Guest Contribution: “Inequality: Diagnoses and Prescriptions”

Today we are pleased to present a guest contribution written by Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at Harvard University, and former Member of the Council of Economic Advisers, 1997-99. This is an extended version of one published in Project Syndicate.

Three things are striking about the rise in economic inequality since the 1970s in the United States. (1) It doesn’t really matter which measure of income distribution we choose; they all show a rise in inequality. (2) There are many different competing possible explanations and interpretations. (3) We do not need to agree on the explanation to agree on what are sensible policies to lessen inequality.

(1) Measures of inequality

There are many different measures of inequality. Even when just measuring inequality of income, one might look at the Gini coefficient, the poverty rate, income going to the upper 1% or ¼ %, the high-low range, the wage share, or median income. Also of interest are measures of the distribution of wealth and measures of inter-generational mobility. They can give different answers. If the topic is global inequality, for example, the historic economic success of many Asian countries has generated a reduction of inequality by some measures (e.g., a big fall in the poverty rate) but not by others (an increase in the high-low range).

In the United States, however, all measures have pointed the same direction since the turn of the century. They all reflect that the benefits of economic growth have gone to those at the top. The share of income going to the top 1/2 of 1 percent, for example, is up to 14%, where it was in the 1920s.

(2) Diagnoses

Normally one would think that diagnosing the cause for such a fundamental shift would be a necessary step in prescribing a cure. In that case one might be discouraged by the over-abundance of plausible explanations that have been offered and the difficulty in choosing among them.

Thomas Piketty’s Capital in the Twenty-first Century emphasized what he saw as a very long term trend arising from a high return to capital which causes inherited wealth to accumulate at a faster rate than earned income grows. The 2013 book did much to restore priority to the subject of inequality on the agenda of American economists. But most researchers see the sources of widening US inequality coming primarily from within earned income, rather than arising from the difference between earned income (wages and salaries) and unearned income (return on capital).

  • The first of the explanations for inequality of earned income is technological change (such as information technology) that raises the demand for skilled workers faster than the supply. It can explain an observed widening gap in wages or incomes between skilled and “unskilled” workers, defined according to whether they are college-educated. But this has little to do with the gap between the upper 1% and the rest.
  • The second explanation is “assortative mating,” according to which highly accomplished professional men no longer marry their secretaries but instead marry highly accomplished professional women.
  • The third is the “winner take all” aspects of many professions, from dentists to university professors to movie stars. Because modern media tell us who is the best dentist in town or the best movie actor in the world, relatively small differences in abilities win far bigger differences in income than they used to.
  • According to the fourth explanation the very high compensation of corporate executives, especially in the financial sector, is not a return to services that are in demand because they are socially valuable (like having gone to medical school or having been born with acting talent). Rather, managers essentially get to set the terms of their own pay, through compensation packages that reflect failures of corporate governance, tax law, and financial engineering. Options, for example, have failed in their original goal of relating pay to performance.
  • A political economy explanation is especially popular: the rich have captured the levers of power, through campaign donations, and so are able to get policies adopted that are favorable to them.

(3) Must the diagnosis determine the treatment?

It sounds reasonable that to address a problem one first has to figure out what caused it and then undo that cause. But this is not always the right approach. One does not necessarily have to figure out why a particular physical injury occurred to determine the best medical procedure for treating it.

Consider, for example, another explanation for inequality that is particularly popular in this election year: trade. To avoid the contentious question of whether trade has helped or hurt lower-income American workers generally, let’s focus on one sector where the claim that trade has hurt the employees is almost certainly true: the auto industry. 50 years ago workers who lacked a college education but were lucky enough to get a job in the auto industry could earn high wages — much higher than other US workers, let alone those abroad. But Detroit back then had a near-monopoly, which allowed it to produce cars that by modern standards cost a lot, got poor gas mileage, and broke down often. A subsequent flood of auto imports from Japan and elsewhere ended all that. One result was that the US auto industry adjusted and today is globally competitive. Another result was that the wages of auto workers were badly hit. (Notice that these were the effects of trade, not of regional trade deals like NAFTA.)

