since income is strongly related to voting patterns, this phenomenon may help explain the rise in residential segregation by political party. As we surround ourselves with people like us, we reinforce our own views, and the result is a more polarized population.

Capital gains and income inequality

Capital gains, mainly from financial assets, is the biggest source of income growth for those at the top of the income ladder. Consider this from an Economix post by Laura Tyson,

According to the Congressional Budget Office, from 2002 to 2007 more than four-fifths of the increase in income inequality was the result of an increase in the share of household income from capital gains, with the remainder the result of an increase in other forms of capital income. Capital and business income are much more unevenly distributed than labor income and have become more so over time. Capital gains income is the most unevenly distributed — and volatile — source of household income. The top 0.1 percent earns about half of all capital gains, and such gains account for about 60 percent of the income of the top 400 taxpayers.

Ironically, it is also that income stream which is taxed at the lowest rate. Capital gains tax was lowered from 28% to 20% by Clinton in 1997 and then to 15% by Bush in 2003. As "carried interest", President Bush extended this rate to fees earned by hedge fund and private equity managers. In other words, while wages are subject to both federal income tax and the payroll tax, capital gains and dividends are taxed at 15% and are not subject to the payroll tax.

These trends are not unique to the US and has become the norm across the world. In fact, in India, long-term capital gains, defined by investment of more than one year, in many assets are tax exempt. Apart from the dramatic concentration of wealth and the widening inequality, the incentives created by the lower capital gains taxes is responsible for the skewed growth of the financial sector itself. Raising this tax to the level of that for other labor income streams, would curtail outsize compensation in the financial sector. Besides, in these times of fiscal crisis, it would provide a much needed boost to government finances.

The largest income transfer in history?

I have blogged here, here, and here with graphics about the alarming concentration of wealth in the US. But this superb graphic series in Mother Jones is simply outstanding and cognitively striking.

This graphic compares how much various income groups make today versus how much they would be making if everyone's incomes had grown at similar rates since 1979. By 2005, the bottom 80% were collectively earning about $743 billion less per year while the top 1% were earning about $673 billion more.



Over the past three decades, the US economy has become the classic winner takes all economy. Even as incomes of all others have remained more or less stationary, those of the top 1% have ballooned.



Productivity has increased, but income and wages have stagnated for all Americans, except those at the top one percentile.



Despite all these, why do Tea Party activism generate front page news? It can atleast partially be attributed to ignorance, as this cognitively striking graphical representations of actual distribution of income and wealth conveys.



I would not be surprised if this would constitute the largest income transfer ever in history anywhere in the world from one income category to another. The public policy dynamics of these three decades in the US has facilitated this widening of inequality. On similar issues, see the comparison of the US with Canada, Germany and Sweden.

Would be great to have such graphical representations of income distribution and other inequality determining aspects in India. The importance of such information in awareness creation and contributing to the depth of public debates on issues of popular concern is underestimated. If the rich data collected by state and central government departments, including the census office, on various sectors is made freely available in readily usable formats, it would be picked up by various advocacy groups and researchers, to generate such striking graphics. Public debate would be the richer for that.

Financial sector and widening inequality

(HT: New York State Comptroller’s Office, via Economix)

Update 1 (15/3/2012)

Times writes,

Before 1990, pay for the chief executives of financial firms were on par with those of chief executives of the largest traded companies, or even slightly lower. By 2005 the pay was roughly 250 percent bigger on average, said Ariell Reshef, a professor of economics at the University of Virginia. Broadly speaking, between 1980 and 2005, bonuses and salaries in finance increased 70 percent more than average pay elsewhere.