Wealth Disparity in America

Wealth vs. Income

People confuse income with wealth. Income is what you report on your income tax each year. It's how much you made in cash and transfer payments for the period of one year.

Wealth is what you own. It's all your real estate, stocks, bonds, bank accounts, collectibles and personal property, minus what you owe (mortgages, etc.)

Rock stars and athletes tend to have high incomes with relatively low wealth, while founders of successful companies have large wealth, but can have small incomes.

Yes, if the rock stars and athletes earn over a long period of time and save, they will have wealth, and company founders can pay themselves huge salaries, but for the purposes of this essay, we are only talking about wealth -- except where I quoted people who confuse the two.

There is a large body of scholars that bemoans the disparity of wealth in the United States. The rich are getting richer, the poor aren't keeping up and the middle class is being squeezed. I am writing this with two days left for Congress and the President to agree on a budget and debt ceiling to avoid default, so there is perhaps more of this kind of bemoaning than usual. At least I've been hit by quite a bit recently.

There is nearly unanimous agreement that the disparity between the richest and poorest in the US is undesirable, there is little agreement about what to do so "solve" the problem. The most commonly suggested way to decrease the gap is to increase taxes. In fact, you can read dozens of articles on the subject and the majority won't bother to suggest how to achieve income distribution nirvana. Those that do, focus on taxes.

In Building a Better America – One Wealth Quintile at a Time Norton and Ariely discuss the increase in the share of wealth by the rich and compare it to what people think the ideal distribution should be. Their conclusion? "Most important from a policy perspective, we observed a surprising level of consensus: All demographic groups – even those not usually associated with wealth redistribution such as Republicans and the wealthy – desired a more equal distribution of wealth than the status quo." But not one hint of a suggestion of how to achieve this narrowing of wealth distribution.

But taxation alone isn't the cure. Timothy Noah in The United States of Inequality: "Income inequality in the United States has not worsened steadily since 1915. It dropped a bit in the late teens, then started climbing again in the 1920s, reaching its peak just before the 1929 crash. The trend then reversed itself. Incomes started to become more equal in the 1930s and then became dramatically more equal in the 1940s." We currently have greater disparity in wealth than we did in 1915 when income tax had just started (1913) and topped out at 7%. If raising the tax rate from 7% to the current 35%, plus all the new state income taxes, hasn't improved the disparity, obviously something else is at work.

It is illustrative to note the general trend in the wealth gap. It rose from 1900 to 1929 and then declined significantly in the 1930's, dropped further in the 1940's, remained relative stable in the 1950's through the 1960's, slowly gathering steam in the 1970's before taking off in the 1980's to 2005. Data after 2005 is mixed and it's too soon to know what the real estate bubble did to the trend.

Those who champion increasing taxes to reduce inequality point to the facts that the maximum income tax rates after 1931 were higher than they are now and that they started declining in 1964. So, there's some correlation between tax rates and income disparity. The question is, is the relationship causal or casual? A causal relationship is one where X causes Y, while a casual relationship is one where there are a bunch of factors that tend to keep X and Y in general harmony, but that changes in one don't cause a change in the other.

One interesting attempt to create a causal relationship was provided by Wealth, Income, and Power by G. William Domhoff, Professor in the Sociology Department, University of California at Santa Cruz, where he states:

According to another analysis by Johnston (2010a), the average income of the top 400 tripled during the Clinton Administration and doubled during the first seven years of the Bush Administration. So by 2007, the top 400 averaged $344.8 million per person, up 31% from an average of $263.3 million just one year earlier.

How are these huge gains possible for the top 400? It's due to cuts in the tax rates on capital gains and dividends, which were down to a mere 15% in 2007 thanks to the tax cuts proposed by the Bush Administration and passed by Congress in 2003. Since almost 75% of the income for the top 400 comes from capital gains and dividends, it's not hard to see why tax cuts on income sources available to only a tiny percent of Americans mattered greatly for the high-earning few.

Here he attempts to correlate capital gains tax rates to the income of the 400 richest Americans. But note, before the cuts in 2003 the average income tripled in the 8 Clinton years and only doubled in the first 7 Bush years. Given the effects of the real estate bubble, the gains for the Bush years will undoubtedly be less than a double. And this is the analysis of someone who concludes: "it's not hard to see why tax cuts on income sources available to only a tiny percent of Americans mattered greatly for the high-earning few." Tax cuts may have mattered, but they weren't the cause or the results of the periods under discussion would have been reversed. In point of fact, the 400 richest Americans almost all founded their own companies and don't need to sell their stock. Some may have taken advantage of a drop in capital gains tax rate, but it was voluntary. Capital gains matters far less to them than to those in the second quintile, who more actively trade stocks.