Even if one cares only about the auto workers’ wage losses and believes that trade is the sole reason for it, what remedy does one arrive at? To protect Detroit fully against foreign competition, the government would have had to raise tariffs on auto imports astronomically, so that domestically produced cars today would cost several times more than foreign produced cars. Does anyone seriously think that is a practical policy solution?

(4) Policy prescriptions

Many of the same policy prescriptions to ameliorate inequality apply regardless what is the cause. Most of them are ways to make the tax system more progressive. This includes lowering the effective marginal tax rate for low-income workers – what President Obama called “Making Work pay” (in 2009, when he passed a refundable tax credit for low income workers, until Republicans took back the Congress and eliminated it]. Enhancing the earned-income tax credit is a live option today. Obama also proposed in January’s State of the Union message expanding wage insurance, which currently helps workers who lose their jobs because of trade but could be made to help as well those who lose their jobs due to technological change. Another possible proposal would eliminate the payroll tax for low-income workers.

In light of looming deficits in social security and Medicare, it would probably be good to make such changes in the tax code revenue-neutral. (Ten years ago, reducing the deficit should have been a clear priority; five years ago, stimulating the economy should have been the short-term priority. Today there is not so strong a presumption either way.) The Republican candidates for president this year, as usual, propose massive tax cuts, focused on the rich, without a plan how to pay for them.

The lost revenue could be balanced with some measures from the following list:

  • End the tax break for “carried interest” — by taxing it at regular income tax rates, rather than at low capital gains tax rates (which is a pure a gift to hedge fund managers) — as Hillary Clinton wants to do.
  • Reduce the estate tax exemption (originally expanded by George W. Bush].
  • Raise the cap on payroll taxes for upper-income workers.
  • Remove oil subsidies and use the gas tax to fund the federal highway trust fund.
  • Tighten some distorting tax deductions like mortgage interest for upper income households.

A lot should be done on the spending side too. Examples include universal high-quality pre-school, health care insurance for all, and infrastructure spending. Many of these measures have been pursued by President Obama.
It is striking how little this list of policy prescriptions depends on the precise diagnosis of the problem.

Many of those who are upset about inequality — perhaps lacking patience for the minutiae of fiscal policy — are attracted to the banner of Bernie Sanders (or the banner of Donald Trump). They like the argument that one must break up banks in order to address the root cause of the problem, which is thought to be that the rich use campaign contributions to influence politicians.

Money in politics is indeed a big problem. But what do politicians use all that money for? It doesn’t go into their pockets (at least not in the US). Rather the money goes to running for office: campaign advertisements and getting out the vote. In my view, voting for the right candidates (by which I mean those who will enact the right policies) is a far more direct strategy than the convoluted Rube-Goldberg chain of causality which says one should vote for the people who want to break up the banks in order to reduce the amount of money in politics so that there will be fewer ads trying to dissuade one from voting for the right candidates.

This post written by Jeffrey Frankel.

33 thoughts on “Guest Contribution: “Inequality: Diagnoses and Prescriptions”

  1. Mike V

    While I think your policy prescriptions are valid from a budgetary/debt perspective, I don’t think they are going to make a dent in inequality. A recent paper by Peter Orzsag found that increasing the top marginal tax rate to 50% would barely reduce inequality.

    Policies to address inequality shouldn’t be framed as a “how can we make the ultra wealthy less wealthy?” question, but a “how can we reduce poverty and increase wages for the lower half of the income distribution?” question.

    1. Josh M Dannett

      Exactly right. The goal should be to make the poor richer, not the rich poorer. Income inequality is not the problem, it’s a symptom of the problem.

      1. Luis Enrique

        you have a lot of confidence that there isn’t a large zero-sum element behind the incomes of the rich. How do you rule out the possibility that these gigantic incomes mainly reflect bargaining power not marginal contributions to productivity?

