Forms and sources of inequality in the United States

Jason Furman 17 March 2016

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The US economic recovery entered its seventh year in 2015, with the unemployment rate falling to half its 2010 peak and nominal wages growing at the fastest rate since the Global Crisis. While it is important to remain vigilant about the short-run macroeconomic outlook, especially the risks posed from outside the US, we should not lose sight of the longer-term challenges that the US economy has faced for decades — especially the insufficient growth of middle-class incomes.

Last year, I wrote about the three factors that drive middle-class incomes:

  • Productivity growth,
  • Inequality, and
  • Participation in the labour market.

This year, the 2016 Economic Report of the President (Council of Economic Advisers 2016) examines the economics and policies that can strengthen productivity while addressing inequality, promoting robust and inclusive growth shared by a broad group of households.

Traditionally, many economists subscribed to a trade-off between growth and inequality, that pro-growth policies could not simultaneously fight inequality. But recent research and policy experience shows that the relationship between growth and inequality is much more complicated. This column looks under the hood, analysing the rise in inequality according in its various forms — of income, wealth, and opportunity — and its various sources — competitive markets and economic rents. Targeted policies that reduce inequality of opportunity and reduce the influence of economic rents can improve the income distribution while also boosting productivity, and other policies have the potential to reduce inequality and increase incomes in an efficient manner. Such policies form the backbone of the President’s agenda for inclusive growth.

The forms of inequality: Income, wealth, and opportunity

The promise of unequal outcomes provides incentives for individual effort and therefore can play a productive role in the economy. Large rewards can motivate innovators, entrepreneurs, and workers and compensate them for taking large personal risks — choices that, in some cases, can benefit households more broadly across the economy. Hard work and personal capital developed the first personal computer, its developer reaped great rewards, but so too did aggregate productivity. Inequality can also simply reflect the choices of two otherwise identical people who make different decisions about how to balance work versus leisure, or an unpleasant job at a high wage versus a pleasant job that pays less.

But excessive inequality may also reflect substantially more than ‘just desserts’, ranging from luck to economic rents. Moreover, while some inequality can play a role in encouraging growth, excessive inequality is not necessarily essential to growth and may even impede growth. This is especially true to the degree that inequality derives from interfering with the competitive market or protecting high returns to capital or labour with barriers, natural or otherwise. To understand how to promote widely shared growth, it is critical to distinguish among various forms of economic inequality to better understand their sources and the relevant policy solutions.

Income inequality

Although a global issue, income inequality is particularly important in the US in terms of both its level and in recent changes. Large advanced economies have seen a persistent trend of rising inequality for decades, as the very highest earners capture a larger share of aggregate income. Until the 1980s, the US experience was similar to other countries, as recently as 1975, the top 1% garnered a similar share of the income in the US as in other G7 countries, as shown in Figure 1. But since 1987 the share of income going to the top 1% in the US has exceeded every other G7 country in each year that data are available. Moreover, the US has continued to diverge further from other advanced economies, with the top 1% income share rising 0.2 percentage points a year on average in the US from 1990 to 2010, well above the 0.1 percentage point average increase in the UK, for example. While comparable international data are scarce after 2010, the gains of the top 1% have continued in the US. In 2014, the top 1% captured 18% of income, up from 8% in 1975 (World Wealth and Income Database 2015).

Figure 1. Share of income earned by top 1%, 1975-2014

Note: Data for all countries exclude capital gains.
Source: World Wealth and Income Database (Alvaredo et al. 2015).

Wealth inequality

When unequally distributed income is saved, it results in unequally distributed wealth. Growing wealth inequality in the US reflects many of the trends and many of the same causes as rising income inequality. Wealth inequality is particularly difficult to measure accurately because we do not track wealth in the way we do income and trends in wealth inequality are concentrated among a small number of households.

One perspective on wealth inequality comes from the Federal Reserve’s Survey of Consumer Finances which, as shown in Figure 2, shows that the top 3% of households have held more than 50% of aggregate wealth since 2007 (Bricker et al. 2014). This share has been on a consistent uptrend since the late 1980s. The next 7% of households in the wealth distribution hold roughly 25% of aggregate wealth, a share that been fairly stable time during this period. Notably, the loss in wealth share experienced by the bottom 90% of households, which in 2013 held only 25% of all wealth, is accounted for by the rise in share captured by the top 3%. This is not a uniform spreading of the wealth distribution, it is a rising concentration of wealth at the very top. Another perspective on wealth, from imputed numbers based on tax data on capital income, finds an even larger increase in wealth concentrated at the very top of the distribution (Saez and Zucman forthcoming).

