Income Inequality: What's Fueling the Divide?

Income Inequality: What’s Fueling the Divide?

In 1955, economist Simon Kuznets pioneered a hypothesis attempting to explain the trend of income distribution through what is known as the “Kuznets Curve”. The Kuznets Curve takes the form of a bell curve (shown below), meant to illustrate that as the income of a developing nation increases, its level of income inequality would increase along with it, but then as the nation continued to develop and its income kept increasing, the level of inequality would peak and then decline. Kuznets’ explanation for this phenomenon was that as a nation grew from its early form of development, its economy would transition from being agriculturally based to industrial based, as workers would flock from the countryside to the cities. As this continued, the divide between labor (workers) and capital (owners), would widen, due to the increased income of owners from profits. As incomes would rise, the level of income inequality would peak. The higher national income would be used to finance public investments aimed to narrow the gap between labor and capital, such as public education, healthcare, and a social safety net, which would lead to decreasing income inequality and thus the downward slope of the Kuznets curve.

The Kuznets Curve

Kuznets would go on to win the Nobel Prize in Economic Sciences in 1971 for his work on growth and national income. His model on inequality had been widely received, as at the time, western nations had experienced a downward shift in the level of inequality from the early to mid-20th century, after a period of highly unequal industrialization. But something started happening in the late 1970s which the Kuznets curve failed to explain: income inequality began increasing in advanced nations.

                                 
                      

As shown in the graph above, the strongest upticks of inequality came from the US and the UK, likely influenced by the “Reagan-Thatcher Revolutions” of 1980. But even societies considered more egalitarian like Canada, Australia, and Sweden experienced notable increases in inequality starting at around the same time, presenting increasing inequality in advanced nations as a systemic global phenomenon rather than a unique national one. This has led many to ask the question: What happened after the 1970s? Notable scholars such as Thomas Piketty, author of Capital in the 21st century, and Branko Milanovic, author of Global Inequality: A New Approach for the Age of Globalization, have made great strides in bringing the topic of income inequality to the mainstream and have attempted to answer this question through large-scale data collection and analysis. And of course, as income inequality has been increasing for decades in advanced nations, many have criticized the legitimacy of the Kuznets Curve for failing to predict this sudden reversal. Piketty goes so far as to say that the reduction of inequality which the Kuznets Curve documents was a unique circumstance unrelated to the natural forces of the market. He states in his book Capital “The sharp reduction in income inequality that we observe in almost all the rich countries between 1914 and 1945 was due above all to the world wars and the violent economic and political shocks they entailed (especially people with large fortunes). It had little to do with the tranquil process of intersectoral mobility described by Kuznets.” (Piketty 15). The factors Piketty lists did not only reduce the capital of the rich but fostered a political climate aimed at providing more public programs for the low and middle class, which were financed by progressive income taxes that placed a large tax burden on the top earners. Piketty goes on to state that rising inequality is a fundamental part of capitalism, which will continue to increase as the gap between the rate of return on capital and economic growth widens (which I will go into more detail later on). Milanovic takes a different approach, instead of dismissing the Kuznets Curve, he builds on the hypothesis, viewing the level of inequality as a series of waves rather than a single curve, which he refers to as “Kuznets Waves”. While the first wave is the transition of an economy from being based on agriculture to industry, facilitated by an industrial revolution, the second wave, which Milanovic believes that advanced countries are currently on, is explained by a transition from manufacturing to services, facilitated by an information revolution. He states in Global Inequality “The 1980s ushered in a new (second) technological revolution, characterized by remarkable changes in information technology, globalization and the rising importance of heterogeneous jobs in the service sector…..the increasing inequality happened in part because the new technologies strongly rewarded more highly skilled labor: drove up the share of, and the return to, capital” (Milanovic 54). While these economists disagree on the inherent trend of inequality, they both mainly agree on the causes of rising inequality in advanced nations, which include technological, economic, social and political forces. These forces are certainly not independent of one another and there exist some overlap and mutual reinforcement between them. Looking at each of these forces will help us understand the current trend of growing income inequality, what the future may look like and most importantly, whether or not the current distribution of income is justified. I will look specifically at the US because it is what I know best, but inequality in the US is (more or less) an amplified version of inequality in the rest of the advanced world, where the forces of inequality listed are all present, they are just stronger in the US.