        1. Josh M Dannett

          Because the pie can get bigger, look at the GDP today vs. GDP 20, 30, 40 years ago.

    2. efcdons

      Wait, so if we only increase the tax on labor income to 50% it won’t solve inequality? I guess then we should just stop trying. Anyway, it’s not like the most wealthy make a large portion of their income as capital gains on owned assets making labor income tax increases less important for the really wealthy.

      Taking money from the ultra wealthy and giving it to the poor increases the amount of money the poor have. Do you use the word “wages” for a particular reason? A wage given in exchange for labor provided is not the only way to get income. Just ask the Walton kids.

  2. A nonymous

    You mention “high quality” preschool. What do you mean by that? Although small pilot programs showed great results (see Heckman et al.), the evidence on Headstart is at best mixed, with most effects wearing off in grammar school. Moreover, isn’t offering universal preschool just an excuse for the government to take over parenting young children? Are you really going to say that sending a three year old to school is really better than being at home with a nurturing parent, playing with siblings and neighbors? Is universal preschool just an underhanded way for liberals to hide the fact that many of their social policies in the past have played a role in the breakdown of two-parent households among poorer communities? Why not address the real problem?

    Second, saying we need to spend more on infrastructure is easy but misguided. Before we increase spending by a dime, shouldn’t we ask why repairing roads and bridges has become so costly and time consuming? No consideration of corruption? Bureaucratic, wasteful spending? Overzealous, slow-moving regulators why manage to delay something simple like repaving a highway for years?

  3. Peter K.

    The concluding paragraphs are rather insulting. Are you not feeling the Bern?

    I doubt the tinkering of a Hillary/establishment Democratic administration will be enough to forestall either a Piketty-death spiral or global climate change. Hillary’s proposals such as they are are not sufficient. Minor tax changes. Only $55 billion/a year in infrastructure spending. Minor trade changes. She has said nothing about monetary policy so we can expect more along the lines of the Obama model: hitting that sweet spot of wage stagnation without falling into deflation.

    Meanwhile Sanders’s fiscal action would be four times as large as Clinton’s. Medicare for all and free public college would certainly go a long way to reduce inequality. Also Pigouvian taxes on Wall Street and financial speculation (to pay for free public college) would help reduce inequality on the top end.

    Breaking up the banks and reforming the corrupt campaign finance system would help with the political economy and power aspect of increasing inequality. Former Treasury official and current Minneapolis Fed President Neel Kashkari has come out in favor of breaking up the banks given their lack of contrition over the financial crisis.

  4. William Meyer

    One additional revenue neutral idea would be a significant carbon tax with the funds rebated on a flat per capita basis. Two birds with one stone.

    Also I am surprised that Professor Frankel fails to mention another explanation: growth in rents (although perhaps he feels this is subsumed under the capture of government by the wealthy or incumbent industries.) In any event I would suGgest much more stringent regulation of natural monopolies and of antitrust generally. Competition is a powerful tool–too bad we have allowed so many industries to become cozy cartels.

    Anonymous–what exactly is your suggestion for reducing inequality? It is not clear, at least to me, that you view inequality as a problem. Do you actually see rising income and wealth in the upper tiers of society as reflecting moral desert? I think you would have a hard time explaining why the wages of the merely college educated have been stagnant–while only those with advanced degrees have prospered? What was the fault of those with merely bachelors degrees? I don’t think the types of criticism that you advance have much explanatory power on what is going on here.

  5. Josh M Dannett

    What about reforming the tax code so that businesses are encouraged to bring their business to the US, keep it here, and hire people (not to mention actually invest in the US)? Or ending federal reserve policies that disproportionately hurt lower income families by increasing the amount they pay at the pump and grocery store? Or removing minimum wage laws that push companies to replace humans with robots ?

  6. WC Varones

    I am stunned that anyone could write so many words about inequality and not even mention central banks.

    1. Mike V

      What evidence do you have that monetary policy has something to do with income inequality? It’s much more of a fiscal policy problem than a money supply problem.