Figure 2. Share of total wealth held by wealth percentile, 1989-2013

Source: Federal Reserve Board of Governors, Survey of Consumer Finances.​

Inequality of opportunity

The traditional argument that inequality results from normal economic competition rests on the notion that competition for unequally distributed rewards encourages production. But when inequality has become so entrenched that it passes across generations and limits opportunity, it narrows the pool of human capital that can compete. Such throttling of opportunity is bad for growth, preventing potential innovators and workers from full economic participation and weighing on productivity growth. Further, if entrenched interests are able to limit future competition either by influencing the policymaking process or by abusing their market power, dynamism in labour markets or firm entry can decrease. The implications of unevenly distributed opportunity are simpler than those of income and wealth inequality — working the wrong way for both equity and efficiency.

It is important to understand the forms that this inequality of opportunity takes and to explore the institutional structures that entrench the pattern. Three particular examples that the Council of Economic Advisers has recently explored in a series of reports include the disadvantages faced by children in low-income families, inequities in the criminal justice system, and the challenges women face in the US economy. In each of these cases — as in many other areas where unequal opportunities limit full economic participation — the case for a trade-off between equality and growth is much weaker. Such unequal opportunities are, all else being equal, unambiguously bad for our economy.

The interplay of the forms of inequality

These three forms of inequality discussed above are not conceptually distinct phenomena — they closely affect one another. Wealth inequality is, in some respects, an outcome of income inequality, as the saving of unequally distributed income produces unequally distributed wealth. But inequality of opportunity is in many ways both a cause and a result of income and wealth inequality. Therefore, unequally distributed opportunities entrench an unequal income distribution, and an unequal income distribution leads to many of the inequities faced by low-income and low-wealth children.

The ‘Great Gatsby’ curve, a term introduced by former Council of Economic Advisers Chairman Alan Krueger, illustrates the relationship between income inequality and inequality of opportunity. Figure 3 shows that areas of the US with more income inequality also tend to have less mobility for children from low-income families. A similar pattern holds across countries. The Great Gatsby curve shows that inequality is correlated with lower mobility, and one important transmission mechanism is the distribution of opportunity. When disparities in education, training, social connection, and the criminal justice system are distributed as unequally as overall wealth, poorer families have a much harder time succeeding in the economy.

Figure 3. The ‘Great Gatsby Curve’ within the US

Note: U.S. commuting zones were ordered by Gini coefficient and divided into 20 equally sized bins. Each blue dot represents a single bin. Upward mobility reflects the mean percentile in the 2011-2012 national income distribution for those individuals in each bin whose parents were at the 25th percentile of the national income distribution between 1996 and 2000.
Source: CEA calculations based on Chetty (2014).

The sources of inequality: Competitive markets and economic rents

In part, income inequality has risen as a consequence of the evolution of competitive markets. To some extent, some of these forces — like technological change and globalisation — reflect the type of desirable economic progress that promotes productivity growth. Technology has increased the returns to skills, and the rise in educational attainment has not kept up, resulting in greater gains for the most-skilled workers. Increased income inequality therefore in part reflects increased differences in the productivity of different workers. But that competitive channel works best when the competition is open to the broadest pool of potential labour and investable capital. Public policy is therefore critical to ensuring that the competitive channel works well, by promoting equality of opportunity writ large. That includes investments in the education, health, and well-being of lower-income children and reforming our criminal justice system, but also providing a safety net for those who face barriers to success in the evolving competitive market — such as providing job retraining, unemployment insurance, robust social security, access to health care, and other policies for which the president has advocated.

But at the same time, a growing body of evidence suggests that much of the rise in inequality stems from cases where markets fail to be competitive. When barriers to competition such as monopolies or preferential government regulations prevent new entry into markets, incumbents can collect more income than their productivity justifies — an economic rent. Evidence suggests that the generation of rents and their increasingly unequal distribution have contributed to the recent rise in inequality. As more rents are captured by a select few investors and high-income earners, inequality worsens but productivity does not grow — the opposite of inclusive growth.

