Taking the Political Spin Out of Inequality (Part 1)

Earlier this month, global leaders from all major sectors of society met in Geneva, Switzerland for the WEF’s 2023 “Growth Summit” to discuss what they believe are the most important economic and social issues facing humanity. One argument that emerged from the conference was that the policies that are being implemented using the classical model of economic growth are presently causing worsening trends in inequality between developed and developing countries. Thus, due to these trends more invasive, “inclusion” based policies must be embraced to redistribute opportunity to create more equitable economic outcomes.

The WEF has made similar arguments toward individual Western countries. For example, the WEF has mentioned the United States as an example of an affluent country with ever-worsening income and wealth inequality that requires the introduction of even more progressive income taxation or the institution of new wealth taxes to rectify wealth disparities.[1]

Let’s begin by looking at the United States’ economic performance over the last 50 years and looking at the evidence of how different parts of the income distribution have gained. In that timeframe, real per capita GDP increased 132 percent to $64,000 per person, the highest level among all countries in the world with a population of at least 10 million people.[2] Additionally, since 1959, incomes for the bottom fifth of the income distribution increased by 262 percent post-tax and transfers, the largest of all the quintiles (Figure 1).[3]

U.S. real GDP per capita has risen by 89.5 percent from 1980-2020, the highest of the G7 countries.[4] A recent 2019 study found that the poorest 20 percent Americans consume more goods and services than the national averages for all people in most affluent countries.[5]

If you listen to international organizations like the World Economic Forum, European Investment Bank, and the United Nations or non-profits like the Ford Foundation and Brookings Institution you would think that inequality is exploding in the US and that the gains of all this growth have somehow not helped those lower in the income distribution. These claims are a distortion of reality.

A famous 2003 paper in the Quarterly Journal of Economics by Thomas Piketty and Emmanuel Saez heavily shaped perceptions about inequality in the US. The paper found that the top 1 percent’s share of income more than doubled from around 10 percent to over 20 percent of all income in the U.S. between 1960 and today.[6] That set off alarm bells – it sounded as though a new gilded age had arrived where the top 1% were getting rich off the rest of us.

Yet this analysis failed to reflect the fact that the progressive tax system in the US has actually redistributed much of these gains.  Government policy redistributes income in two ways: through progressive taxation (taxing higher incomes at higher rates than lower incomes) and through spending and welfare programs. Inequality estimates before and after taxes are paid and government spending is redistributed can vary.

Recent estimates from economists Gerald Auten at the US Treasury Department and David Splinter at the Joint Committee on Taxation have found that after taxes and transfers, the top 1 percent income share has remained effectively unchanged since 1960 (see Figure 2 below).[7] These authors also find much more muted differences in pre-tax income as well relative to the large differences presented by Piketty and Saez. The Congressional Budget Office’s data series on pre- and post-tax and transfer income shares paints a similar picture. Recent research suggests that the rise might be even smaller if one considers definitions of income that include all corporate retained earnings and not only dividends and realized capital gains.[8]

In a separate but related study, economists Phil Gramm, Robert Eklund, and John Early in their book The Myth of American Inequality estimated changes in living standards across income quintiles, finding massive gains for the lower quintiles over the last 50 years (e.g., the share of Americans living in poverty decreased from 15 percent in 1967 to just 1.1 percent in 2017). Piketty and Saez would have us believe that we need a wholesale socialization of income to undo this rising inequality. In fact, the system has already largely done this.

If income disparities after tax have in fact not risen, what about disparities in wealth? Emmanuel Saez and Gabriel Zucman find large increases in wealth concentrations at the top of the wealth distribution[9], finding that the top 0.1 percent share has increased from 7 percent to 22 percent between the 1970s and 2012. While Saez and Zucman have written this from an academic perspective, they also have written polemics, arguing that federal intervention is necessary to “save democracy”[10]. Media outlets have rewarded them with largely uncritical praise, crediting their ideas as having the potential to solve wealth inequality.[11]  

