The House Budget Committee has released a fascinating report that analyzes and parries with a recent CBO report on income inequality. Though I can’t imagine it will persuade many liberal egalitarians that Chairman Ryan is right and the left-of-center consensus view is wrong, it does bring to light a number of interesting phenomena:
Considering the population as a whole, real average after-tax household income in the United States grew by 62 percent over this 30-year period. After-tax median income (half of thepopulation is above the median, half is below) grew by 35 percent. But the trend of absolute gains across all income levels was not the focus of the study. Instead, the CBO sought to analyze the distribution of these income gains and their uneven growth over time.
One of the reasons this is true is that transfers have increased over this 30-year period. We often see references to stagnant median household incomes, which are an artifact of a number of interrelated phenomena: the changing mix of households, the decrease in male work-hours and the increase in female work-hours, assortative mating concentrating high-earners in the top two quintiles, etc. Because references to stagnant median household incomes are often associated with political arguments for more transfers, however, the fact that transfers have increased as much as they have is presumably very salient.
The Budget Committee staff makes an observation that some on the left like Christopher Howard and Suzanne Mettler have made, i.e., tax and transfer policies have in some respects exacerbated inequality:
One underreported conclusion from the CBO study is that shifts in government transfers and federal taxes have contributed to increasing inequality over time. Both taxes and government transfers remain progressive, but the equalizing effect of transfers and taxes on household income was smaller in 2007 than it was in 1979 (see Figure 3).
This is mainly because the distribution of government transfers has moved away from households in the lower part of the income scale.For instance, in 1979, households in the lowest income quintile received 54 percent of all transfer payments. In 2007, those households received just 36 percent of transfers.
This shift reflects a growth in programs that focus on the elderly population and are not for the most part income-adjusted, such as Social Security and Medicare. In other words, the structure of some of the nation’s largest entitlement programs has decreased the share of government transfer payments going tolower-income households and directed an increasing share of government spending to wealthier seniors. According to the CBO’s findings, this trend, accelerated by the retirement of the baby-boom generation, contributes to an increase in inequality.
The tax system has also become slightly less of an equalizing factor today than it was in 1979. The composition of federal taxes changed between 1979 and 2007, as less-progressive payroll taxes grew faster than more-progressive income taxes. The average payroll tax rate was slightly higher at the end of the period, while the average individual income tax rate was slightly lower.
I was surprised that the Budget Committee didn’t mention the role of tax expenditures in this section, as it has also contributed to the fact that the equalizing effect of transfers and taxes on household income has decreased.
The report cites Scott Winship’s excellent article in National Review, and it moves the mobility discussion in an interesting direction:
[I]n a recent article for National Review, the Brookings Institution’s Scott Winship – a former research manager for the Economic Mobility Project – explained that the problem illustrated by these studies is not a lack of mobility between middle- and upper-income groups in America. Rather, it is mobility from the very bottom up – especially for young men – where the United States lags behind. A variety of factors associated with entrenched poverty reduce mobility for this income group. Winship writes that children of unwed mothers, for example, are less likely to escape from the bottom of the income distribution than other children. Winship’s analysis details the tragedy of broken families and minority groups that are disproportionately remaining at the bottom of national income distribution. “Simply put, two-thirds of black children experience a level of neighborhood poverty growing up that just 6 percent of white children will ever see,” Winship writes.
This analysis shines light on a particularly vexing problem for those policymakers who wish to improve upward mobility in the United States. But it also highlights another limitation in the CBO’s study – by failing to distinguish between mobility and inequality, policies aimed at the latter can impair the former. Redistributive welfare programs can impede upward mobility by creating dependency, yet welfare reforms that reduce dependency and promote work appear in the CBO’s analysis as zero-sum deductions from government efforts to reduce income inequality (see “Welfare reform” below). Omitting the incentives to work that were built into the successful welfare reforms of the 1990s results in an analysis that fails to capture how such reforms actually affected mobility.
Income mobility is important because it implies that longer-term income, or “lifetime income,” is more equal than what is observed in annual snapshots. Studies that rely on “snapshot income” and ignore income mobility can give an incomplete picture of trends in inequality.