For all the talk about the correlation between taxes and the disparity in income, there are two far more obvious, far better correlated indicators of the gap: Gross Domestic Product and the stock market. Federal Reserve numbers show Gross Domestic Product increasing approximately ten-fold, from $275 billion to $2.7 trillion, between 1950 and 1980, while it increased little more than half as much for last 31 years (to $14.8 trillion first quarter 2011). The general public, through more jobs and increased wages, benefitted from the rapid growth of the 1950-80 period. The slower growth of the last 31 years means job growth slowed, wages compressed and the middle class growth slowed.

The rich own stocks, the poor don't -- at least in meaningful numbers. So when the stock market goes up, the rich benefit disproportionately. When it goes down, they suffer disproportionately. That's why the rich grew richer in the 1920's and poorer in the 1930's. That's why things were relatively even from the 1950's to the 70's. And why the gap has exploded since. In the 30 years between 1950 and 1980 the Dow Jones Industrial Average only went from about 200 to about 900, while it has gone from under 900 to over 12,000 in the 31 years since. Who owned most of those stock? Not the poor. The value of stocks has gone up three times as fast over the past 31 years as compared to the 30 years from 1950 to 1980.

Not only did the richest benefit from the stock market gains, but only 4 locations accounted for nearly all the gains of the richest 1%. According to Income Distribution and the Information Technology Bubble by James K. Galbraith and Travis Hale, " . . the information technology bubble of the 1990s had a major effect on the geographic dispersion of income in the country, and this effect was driven very largely by the impact of dramatically higher incomes in a very small number of places." Their conclusion: ". . .what would have happened if four hi-tech counties (Santa Clara, San Mateo, and San Francisco Counties in California and King County, Washington) had not seen per capita incomes explode, but had instead experienced more moderate growth?" Absent Silicon Valley and the area around Microsoft, income distribution in the 1990's would have been "basically flat."

So, to "prevent" the wealth disparity from worsening in the 1990's all we had to do was make sure that Silicon Valley and Microsoft didn't explode with new technology. Transferring that wealth via taxes would have been impossible: The founders of the tech companies weren't selling stock. They were creating companies whose value went up. We have no taxing mechanism to tax an increase in the value of assets unless they are sold.

Because the average citizen benefits more from growth in GDP while the rich benefit more from stock market gains, it isn't a surprise (to me, at least) that the public did much better when the general economy was growing faster than the stock market and that the tables were turned when the situation reversed.

But there is another reason why the middle class isn't doing better. Their share of stocks, bonds and bank deposits has gone down over the past 40 years. Their share of real estate went up for a good part of the period, but that was undoubtedly the effect of the real estate bubble on the homes they owned. What shift has caused the middle class to reduce their participation in capital markets? My theory (and it's only a theory) is that it's the lack of a recent depression. My parents were children of the depression. They and most of their friends saved. They set aside money from every paycheck because they didn't have faith that the economy would continue to go up and up. They purchased mostly inexpensive cars, lived in houses below their ability to afford so they could have extra money to save and husbanded their money carefully.

The old rules that you couldn't get a mortgage where you were spending more than 25% of your net income on a home are gone. Even in the post-real estate boom era, you can go to 35% with good credit. No one wants to buy cars any more. You lease, and when the lease is up, you lease again. The ads on TV don't mention price or purchase payments any more. Only lease payments. This is all part of the mentality of those who have lost their fear of depression. The Depression is just something that happened in history books. Not to worry, mate. Forty years ago no one could, much less would, have set themselves up to pay such a high percentage of their income on fixed costs.

Don't get me wrong. I do believe that the current wealth disparity is a bad thing. I do believe we should attempt to narrow it. But policies that would deter GDP growth over the long term are wrong-headed, and this includes most proposals to increase income and capital gains taxes (not inheritance taxes). If we attempt to make the wealth disparity better by increasing taxes on the wealthy, we run the risk that we dry up capital for new ventures. Yes, taxing the rich into another depression would reduce the disparity, but no one would like the medicine.

But I do think we could narrow it by discouraging purchases and encouraging savings -- most especially among the middle class. Make the first $10,000 of investment income (savings accounts, bond interest and stock dividends) tax free and then increase the income tax rate for the middle class to cover the lost revenues (making it revenue neutral). As more people take advantage, ratchet up the tax rate, keeping it revenue neutral. Make IRA's and other retirement savings more attractive. Maybe some of the money the government spends on public service announcements could encourage savings. I wager that over the next 30 years we would have a much better distribution of wealth than we do now.

Of course, given the law of unintended consequence, we would enact this just before the stock market crashes.

July 31, 2011