Technological

Since the 1980s, the US has undergone a revolutionary technological change that has launched the nation into what many call the “Information Age”, which has led to massive breakthroughs in robotics, computers, and telecommunications.  These advances, in turn, have increased overall productivity and living standards of Americans, but it has also been a strong force for income divergence, as the gains in the new technology have disproportionately favored high-skilled workers. This phenomenon is known as “skills-biased technological change”, a shift in technological advancement that benefits skilled workers through increased productivity and demand for their services. Workers in fields such as healthcare, computers, and information technology have benefited greatly from recent advances and have seen their overall wages and job prospects increase. But technology has also led to automation, which has reduced the wages and job prospects of low-skilled workers who have found themselves being replaced, thus creating a widening gap between high skilled and low skilled labor. While Americans enjoy cheaper goods and businesses are earning larger profits as a result of advancement, it has come at the expense of a lower standard of living for many low-skilled workers. As shown in the graph below, there has been a clear and sharp divide between the wages of highly educated and low educated male workers, presenting the losers and winners of the inequality trend. 

 But technology doesn’t always have a skills bias, for instance, the industrial revolution made skilled laborers such as weavers and hand spinners obsolete due to machines like the Spinning Jenny and the Water Frame. The newly invented machines also benefited low-skilled workers, who had stronger job prospects as a result because they were able to work machines which required little skill to operate, and for a lower wage than skilled workers, who the machines replaced. The machines allowed workers to use their labor to generate greater productivity, thus increasing their wages. It is certainly possible for technological advancement to benefit low-income workers (a low-skilled biased technological change), but that is not the case with the Information Age and the current skills bias trend will likely continue into the near future. This has led economists like Milanovac, as stated earlier, to theorize that we are on a second Kuznets wave, which will (hopefully) peak at a certain level and then decrease. Yet for the moment, and likely the near future, technology will continue to benefit the skilled and replace the unskilled, exacerbating inequality.  But while the income divergence of the information age would have many convinced that current inequality is solely a result of advancement in technology a study by economists David Card and John Dinardo show that while skills-biased technological change has played a large role in the trend of divergence, there is much that the rise of technology fails to explain. Card and Dinardo state “we believe that a narrow focus on technology has diverted attention away from many interesting developments in the wage structure that cannot be easily explained by SBTC”.  Clearly, other forces must be looked at as well to fully understand what's shaping inequality.

Economic

A central theme of Piketty’s book Capital: In the 21st Century is that the larger the gap between the rate of return on capital (interest, rents, profits, dividends, royalties etc.) and the growth rate (annual GDP growth of the economy), then the greater the level of income inequality becomes. This is summed up by his prominent equation: r>g. This would not hold true if capital (real estate, buildings, deposits, stocks, securities, patents, etc.) was distributed more equally than the distribution of labor income. First, I want to make the distinction between capital (and wealth), labor income and total income. While wealth is the amount of assets owned, like the assets listed earlier, labor income is the amount of annual earnings from employment (wages, bonuses) and total income is simply the sum of income earned from wealth and income earned from employment. Wealth is what you own, labor income is what you make from your job a year, and total income is what you earn from your wealth and your job in a year. If wealth (or capital) was MORE equally distributed than labor income, and if the gap between r and g rises, the inequality of total income (labor and capital) would actually decrease as the return on capital would be more evenly distributed throughout the income brackets. But this is not the case, as wealth is much more unequal than labor income and heavily concentrated within the top income brackets. According to data collected by Piketty, the top 10% own 70% of American owned wealth, while the bottom 90% own just 30% of the American owned wealth. But for labor income, according to Piketty’s data, the top 10% receive just 35% of total US earnings, and the bottom 90% of Americans earn 65% of earnings (Piketty 248). This shows how vastly unequal wealth ownership is as compared to labor income. So as wealth is more concentrated among a small portion of Americans, it has also been playing a stronger role in our economy, at the expense of labor. According to a study by researchers Karabarbounis and Neiman, the labor share of income has been falling since the 1980s, meaning that for the past three decades, out of all the income that the US generates, a smaller portion of that income has been going to labor while more have been going to returns on capital. The study states that as the Information Age has reduced the costs of technology and machines, financiers are getting a larger return on investment, increasing the income being generated from capital. Businesses are seeing their profits increase as a result, while many low-skilled workers are seeing a decrease in their wages and job prospects. And while capital is heavily concentrated among top earners, the returns on capital are mainly going to them. The shift in the economy to be more capital focused, as well as the substitution of labor for capital, in order to finance new, more productive technology, have widened the income divide. An economy where capital plays a larger role will inherently become be more unequal, due to the fact that the distribution of capital is inherently unequal.