The division of rents

Rents impact inequality not only through their overall level, but also in the way they are divided. Whenever a firm hires a worker, the difference between the highest wage the firm would pay and the lowest wage the worker would accept — the surplus created by the job match — is an economic rent. The division of that rent between firm and work depends on their relative bargaining power. As markets grow concentrated and certain forms of labour are commoditised, the balance of bargaining power leans toward the firm. Unionisation and collective bargaining — along with policies like the minimum wage — help level the playing field, encouraging the firm to share those rents with labour. This process traditionally helped bolster the wages of lower- and middle-wage workers, thereby reducing inequality.

But union membership has declined consistently since the 1970s, as shown in Figure 4. Approximately a quarter of all US workers belonged to a union in 1955 but, by 2014, union membership had dropped to just below 10% of total employment, roughly the same level as the mid-1930s. In some states, just 3% of workers belong to unions (CEA 2015).

Figure 4. US union membership and top 10% income share, 1917-2015

Note: Union membersahip is expressed as a percent of total employment. Total employment from 1901 to 1947 is derived from estimates in Weir (1992). For 1948 to 2014, employment data are annual averages from the monthly Current Population Survey.
Source: Troy and Sheflin (1985); Bureau of Labor Statistics, Current Population Survey; Weir (1992); World Wealth and Income Database; CEA calculations.

Research suggests that declining unionisation accounts for between a fifth and a third of the increase in inequality since the 1970s (Western and Rosenfeld 2011). Unions also increase the likelihood that workers have access to benefits and work under safe conditions.  

Evidence for the growth in economic rents

The challenge is not just that the division of rents is changing based on comparative bargaining power. Moreover, the structure of the US economy and market appears to be generating greater rents and tilting these toward profits and profitable firms.

One important piece of evidence that rents are on the rise is the divergence of rising corporate profits and declining real interest rates. In the absence of economic rents, corporate profits should generally follow the path of interest rates, which reflect the prevailing return to capital in the economy. But over the past three decades, corporate profits have risen as interest rates have fallen, as shown in Figure 5. This suggests that some corporate profits could reflect an increase in the economic rents collected by corporations, not a ‘pure’ return to capital. Of course, this divergence can be affected by other factors such as credit risk, but such factors are unlikely to explain the full gap.

Figure 5. Corporate profits and real interest rates, 1985-2015

Note: Corporate profits for 2015 are an average of the first three quarters of the year. The real U.S. Treasury rate is defined as the nominal constant-maturity rate estimated by the Federal Reserve, less realized inflation defined by the Consumer Price Index.

Source: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve

Another piece of evidence for the rising importance of rents is increased market concentration across a number of industries. Table 1 shows that the share of revenue earned by the largest firms increased across most industries between 1997 and 2007. This observation complements a range of studies that find increasing concentration in air travel, telecommunications, banking, food-processing, and other sectors of the economy.

Table 1. Change in market concentration by sector, 1997-2007

Note: Concentration ratio data is displayed for all North American Industry Classification​ System (NAICS) sectors for which data is available from 1997 to 2007.
Source: Census Bureau.

Increased concentration may play a role in the strikingly large and growing disparity in return to invested capital across major corporations (Furman and Orszag 2015). As shown in Figure 6, the returns earned by firms at the 90th percentile are now more than six times larger than those of the median firm, up from less than three times larger in 1990.

Figure 6. Return on invested capital excluding goodwill, US publically-traded nonfinancial firms, 1965-2014

Note: The return on invested capital definition is based on Koller et al (2015), and the data presented here are updated and augmented versions of the figures presented in Chapter 6 of that volume. The McKinsey data includes McKinsey analysis of Standard & Poor’s data and exclude financial firms from the analysis because of the practical complexities of computing returns on invested capital for such firms. ​
Source: Koller et al. (2015); McKinsey & Company; Furman and Orszag (2015). 

There is also evidence of increased rent-seeking in occupational licensing, the requirement of a government-issued license to be employed in certain professions. As documented in Kleiner and Krueger (2013), the share of the US workforce covered by state licensing laws grew five-fold in the second half of the 20th century, from less than 5% in the early 1950s to 25% by 2008, as shown in Figure 7. Although state licenses account for the bulk of licensing, the addition of locally and Federally licensed occupations further raises the share of the workforce that is licensed to 29%.

While licensing can play an important role in protecting consumer health and safety, there is evidence that some licensing requirements create economic rents for licensed practitioners at the expense of excluded workers and consumers — increasing inefficiency and potentially also increasing inequality.

