Income Inequality, Writ Larger

June 10, 2007

By DANIEL GROSS
INCOME inequality is a hot topic in politics and economics. The rising economic tide is lifting a bunch of yachts, but leaving those in simple boats just bobbing along.

Two professors — Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California, Berkeley — have found that the share of gross personal income of the top 1 percent of American earners rose to 17.4 percent in 2005 from 8.2 percent in 1980.

Many economists, especially those who find themselves in the Bush administration, argue that the winner-take-all trend is fueled by other, unstoppable trends. After all, globalization, information technology and free trade place a premium on skills and education. “The good news is that most of the inequality reflects an increase in returns to ‘investing in skills’ — workers completing more school, getting more training and acquiring new capabilities,” as Edward P. Lazear, the chairman of the Council of Economic Advisers, put it last year.

It takes an optimist to find good news in the fact that the top 1 percent have steadily increased their haul while the other 99 percent haven’t; after all, many more than one in every 100 Americans are investing in skills and education.

But the orthodoxy surrounding income inequality is being undermined by research that looks at institutional issues: changes in the way the corporate world measures the performance of workers, the decline of unions, and government wage and tax policy. In this view, skills, education and trade aren’t the whole story. They’re simply “factors operating within a broader institutional story,” as Frank Levy, the Rose professor of urban economics at the Massachusetts Institute of Technology, describes it.

One big change in recent decades has been a rise in performance-based pay. Through the 1970s, thanks in part to unions that negotiated wages collectively, “people with different abilities and capabilities were frequently paid the same amount for doing similar jobs,” said W. Bentley MacLeod, an economics professor at Columbia.

But as companies and compensation consultants began using information technology to determine more accurately the contributions of individual employees, employers began to discriminate among employees based on performance. In a working paper, Professor MacLeod, along with Thomas Lemieux of the University of British Columbia and Daniel Parent of McGill University, mined census data and found that the proportion of jobs with a performance-pay component rose to 40 percent in the 1990s from 30 percent in the late 1970s.

“Since companies are better able to measure precisely what an employee contributes, we’ve seen a greater range of incomes among people doing roughly the same jobs,” Professor MacLeod said.

The fact that more Americans are paid less on the basis of a job title and more on their individual output inexorably leads to greater inequality. The authors’ conclusion is that the rise of performance-based pay has accounted for 25 percent of the growth in wage inequality among male workers from 1976 to 1993.

“All the bits of evidence we have tend to say that this trend is continuing,” Professor Lemieux said. In 2003, the authors note, 44.5 percent of workers at Fortune 1000 companies received some form of performance-based pay, up from 34.7 percent in 1996. And think of the growing legions of self-employed — people selling items on eBay, mortgage brokers and real estate brokers, freelance journalists and consultants of all types — for whom all pay is performance-based. Among these growing cadres, the dispersion of incomes is rather large.

“When you look at the self-employed and contractors,” Professor Lemieux said, “inequality is much higher.”

Aside from corporate compensation policies, public policies have played a significant role in contributing to the growth of income inequality. That’s the argument made in a recent, brilliant National Bureau of Economic Research working paper by Professor Levy and Peter Temin, the Elisha Gray II professor of economics at M.I.T. The paper, which is more narrative than quantitative — Professor Temin is a distinguished economic historian — argues that the rise of income isn’t simply a byproduct of the free market working its wonders.

Professor Levy and Professor Temin divide the second half of the 20th century into two periods. In the first, 1955 to 1980, a grand bargain between labor and corporate America involving New Deal-era protections for workers and high marginal tax rates (the top rate was 90 percent in the 1950s) led to what economists have called the Great Moderation. The middle class grew dramatically, income inequality decreased, and corporations generally enjoyed labor peace.

Since 1980, they argue, it’s been a different story, thanks in part to a shifting political environment. Unions have weakened, the minimum wage hasn’t come close to keeping up with inflation, and marginal income tax rates have been cut — the top marginal rate is now 36 percent, down from 70 percent in 1980. A result has been declining bargaining power for workers and the rise of a winner-take-all environment.

“The last six years of federal tax history have involved an inhospitable politics in which winners have used their political power to expand their winnings,” the authors say. In other words, if capital has lately been prevailing in the centuries-long battle with labor, it is doing so with a substantial assist from the government.

Professor Saez agrees with the broad argument, but says that the impact of tax policy in recent years has been minor. When the top income tax rate was 5o percent in the 1970s, he says, “the force to pay according to talent was much weaker” because most of the excess pay would be eaten up by taxes. “Once the very high tax rates for big fortunes were removed in the 1980s,” Professor Saez says “then the market could drive up the compensation at the top.”

WHAT are the political — and policy — implications of this rethinking of the roots of income inequality? Too often, economists have argued that the government can’t — and shouldn’t — do much to reverse the growth of income inequality, beyond exhorting workers to get more skills and education. But given the institutional factors at work, that may be a cop-out.

“The historical evidence suggests that institutions do have some power to modify some of these outcomes,” Professor Levy said.

It is commonplace to hear that the current set of arrangements and policies is the only possible way the economy can work, given trends like the rise of China and global economic integration. As Professor Levy said, “That’s a very convenient argument for people to make if they’re doing very well.”

Daniel Gross writes the “Moneybox” column for Slate.com.


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