Social

While market forces have been playing a strong role in shaping inequality, non-market forces like social norms, have been reinforcing the trend. As women continue to play a more active role in the labor market and take on higher paying professions, they tend to be marrying men who are in the same income bracket as them. This is known as “assortative mating” and these high-income couples are often referred to as “power couples”. Today, more couples are to be of the same socio-economic than in the past few decades, according to a study by the Institute of the Study of Labor, which measures the effects of  assortative mating on income inequality in the US. The study concludes that  “technological progress in the home is an important factor for explaining the rise in married female labor-force participation.....higher levels of educational attainment, stronger positive assortative mating, and the hike in married female labor-force participation magnify the rise in household income inequality”.  While the rise of power couples and of women in the labor force hasn’t been the driving force of inequality, it certainly is a reinforcing force. It is also not an area that public policy can or should play a role in countering, as no one wants the government dictating or even influencing who they should marry.

Political

What is widely believed to be the cause of the uniquely high level of US income inequality, is its political structure. The US suffers from a form of plutocracy, where the government, although democratically elected, over represents the interests of the rich at the expense of the rest of Americans.  It should be no surprise that when rich attain a larger level of wealth, they will likely use their newly gained wealth to influence the political system in their favor. And why wouldn't they? To ignore the circumstance of the rich using money to shape the government for their own gain is to ignore a fundamental aspect of economics: People act on incentives. And if the rich will benefit by lobbying congress and providing campaign donations, in hopes that politicians will provide them with public policies they support, even if it conflicts with the wishes of Americans, it makes perfect sense economically to do just that. Just as the rich seek a return when investing in a business, they also seek a return when investing in a campaign. Supreme Court Justice Louis Brandeis said it best “We may have democracy, or we may have wealth concentrated in the hands of a few, but we can't have both”. The findings of political scientists such as Larry Bartels and Martin Gilens, who have studied the effects of wealth on politics, agree with Brandies and both conclude that politicians disproportionately cater to the interests of high-income constituents rather than middle and low-income constituents. Bartels links economic inequality to potential political inequality, each of which builds upon one another through a vicious cycle. He states “These disparities are especially troubling because of the potential for a debilitating feedback cycle linking the economic and political realms: increasing economic inequality may produce increasing inequality in political responsiveness, which in turn produces public policies increasingly detrimental to the interests of poor citizens, which in turn produces even greater economic inequality, and so on” (Bartels). The issue with inequality is that it has negative effects on democracy, because as the wealth of a group increases, it is in their best interests to use that wealth to further increase their gain, at the expense of democracy. In the graph below, created by Gillens to illustrate his findings on the effect of wealth on public policy, he presents a direct relationship between the policy wishes of high-income voters and the likelihood that the policy will be enacted and the lack of that correlation among low and middle-income voters

                        

Gillens states in his blog that if public policy was more founded on the wishes of Americans, we would have “a more progressive tax structure, higher unemployment benefits, stronger regulation of business and industry”. The fact that a high concentration of wealth threatens democratic institutions cannot be ignored as the rich actively fight against policies which will reduce inequality, such as a more progressive tax system and more public benefits, which Americans tend to be in favor of. If the trend of rising income inequality continues, a less democratic government will likely follow suit. 

In summary, technology has driven the economies of the advanced nations to be more capital based, increasing the return on investment for the rich, who have used their newly found gain to influence public policy (Especially in the US), exacerbating inequality, and this is being reinforced by social trends such as assortative mating. I have neglected the role of globalization, falling union membership and low economic growth for creating inequality, but that will be for another time. While income inequality is an essential aspect of a healthy economy in order to provide incentives, the level of inequality must also be justified by the values of society. When the level of inequality goes beyond what a society views as just, it must be put into question and public policy should play a more active role.