Figure 7. Share of workers with a state occupational license

Source: Council of State Governments (1952); Greene (1969); Kleiner (1990); Kleiner (2006); and Kleiner and Krueger (2013), Westat data; CEA calculations.

Land-use regulation may also play a role in the presence of increased economic rents. Such regulation in the housing market can serve legitimate, welfare-enhancing purposes, such as restrictions that prohibit industrial activities from occurring alongside or within residential neighbourhoods or limitations on the size of a dwelling due to a fragile local water supply. But when excessive and primarily geared toward protecting the interests of current landowners —including their property values — land-use regulations decrease housing affordability and reduce nationwide productivity and growth. The presence of rents in the housing market, moreover, may also restrict labour mobility and exacerbate inequality. 

Policies to promote inclusive growth

As economists’ understanding of the relationship between growth and inequality evolves, it is critical to choose economic policies that can promote growth in an inclusive manner along with policies that can reduce inequality in an efficient manner. Analysis of the various forms and sources of inequality in the US can help to elucidate the mechanisms by which certain pro-growth policies can reduce inequality through either the competitive channel or the rents channel. Policies that promote inclusive growth can be grouped in four categories – those that strengthen aggregate demand in general; those that make the competitive channel work better by promoting equality of opportunity; those that reduce unproductive inequality by reducing inefficient rents and rent-seeking behaviour; and those that help better protect workers and their families from the consequences of inequality — while also serving as a springboard for upward mobility. The president’s agenda includes a range of policies along each of these dimensions.

Strengthening aggregate demand

When an economy operates below its full potential, pro-growth policies that help to close the output gap naturally combat inequality. Indeed, unemployment or sub-optimal employment is a form of inequality itself, resulting in zero or insufficient labour earnings for a subset of workers. The same macroeconomic policies usually employed to boost growth and return the economy to full employment can unambiguously reduce this cyclical form of income inequality. Aggressive demand management strategies implemented by the US can, in this context, also be seen as distributional policies. Part of the US response to the Global Crisis involved large-scale support to low-income households via the fiscal expansion in the American Recovery and Reinvestment Act of 2009 and extended unemployment insurance, among other programmes.  Fiscal expansion and accommodative monetary policy worked to boost aggregate output and incomes, resulting in the restoration of income to those who found themselves out of work during the crisis.

Promoting equality of opportunity

The competitive market works best when competition is open to the largest pool of potential labour and investable capital — so it depends upon equality of opportunity that allows all Americans to participate in the economy to their full potential. Education and training are critical in this respect, as are policies that invest in low-income children and increase opportunities in neighbourhoods of concentrated poverty. This starts with the president’s plan to increase access to child care for working families while investing billions of dollars in quality early learning and preschool programs to help our youngest learners succeed — especially those from low-income families. The president has also proposed to make community college free for all responsible students and to improve business engagement, accountability, access, and alignment across job training, employment service, and adult education programs. All of these steps help increase the supply of skilled workers, allowing more people to take advantage of the returns to skills while also increasing the relative demand for less-skilled workers, driving up their wages and reducing the dispersion of incomes.

Reducing market power concentration and rent-seeking behaviour

To the degree that rising aggregate rents stemming from growing market power are contributing to increased inequality, then changing the balance of that power or fostering more competitive markets will increase efficiency while reducing inequality. Policies like raising the minimum wage and greater support for collective bargaining can help level the playing field for workers in negotiations with employers. Because such policies change the division of rents, they can reduce inequality without reducing overall efficiency. In fact, when appropriately tailored, they can foster the previously discussed growth benefits of a better-paid workforce like greater access to education and increased entrepreneurship.

Appropriate balancing of market power, rationalising licensing requirements for employment, reducing zoning and other land-use restrictions, and appropriately balancing intellectual property regimes, all can help reduce excessive rents. Firms with extensive market power can take many anti-competitive actions that generate inefficient rents. Often, there are existing regulations prohibiting such behaviour. Carefully administering the regulations that fight rent-seeking can therefore improve efficiency and inequality at the same time.

In addition, the growth of the financial sector appears to be potentially playing an outsized role in the growth of inefficient rents. The Dodd-Frank Act’s Wall Street Reforms have made significant strides to make the financial system safer and improve consumer protections, but the president is proposing to go further, including the proposal of a new financial fee to discourage excessive scale or risk for the largest financial institutions and also steps to close loopholes on the taxation of the financial system, such as the fact that carried interest can avoid taxation as ordinary income.