      1. Josh M Dannett

        Just look at QE – its primary mechanism was a wealth effect…increasing the value of capital markets, which are mainly owned by the rich…

  7. PeakTrader

    After the 1970s, when the Information Revolution accelerated, demand for high-skilled labor increased and supply of low-skilled labor increased.

    New firms like Microsoft, which produced several billionaire and 10,000 millionaire employees, created upper income mobility, while tens of millions of low-skilled immigrants with little wealth, and their children, also moved-up in the U.S., compared to their countries (while displacing low-skilled domestic workers).

    What to do about wealth and income inequality? Raise the minimum wage, reduce regulations, and lower middle class taxes, to spur small business start-ups and expansions, create jobs, raise demand, create more taxpayers, and reduce government spending on the poor. And, allow more Microsofts to be created to generate even more tax revenue. There aren’t enough low-skilled workers earning $30 an hour in compensation after 20 years of work.

    1. PeakTrader

      Wages normally account for two-thirds of compensation. And, we need more businesses like Costco (part of 2013 article):

      “The no-frills warehouse chain, Costco, pays its hourly workers an average of just over $20 an hour, compared to just under $13 at competitor Wal-Mart.

      Sales at Costco have grown an average of 13% annually since 2009, while profits have risen 15%. Its stock price has more than doubled since 2009. During the same period, discount retailer Wal-Mart’s sales grew an average of 4.5% each year, profits rose 7%, and its stock price increased 70%.

      Cesar Martinez, a 37-year-old fork lift operator, has worked at a Costco in North Carolina for 19 years. He makes $22.82 an hour, gets health benefits and a pension plan. He manages to save, and doesn’t worry about hospital bills for his daughter, who suffers from asthma.

      “That’s the reason why I’ve been here for so long,” he said. “The company gives you a decent wage and treats you with respect and takes care of you. That’s why we all give 100%.”

      Research shows that it pays to pay employees well, because satisfied workers are more productive and motivated, according to MIT Sloan School of Management professor Zeynep Ton, who focuses on operations management.

      “How many times have you gone to a store, and the shelves are empty or the checkout line is too long, or employees are rude?,” she said. “At Costco, you see a huge line that disappears in minutes.”

      The productivity translates into sales, she said.

      According to Ton’s research, sales per employee at Costco were almost double those at Sam’s Club, its direct warehouse competitor owned by Wal-Mart.”

  8. 2slugbaits

    Prof. Frankel While I agree with virtually all of your policy recommendations, I’m not convinced that they really address the core issue of extreme inequality. Yes, expanding the EITC would be a good idea. Yes, we should end the tax break for carried interest. Yes, health care insurance for all. Yes, spending on much needed infrastructure spending. I agree with all of those policy prescriptions. Those policy proposals would go a long way towards making life better for the bottom 99%; but they wouldn’t do “jack” about extreme income inequality. The one policy action that might go a long way towards cutting the super rich down to size would be to break up the big banks, which is a Sanders proposal. Why might we expect this to narrow the income gap? Because we have a lot of evidence that big pay is associated with big institutions more than it is with specific skill sets. A CEO at a mega-billion dollar company makes a lot more than a CEO at a mega-million dollar company even though both CEOs have the same skill set. Break up the big banks and you will almost certainly reduce the incomes of big bankers. I won’t shed too many tears for our former scions of finance because they’ll still be doing okay…they’ll just have to learn to live with fewer billions.

    Some commentators here have suggested that the goal should be to raise the poor, not bring down the rich. I disagree with half of that. We should raise the poor, but we should also bring down the super rich. This isn’t just an economic issue, inequality is first and foremost a political issue. In almost 2,500 years of history there are no examples of a democratic government surviving for long once that state hits the magic gini number of 0.40. According to the World Bank the US is at 41.1, which puts us on par with countries like Russia, Uruguay and Argentina. Most of the advanced European countries have gini coefficients half to three-quarters of ours. Not good. Contrary to what some commentators here seem to believe, inequality is not a problem within the bottom 99%; it’s a problem between the bottom 99% and the top 1%. Or more accurately, between the bottom 99.99% and the top 0.01%.

