Income share of top 1 percent: one number, many conjectures.

The U.S. Census Bureaus report on changes in household monetary income published on September 17th is disturbing. Adjusted for inflation, a typical family earns less than in 1989. The median income is 8.3 percent less than its prerecession peak in 2007 and continues to decline even though the economy is bigger than its pre-recession peak. Equally glaring is the differential growth in income. The top 5 percent of earners is earning as much as before the recession while the bottom 80 percent is earning considerably less. Academic economists have done extensive study of the changes in national incomes and their distribution in US and other developed nations. A recent symposium in the Journal of Economic Perspectives analyzes the trends in data and examines possible explanations. But the participants are not able to arrive at a consensus on the causes or on corrective measures.1 Since the Occupy Wall Street movement, there is emphasize on the income share of the top 1 percent.2 In US it takes a U-shape, declining from a high in the years before the Second World War to a low in the late 70s and then rising again. More recently, it went from 9 percent in 1976 to 20 percent in 2011. United Kingdom, Canada and Australia exhibit fairly similar trends. Interestingly, during the same period, the trend in share of the top earners declined (with fluctuations) in France, Germany, Japan and Sweden. What are the possible explanations for these trends? (1). Changes in top marginal tax rates: Since 1960 the United States and the United Kingdom had more than 40 percent reduction in the top marginal tax rate, Japan and Canada around 30 percent, Australia and France less than 20 percent, and Germany few percent. The changes in the share of top 1 percent in Anglo -Saxon countries varies inversely with the tax rate. But before drawing the conclusion that tax rates caused increasing inequality, other possible explanations should be considered. (2) In times of economic growth, some sectors grow much faster than others as they introduce new technologies. Industrial revolution began with mechanization of the textile industry but at that time patenting was in its infancy and some of the pioneers ended in penury. As patenting laws were enacted, inventors from Thomas Edison to Steve Jobs earned a fortune. So did, to cite more examples, the pioneers in automobile, railroads and steel industries. Financial industry
1 2

The Journal of Economic Perspectives, The Top 1 Percent, 27 (3), 2013, pp.3- 123. Financial Times Uneven US recovery hits family incomes, http://presscuttings.ft.com/presscuttings/s/3/articleText/77005962#axzz2fHGnOVTe ; The New York Times, Household Incomes Flat Despite Sunnier Economy, http://www.nytimes.com/2013/09/18/us/median-income-andpoverty-rate-hold-steady-census-bureau-finds.html?ref=us&_r=0; Americas Sinking Middle Class, http://www.nytimes.com/2013/09/19/business/americas-sinking-middle-class.html?ref=global; US Census Bureau, Income, Poverty and Health Insurance Coverage in the United States: 2012, http://www.census.gov/prod/2013pubs/p60-245.pdf.

developed many innovations to raise capital and share risk. It is an industry where many fortunes were made. However well deserved, they increase inequality of income. One way to evaluate the dynamics of income distribution is to consider the background of those in the Forbes 400 list. Between 1982 and 2011, the percentage of those born wealthy declined from 60 to 32, those who were born to families with some wealth increased by 30 percent while the share of those who were born to little wealth remained the same. Considering the business background of the group, those in finance and investment increased by 16 percent, those in technology by 11 percent. There were fewer in in energy and real estate. (3) It is an accepted norm that those who are more productive should paid for performance. The problem is with the converse proposition: are those receiving higher income than others in the same group or profession necessarily the more productive ones? Gary Becker of the University of Chicago is famous for the argument that if one group among two of equal productivity receives lower salary, then firms will compete to hire from the first group while laying of those in the other. The shift in demand will equalize salaries. This powerful argument is valid only if the labor market is competitive and that is where the debate is. 3 If those who are at the top of the income ladder also have the power to set compensation schemes, they can tilt the game in their favor and earn economic rent return in excess of what they can earn in a perfectly competitive market. The compensation committee of the board of directors determines the bonuses and stock options. If the criteria for fixing them are based on increases profits or stock prices within the year, the CEO and senior management can take actions that increase stock prices now without regard to how the policies affect the firm in the long run. Sales representatives are known to push sales towards the end of the year knowing well that many of the items sold will be returned next year. The problem in estimation is that the share of rent in compensation cannot be directly observed. Statistical analysis of compensation data showing increases in rent cannot be ignored. Firms are affected by the business cycles and, in each phrase of the cycle, some industries outperform others. To correct for fluctuations that are beyond the control of executives of any corporation, their compensation should be based on their performance relative to others in the industry. If the stocks in all firms in an industry are falling, executive of a company doing better than average should be rewarded for his performance. In industries enjoying a boom only those who are able to outperform the trend should be rewarded. Yet stock options and bonuses reward executives irrespective of their relative performance; studies show that reward for luck is larger than reward for performance. Even more objectionable is that, particularly in finance but also in other areas too, executives were able to earn exorbitant income by reporting good performance of their firms while hiding the risks inherent in their positions. Some like executives of Enron resort to

The debate on racial and sexual discrimination centers on the efficient working of labor market. It is a separate topic and not developed here.

accounting fraud. Either case firms are eventually forced to recognize large losses and some like Enron and Lehman are driven to bankruptcy. In a democracy vote will reflect the interest of the voters. Economic conditions that result in the majority falling behind economically is not consistent with political stability . Politicians of all hues like to see the reemergence of the middle class and the flattening of the income distribution. If growth in inequality is due to rent extraction as Joseph Stiglitz argued, there is justification for reversing the reduction in marginal tax as it reduce innovation and economic growth.4 Others claim that the tax reduction will lead to economic growth. Growth will ultimately create jobs and reduce inequality. The reality is that economy needs a transformation and at this point neither economists nor policy makers have a clear and convincing idea on how to achieve it.5 Rama V. Ramachandran
Author Opportunities and choices: Understanding our economic decisions http://www.visualeconomicanalysis.info/index.html Facebook: Ramanomics
Copyright 2013 Rama V. Ramachandran

Joseph Stiglitz, The price of inequlity: How todays divided society endangers our future (New York: W.W. Norton & Company). 5 James Surowiecki asks how de Blasio is going to keep his promise to reduce inequality in the financial capital of the United States. James Surowiecki, Coring the Big Apple, The New Yorker, September 13, 2013. p.50. http://www.newyorker.com/talk/financial/2013/09/23/130923ta_talk_surowiecki.