Finally, to the degree that rent-seeking warps regulations, policymakers should reduce the ability of people or corporations to seek rents successfully through political reforms and other steps to reduce the influence of regulatory lobbying. Much like the first two channels, policies that reduce these rents can also increase efficiency while reducing inequality.

Protecting families against the consequences of inequality while fostering mobility

A progressive tax system combined with important safeguards that exist today — like unemployment insurance and the Affordable Care Act — and new proposals the president has put forward, like wage insurance, can help both reduce inequality and protect those who face challenges in the market, whether a downturn in a given year or disadvantages over longer periods of time. In many cases, such policies do not just affect after-tax incomes, but also help increase before-tax incomes over time. The Earned Income Tax Credit, for example, has been shown to increase labour force participation by single mothers, raising their earnings and their after-tax income (Liebman 1998).

Moreover, a growing body of economic research has helped confirm that programmes to support low-income families, including Medicaid, housing vouchers, and the Supplemental Nutrition Assistance Program, can not only strengthen the position of the families themselves, but also have important benefits for long-term productivity (Brown et al. 2015, Hoynes et al. 2012, Chetty et al. 2011). Indeed, the link between growth and equality is especially apparent at the lower end of the income distribution where the unequal distribution of opportunity is most important.

Conclusion

Middle-class incomes are shaped by productivity growth, labour force participation, and the equality of outcomes. As the US economy moves beyond the recovery from the Global Crisis, our policy stance should focus on promoting each of those factors to foster inclusive growth. This year’s Economic Report of the President distinguishes among the various forms and sources of inequality in order to better delineate that ways we might accomplish this goal. By promoting equality of opportunity and addressing the influence of economic rents — while maintaining our commitment to boosting overall aggregate demand and protecting working families — we can help ensure that our long-term growth is robust, sustained, and shared.

References

Alvaredo, F, A B Atkinson, T Piketty, E Saez, and G Zucman (2015), “The World Wealth and Income Database”, http://www.wid.world/.

Bricker, J, L J Dettling, A Henriques, J W Hsu, K B Moore, J Sabelhaus, J Thompson, and R A Windle (2014), “Changes in U.S. Family Finances from 2010 to 2013: Evidence from the Survey of Consumer Finances”, Federal Reserve Bulletin, Vol. 100, No. 4.

Brown, D W, A E Kowalski, and I Z Lurie (2015), “Medicaid as an Investment in Children: What is the Long-term Impact on Tax Receipts?”, National Bureau of Economic Research Working Paper No. 20835.

Chetty, R, J N Friedman, and J Rockoff (2011), “New Evidence on the Long-Term Impacts of Tax Credits”, Internal Revenue Service Statistics of Income Working Paper.

Council of Economic Advisers (2015), “Worker Voice in a Time of Rising Inequality.” Issue Brief.

Council of Economic Advisers (2016), Economic Report of the President.

Furman, J and P Orszag (2015), “A Firm-Level Perspective on the Role of Rents in the Rise in Inequality”, Presentation at “A Just Society” Centennial Event in Honor of Joseph Stiglitz Columbia University, October 16, 2015.

Hoynes, H W, D Whitmore Schanzenbach, and D Almond (2012), “Long Run Impacts of Childhood Access to the Safety Net.” National Bureau of Economic Research Working Paper No. 18535.

Kleiner, Morris M and Alan B Krueger (2013), “Analyzing the Extent and Influence of Occupational Licensing on the Labor Market”, Journal of Labor Economics 31(2): S173-S202.

Krueger, Alan B (2012), “The Rise and Consequences of Inequality in the United States”, Remarks at Center for American Progress, 12 January.

Liebman, J B (1998), “The Impact of the Earned Income Tax Credit on Incentives and Income Distribution”, Tax Policy and the Economy 12 MIT Press.

Saez, E and G Zucman (forthcoming), “Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax Data”, Quarterly Journal of Economics.

Western, B and J Rosenfeld (2011), “Unions, Norms, and the Rise in U.S. Wage Inequality.” American Sociological Review 76(4): 513-537.

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Topics:  Poverty and income inequality

Tags:  Inequality, the 1%, the 99%, wealth, global crisis

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