    1. PeakTrader

      The super rich invest a tremendous amount of money. That helps explain why Corporate America is the envy of the world. The best and brightest, of the world, want to work and live here. Taking their money and giving it to politicians would be a big mistake.

      1. spencer

        Actually, the super rich account for only a very small share of investments.

        The overwhelming bulk of private investment is by corporations out of their retained earnings or profits.

        1. PeakTrader

          So, you’re saying the super rich invest or reinvest very little. Then, what do they do with their wealth – spend it?

  9. Josh M Dannett

    In your 2500 year study how many of those countries were democracies? Yes campaign financing is an issue, but in a democracy the 99.99% have the power to move elections, so I’m unsure why this is predominantly a political issue.

  10. PeakTrader

    U.S. per capita income with a higher Gini coefficient is over $10,000 a year higher than the large European countries. I find it amazing some people want to adopt the European model of disincentives to work, less consumption, a lower standard of living, and fewer opportunities for upward income mobility. It’s better to promote growth and tax it to raise both the rich and poor.

    As JFK said before the Democratic Party became socialist: “A rising tide lifts all boats.”

    1. 2slugbaits

      Lots of problems with your comment. First, no one said that extreme income inequality was inconsistent with higher per capita income. It’s the old joke of Bill Gates walking into a bar and immediately raising the per capita income. Second, no one said that extreme income inequality was inconsistent with economic growth; it may or may not be. I think the jury is still out on that. But extreme income inequality is inconsistent with democratic values and represents a political danger. That was my point. Third, there is no evidence that taxing higher incomes that are derived from rents also reduces incentives to work. None. Zilch. Higher taxes can and do reduce incentives against wages, but the mega-incomes of the 0.01% are more properly treated as rents rather than wages. Besides, the world would no doubt be a better place if Jamie Dimon worked less and spent more of his time golfing or floating around in his yacht. Fourth, the US ranks pretty low in terms of income mobility. The US has less mobility than the UK. Finally, JFK was good at reading catchy ghost written quips, but his “rising tide lifts all boats” metaphor doesn’t stand up to close scrutiny. And it surely didn’t apply in his own case. JFK earned his money the old fashioned way…he inherited it.

      1. PeakTrader

        There has been tremendous upward income mobility in the Information and Biotech Revolutions, where the U.S. not only leads the world, it leads the rest of the world combined (in both revenue and profit), along with the tremendous upward income mobility of dirt poor immigrants. Of course, the comparison to just after WW II, when the U.S. dominated the global economy and there was much less competition skews the results. You can say there was much more upper income mobility in China too.

        You’re making an assumption government is better at allocating capital than the super rich. There’s plenty of evidence that shows the super rich gets much more “bang for the buck” than government. And, therefore, for society.

        The existence of a Bill Gates helped create thousands of millionaires at Microsoft, multiplier effects, and tax revenue. The existence of a Jamie Dimon helped create and expand many businesses and homeowners, which also generated multiplier effects and tax revenue.

        Why limit the value anyone creates and contributes to society? More super rich will raise the poor.

        1. Ulenspiegel

          Peak Trader: “fewer opportunities for upward income mobility.”

          Vertical mobility is higher in “socialist” European countries, sorry, you are talking nonsense.

          “There has been tremendous upward income mobility in the Information and Biotech Revolutions, where the U.S. not only leads the world, it leads the rest of the world combined (in both revenue and profit))”

          You provide no evidence that these fields compensate when we are talking about well paid jobs for the losses in other fields like traditional industry. Here even guys fron Silicon Valley are moer sceptical.

          1. PeakTrader

            You mean vertical mobility is limited in socialist European countries, sorry, you’re talking nonsense.

            In the U.S., there has been tremendous booms in the Information and Biotech revolutions, other valuable services, and high-tech manufacturing.

            U.S. consumption is 70% of GDP (compared to 60% of much smaller GDPs in Western European countries). So, there’s more U.S. employment in retail.