There is reason to believe that we have seen greater dispersion in lifetime income, because within-group inequality among the educated tends to be somewhat higher (“stochastic inequality”). But the authors are right to suggest that lifetime income is important, and that policies aimed at mitigating inequality can have unintended consequences. As the work of Katherine Newman reminds us, one key contributor to upward mobility is embeddedness in a strong kinship network. But of course kinship networks have costs. Transfers can help liberate individuals from kinship networks — but nuclear families or individuals that are disembedded might have a harder time getting back on their feet once they experience an economic shock. For those on the left, I think it’s say that the intuitive solution is to layer on new safety net programs. Those on the right, in contrast, might be more inclined to suggest that there is a downside to lowering the cost of disembeddedness.
The Budget Committee staff references the role of labor force participation:
Household demographics also go a long way toward explaining observed inequality at any one point in time. University of Michigan economist Mark Perry illustrated this point using the latest Census data for 2010. Those figures show that nearly three-quarters of households in the highest income quintile included individuals in their prime earning years, compared to less than half for households in the lowest quintile. In addition, 77 percent of households in the top quintile had at least one adult working full time, whereas only 17 percent in the lowest quintile did.
Perry summed up his view that household demographics have much to do with income inequality: “American households in the top income quintile have almost five times more family members working on average than the lowest quintile, and individuals in higher-income [households] are far more likely than lower-income households to be well-educated, married, and working full-time in their prime earning years. In contrast, individuals in low-income households are far more likely to be less-educated, working part-time, either very young or very old, and living in single-parent households.”
To be sure, labor force participation among less-skilled men has decreased for a number reasons, e.g., the deterioration of labor market prospects for all less-skilled, and in particular for ex-offenders. And once again, we see the impact of disembeddedness.
One way of thinking about these issues is that we’re playing a game with many rounds, and people who have fared well in the last round are able to bring those advantages into future rounds. So in the last round, I was able to form strong attachments because I had two loving parents and I was raised in a stable home. Now I will be in a better position to do the same. Over time, our society has changed so that people with high earning potential tend to marry each other — a product of a more gender-egalitarian cultural landscape. This is in many respects a good thing. It also means, however, that the top quintile is further away from the first quintile, and indeed from the fourth quintile. Relative mobility is harder to achieve because the top quintile is a moving target. Families in the top quintile tend to be somewhat smaller. So if parents invest the same amount of time in fewer children, we can expect the stress level, etc., to be lower. This, in turn, can extend healthy lifespan and labor-force attachment.
The classic progressive response to this dynamic is that we thus need things like high-quality universal child care that is publicly provided. This, however, is very expensive, due to Baumol’s cost disease and the tendency of public employees and their allies to extract rents in high-amenity regions. That is, regions that are highly productive are sticky — people don’t want to leave unless they must. This gives public sector employees leverage to demand higher wages, which in turn leads to a higher tax burden. These higher wages needn’t correspond to productivity or the quality of the service provided. Rather, they correspond to the willingness of those living in relatively attractive, high-productivity region to bear a higher tax burden. The willingness to bear a higher tax burden is strengthened by measures like the state and local tax deduction, the structure of which biases state and local governments towards a highly-volatile tax base.
Moreover, even an excellent, well-designed public program can’t make a big difference with regard to cognitive skills beyond the first two years of life. This suggests that we should shift public resources towards early childhood interventions and, for older children, an emphasis on developing noncognitive skills. Unfortunately, incumbent public providers are resistant to shifting resources from other domains. And so the debate is over increasing public expenditures rather than re-prioritizing public expenditures. As new public employees sign on in new domains, they expand the political constituency for protecting the interests of the median public employee in older domains.
This isn’t necessarily how the expansion of the public sector has to turn out. But it is a scenario that worries conservatives, and for good reason. Apologies for the lengthy aside.
The report’s discussion of how international trade shapes the domestic landscape is well done:
Increased trade and globalization has also played a role in widening earning and income gaps because, like new technology, it has tended to reduce demand for lower-skilled workers in the United States while raising demand for higher-skilled workers. The United States tends to export goods with a heavy skilled labor component while importing goods produced by lower-skilled workers.14This is the comparative advantage profile of a highlydeveloped economy, and it has shaped various segments of the domestic labor market and relative wages. The trend is most evident in the U.S. manufacturing sector. The U.S. economy has generally shifted away from lowerskilled manufacturing, such as the apparel and textile industry, and towards a service sector that requires a highskill, high-intellect workforce.