But this analysis leaves out several important points. Economists Matthew Smith, Owen Zidar, and Eric Zwick in a 2023 paper published in the Quarterly Journal of Economics, re-evaluate technical assumptions in Saez-Zucman and find more muted changes. They estimate an increase in the top 0.1 percent wealth share from 13 percent to 15 percent between 2000 and 2016.[12] Economists Sylvain Catherine, Max Miller and Natasha Sarin add to this debate the fundamental point that Social Security represents an important source of wealth for lower income households. They find in a 2020 paper that when accounting for the bottom 90 percent’s social security benefits, top wealth shares have in fact remained unchanged over the last 3 decades.[13]

Of course, the mere fact that income and wealth inequality remain unchanged does not imply that U.S.’s current tax regime is optimal, as these disparities in and of themselves say nothing about arguably more important measures of human welfare. For example, suppose that due to increased progressivity in the tax code, wealthier taxpayers decide to engage in unproductive behaviors such as either moving their money offshore or paying tax accountants to reclassify income to avoid further taxation. Or instead suppose that poor taxpayers adjust the number of hours they work or the types of jobs they seek, fearing that they may lose potential transfer income from the government due to reaching higher income brackets. In both of these cases, individuals are being incentivized to make suboptimal economic decisions that severely limit the long-run economic potential of themselves and the broader economy.

For some though, even if middle- and lower-income people today in the U.S. and in other countries have seen dramatic increases in their incomes, wealth, and quality of life due to a version of capitalism that is less progressively taxed or regulated, this is insufficient if it means that any upper incomes have grown at a faster rate. In the words of Margaret Thatcher, those who seek equity at all costs would “rather that the poor were poorer, provided that the rich were less rich.” In a future installment, we will more comprehensively address these second and third order human welfare concerns related to income, wealth, and redistributive policies.

When looking beyond the borders of the U.S. at developing countries, political institutions and norms are typically the primary determinants of the success of economic development. For example, insofar as investment does reach the country, are there sufficient private property protections that allow for that investment to create opportunities? Daron Acemoglu and James A. Robinson in their seminal 2012 book Why Nations Fail: The Origins of Power, Prosperity and Poverty make this key insight – that nations with strong institutions that encourage economic activity are successful while those with institutions that are “extractive” in nature serve those holding power at the expense of the broader population.[14]

Simply focusing on the income and wealth differences between developed and developing countries ignores the important factors that actually drive growth. Before condemning the system or approach that made the West and the U.S. in particular incredibly wealthy across income levels, institutional factors — such as rule of law, functional courts, sound money, and societal norms — should be the primary focus for any country looking to achieve similar levels of success.

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[1] https://gabriel-zucman.eu/files/SaezZucman2020JEP.pdf

[2] https://data.worldbank.org/indicator/NY.GDP.PCAP.KD?locations=US&most_recent_value_desc=true

[3] James Elwell et al., Income Growth and its Distribution from Eisenhower to Obama: The Growing Importance of In-Kind Transfers (1959-2016) 42 (National Bureau of Economic Research, Working Paper No. 26439, 2019). https://www.nber.org/papers/w26439

[4] Data from UN Conference on Trade and Development, Statistics Division (UNCTAD-STAT)

[5] https://fee.org/articles/the-poorest-20-of-americans-are-richer-than-most-nations-of-europe/

[6] https://eml.berkeley.edu/~saez/pikettyqje.pdf & https://www.economist.com/briefing/2019/11/29/economists-are-rethinking-the-numbers-on-inequality

[7] https://davidsplinter.com/AutenSplinter-Tax_Data_and_Inequality.pdf

[8] http://www.columbia.edu/~wk2110/bin/InequalityConsolidated.pdf

[9] https://www.aeaweb.org/articles?id=10.1257/jep.34.4.3

[10] https://www.nytimes.com/2019/01/22/opinion/ocasio-cortez-taxes.html

[11] https://www.wired.co.uk/article/thomas-piketty-capital-ideology

[12] https://www.nber.org/system/files/working_papers/w29374/w29374.pdf

[13] https://law.yale.edu/sites/default/files/area/center/corporate/spring2021_paper_sarinnatasha_2-25-21.pdf

[14] https://notesonliberty.com/2013/06/20/critical-junctures-and-path-dependency-in-why-nations-fail-implications-for-u-s-foreign-aid-policy/#:~:text=Authors%20Daron%20Acemoglu%20and%20James,with%20extractive%E2%80%9D%20political%20institutions%20fail.