            Most Western Europeans aspire to an overpaid, easy, and static government job, where it’s almost impossible to get laid off.

            However, in the real economy, Americans live much better and contribute much more value to the global economy.

            A hundred years ago, immigrants to America had roughly the same skills as the domestic population.

            Since the 1970s, immigrants to America were generally much lower skilled than the domestic population.

            Consequently, since they worked harder and were more desperate for jobs, than many lower skilled Americans, they drove down lower skilled wages and displaced many Americans.

            So, the boom in high wages in some segments and depressed wages in other segments from immigration created more income inequality, although inequality in consumption is much less.

            Also, I may add, the U.S. offshored older industries with declining prices, imported those goods at lower prices and higher profits, and shifted limited resources into newer industries with market power. The U.S. economy has been able to expand even with huge annual trade deficits (which subtract from GDP growth).

    2. Keith

      Upward mobility is stronger in “socialist” Europe than the US and while per capital income is lower in Europe, poverty is also.

      1. PeakTrader

        Rising riches: 1 in 5 in U.S. reaches affluence
        December 6, 2013

        “New research suggests that affluent Americans are more numerous than government data depict, encompassing 21% of working-age adults for at least a year by the time they turn 60. That proportion has more than doubled since 1979.

        Sometimes referred to by marketers as the “mass affluent,” the new rich make up roughly 25 million U.S. households and account for nearly 40% of total U.S. consumer spending.

        In 2012, the top 20% of U.S. households took home a record 51% of the nation’s income. The median income of this group is more than $150,000.”


        Growth in the
        Residential Segregation
        of Families by Income,

        “The proportion of families living in affluent neighborhoods doubled from 7 percent in 1970 to 14 percent in 2007.

        Likewise, the proportion of families in poor neighborhoods doubled from 8 percent to 17 percent over the same period.”

        My comment:

        In 1970, the proportion of Americans in the “affluent” and “upper income” classes, and also in the “low income” and “poor” classes were relatively small, while the proportion of Americans in the “high middle income” and “low middle income” classes were very large.

        If you break down those six classes into three classes, the high and low classes grew and the middle class shrunk. Those three categories are almost equal in size today.

        In 1970, both the high and low classes were about 18% each, while the middle class was over 60%. In 2007, both the high and low classes were about 30% each, while the middle class was over 40%.

        Many middle class Americans moved into the higher classes, while many immigrants from dirt poor countries moved to the U.S. and into the lower classes.

        Despite conventional wisdom, there has been tremendous upward income mobility in the U.S..

  11. c thomson

    Amazing that no one mentions social issues like the high correlation between single mothers and inequality or the deficiencies of the public schools, esp. in poor areas.

    And behind these, the massive need for realistic birth control. We experiment with paying poor children to stay in school. Why not experiment with paying welfare mums to stop after one normal child? Call it a BBO – a breeding buy out.

    No matter how we slice, dice and tax, eliminating new recruits to the underclass would do wonders for reducing inequality.

  12. PeakTrader

    So, to reduce inequality, we need to tax upper income Americans and spend on lower income Americans. Yet, we spent trillions of dollars on poverty and it didn’t reduce poverty. We squandered too much money.

    We need an extensive overhaul of government spending, taxation, and regulations, because of high federal debt and the growing Baby-Boom retirement, along with slow economic growth and budget deficits. I’m sure, government policies can be much more pro-growth, which we need desperately.

  13. Alexander Hamilton

    See Piketty/Saez/Stantcheva. One can explain the evolution of inequality internationally very well using top marginal tax rates. There is not evidence for any of the other explanations.

    1. PeakTrader

      A study by Brookings concluded raising the top marginal tax rate would do little to reduce income inequality.

      “…it would require a $1 trillion shift in resources to offset the long-term impacts of inequality, raising the top tax rate to 50 percent would yield one-tenth as much – something like $96 billion in revenue (and presumably less if we adjusted for behavioral responses).”

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