Technology and trade are obviously two economic forces that have contributed to dislocations and relative wage inequalities in recent decades. But it is also true that these same forces, which have exponentially increasedaccess to consumer goods and services, have been hugely beneficial for the living standards of citizens across all income levels. These economic trends have also contributed to increased inequality in most other advanced industrial economies around the world, not just the United States (see Figure 7). In fact, of the few countries that have seen decreasing inequality over the past thirty years, one of them, Greece, is in the midst of a severe debt crisis and is teetering on the edge of economic collapse. This underscores the point that increased equality does not always mean better economic outcomes for all.
Germany, a country that is often singled out as a success story for having maintained high employment levels throughout this period, is an interesting case. A combination of severe wage repression and an undervalued currency (while the euro is too strong a currency for southern Europe, it is arguably too weak for Germany) has helped sustain relatively high employment levels, yet Germany has also experienced sluggish productivity growth (per The American Phoenix), masked by the increasing integration of central and eastern Europe into German supply-chains. There is good reason to believe that as Germany’s export markets, e.g., China, experience severe economic dislocation, its economy will suffer and its social model will lose luster.
The authors also cite Ken Rogoff’s argument that the commoditization of higher education might mitigate wage dispersion, a possibility that is only rarely discussed. Interestingly, the commoditization of higher education has been fiercely resisted by incumbent providers, who tend to receive large public subsidies, despite the fact that it would represent an unalloyed gain to poor and near-poor students.
One of the more disturbing findings from the CBO report is that while the tax system became more progressive, transfers became less so. The problem is that the progressivity of public expenditures is arguably much more important than the progressivity of taxation. There is a good case that the federal tax system should be fairly progressive because state and local tax systems should be somewhat regressive, i.e., state and local tax systems should rely on more stable sources of revenue like the value of unimproved land rather than highly-mobile tax bases, like capital income. The straightforward reason is that state and local governments are subject to balanced budget requirements and they tend to deliver core services, like education and public safety, that should be funded in a fairly consistent way.
The Budget Committee staff offers a sophisticated discussion of how taxes and transfers have evolved over the last three decades. For example, consider the following on the distribution of Medicare expenditures:
The growth in the fungible value of the Medicare benefit was not distributed evenly among income groups, but rather tilted toward the middle- and upper-income groups, in part because lower-income groups rely more on Medicaid. For the lowest-income quintile, the fungible value of the Medicare benefit as a share of household income nearly doubled, from 7.1 percent to 14.1 percent. But for the middle quintile, it more than quintupled, from 0.9 percent to 4.7 percent. For the fourth quintile (those households making between $42,202 and $60,557), it quadrupled, from 0.5 percent to 2.1 percent. This disparity in the distribution of per capita Medicare spending, driven primarily by rising health care costs, also contributed to the decline in the progressivity of transfer payments observed by the CBO.
The authors also address, albeit it implicitly, the idea that the shifting tax and transfer landscape has represented a deliberate effort to enrich the rich and the expense of the not-rich:
Rising incomes, particularly at the top of the income distribution, tended to increase the progressivity of federal income taxes while simultaneously decreasing the progressivity of payroll taxes.
As incomes at the top rose, the amount of income subject to the top federal rate went up, shifting the burden of the federal income tax to higher-income households. This phenomenon, combined with steadily falling average federal income tax rates for the bottom 80 percent of households, led to an increase in the progressivity of federal income taxes.
Also, as incomes at the top rose, the amount of income exempt from the Social Security payroll tax went up, lowering the average payroll tax rate for higher-income households. This phenomenon, combined with legislated increases in payroll tax rates, led to a decline in the progressivity of payroll taxes
For the most part, these changes in the progressivity of the tax system did not occur due to government action, but rather because incomes at the top of the distribution were rising and thus affecting average tax rates.
An obvious reply is that the federal government should have taken affirmative steps during this period to redress the growing imbalance. Alvin Rabushka, for example, proposed combining the payroll tax and the personal income tax into a unified single-rate tax system with a large exemption. This might have represented a better, more progressive approach, though it is easy to imagine the center-left attacking such a proposal vigorously.
All in all, the Budget Committee’s report on inequality is an encouraging, intelligent read that presents a familiar set of facts in an unfamiliar frame. Now if only we could get all congressional Republicans to think this clearly.