Wednesday, February 03, 2016
Inequality in wealth and income is much less than it first seems if you take the full picture into account
Inequality was the single most popular topic when economists gathered at their annual convention in San Francisco last month. But here is what everyone should know. Most of the studies you read about in newspapers are flawed. A new study exposes those flaws and presents a much rosier picture of the American economy.
A typical study of the distribution of income compares people on the top and bottom rungs of the income ladder. The problem: the entire population is on the ladder. That means these studies are comparing retirees with people who are working. They are comparing people who are at the peak of their career earnings with people who are just starting out.
Studies of the distribution of wealth typically have an even bigger problem. They count private savings (such as an IRA or 401(k) account) and private pensions as part of an individual’s wealth. But they ignore Social Security and other entitlement benefits, even though people pay taxes to these programs at the same time they are contributing to their private retirement accounts.
A 60 year old couple, each having earned the maximum FICA wage over their work lives, is entitled to Social Security benefits worth $1.2 million. If they delay the collection of benefits until age 70, their Social Security wealth is about $1.6 million. Does anyone think this hidden asset should be ignored in comparisons of the distribution of wealth?
The new study is by Alan J. Auerbach (Berkeley), Laurence J. Kotlikoff (Boston University) and Darryl Koehler (Fiscal analysis Center). It departs from previous studies in three important ways: (1) it recognizes that the only meaningful way to compare income and wealth is to do it for people of approximately the same age, (2) it chooses people’s after-tax consumption (standard of living) as the best measure of wellbeing – not just at a point in time, but over the remainder of individuals’ entire lives and (3) it includes such government benefits as Social Security, Medicare and Medicaid in calculating people’s expected consumption.
To appreciate what difference this approach makes, take people in their 40s. Those in the top fifth of the distribution can expect to enjoy 55.3 percent of this age group’s lifetime resources over the remainder of their lives. People in the bottom fifth can expect only 4 percent. That’s a wealth difference of almost 14 to 1. But after government transfer programs do their redistribution, the wealth difference is cut in half: the difference in lifetime consumption drops to 7 to 1.
It is well known that inequality increases with age, with the greatest inequality existing among the elderly. Other studies have concluded that the main reason for this is differences in saving behavior, not some mysterious Wall Street malfeasance imagined by Paul Krugman or Bernie Sanders. Those who save more when they are young accumulate more and have more when they retire. Those who save very little, will have a lot less in the retirement years.
This study finds that among 20 year olds, the wealth difference between the highest and lowest fifths is 7 to 1. But among 70 year olds the difference in wealth is more than 70 to 1. That change over the lifecycle of a group of cohorts is rather astonishing. Even so, after government redistribution takes its toll, the difference in remaining lifetime consumption falls all the way down to 8.6 to 1 for this age group.
One reason for these results is our highly progressive fiscal system. Consider again, those people in their 40s. For those in the top 1 percent of this age group, the expected net tax rate going forward (taxes minus entitlement benefits) is 45 percent. For those in the top fifth of the distribution, the average net tax rate is 32.5 percent. But for those in the bottom fifth, the net taxes are negative: every dollar of private sector income is matched by a 34 cent government subsidy.
Among those in their 70s, the redistribution is much greater. The top 1 percent in this age group faces a remaining lifetime net tax rate of 26.8 percent. In contrast, those in the lowest fifth face a negative net tax rate of nearly 700 percent! For every $1 of private income, they get $7 from the government.
Interestingly, one important contributor to inequality of lifetime consumption is inequality in life expectancy. The gap in expected years of life for those in the top and bottom fifths of the income distribution has been growing for some 30 years and it has a big effect on lifetime consumption. Take people in their 20s. The authors estimate that if those in the bottom fifth lived as long as those in the top fifth, they would get one-third more benefits from government over their lifetimes.
Overall, our fiscal system is highly progressive. There is a price to be paid for this progressivity, however. The more redistribution that takes place, the smaller the rewards for working, saving and investing and the larger the rewards for not working, not saving and not investing. That has to be bad for economic growth.
The downsides of popunomics
Economic historian MARTIN HUTCHINSON supplies an economist's perspective on the Presidential races. He sees much irrationality on all sides
Donald Trump currently looks likely to win the Republican Presidential nomination and it appears Bernie Sanders has a decent shot at the Democrat one. The two candidates have unexpectedly strong support from voters who normally do not participate in elections and, although they are nominally from opposite political poles, their economic nostrums have a lot in common. While one can democratically rejoice that these new voices are being heard, there is just one problem. The populist economics — “popunomics” — that both candidates are selling may appeal to the masses, but is highly economically counterproductive.
There is a reason economics is called the “dismal science.” Most of its tenets are very unappealing to the mass of people, who can only with great difficulty be convinced of their validity. Many tried and tested tenets of economics, validated by centuries of experience, appear both unattractive and unlikely to the man in the street assessing them by “common sense.”
One man one vote electoral systems make no distinction between voters educated in the relevant disciplines and those who are not. This does not matter for most areas of knowledge; few elections are decided on the arcana of differential equations or cosmology (though the age of the universe may become an issue if the Republicans nominate a creationist!)
Sometimes “common sense” is more correct than received wisdom that has been polluted by ideology or careerist considerations. The “scientific consensus” on global warming, for example, is mostly a consensus of those scientists paid or ideologically motivated to be alarmist about it; the truck driver’s healthy skepticism is much close to what appears to be the truth. Similarly on immigration; the economic studies purporting to show from experience after the 1980 Mariel influx of uneducated Cubans to Miami that low-skill immigration does not affect wages turn out to have been hopelessly flawed in their methodology, and driven mostly by the ideological blinkers of the researchers and/or the economic interests of those paying them. In this case, truck driver prejudice again turned out to be correct – but so would an argument from economic first principles, as set out in this column as far back as 2004.
Nevertheless, William F. Buckley’s famous claim that he would rather be governed by the first two thousand names in the Boston telephone directory than by the Harvard faculty is misguided. (For one thing, a bunch of people called Lemuel P. Aardvark and AAA1 Auto Repair might have biases of their own! – AAA1 Auto Repair is a salt-of-the-earth type with great foreign policy expertise from his early years in Nicaragua, but Aardvark is a Beacon Hill-dwelling Brahmin, even snootier and more left-wing than the Harvard faculty!) As Lord Liverpool knew very well 200 years ago, it was not a good idea to extend the franchise to so many ignorant people that knowledge and understanding among the electorate are swamped by prejudice.
Popunomics has a number of core beliefs, held without any possibility of change by argument, and some peripheral ideas that can sometimes be modified or dropped. Perhaps its most important core belief is that free trade is a crony capitalist rip-off designed to export American jobs to the Third World and giving unfair advantages to China, which does not “play fair.” Both Trump and Sanders appear to believe this, and share their belief with voters, who regard it as painfully obvious, subject to doubt only by those with a financial axe to grind.
As economically knowledgeable readers will know, the falsity of this belief was demonstrated 200 years ago next summer, by David Ricardo. By his principle of comparative advantage, if the U.S. makes those things at which it is best, and China specializes in those things at which its costs are relatively lower, both countries’ economies benefit.
The last 20 years have been difficult for free traders. The Internet and modern telecoms, which cannot be un-invented, have greatly reduced the cost of running a truly global supply chain. This has thereby increased the economic possibilities for low-wage workers located far from the major centers of consumption in the West, and conversely lowered the equilibrium wage for low-skill U.S. and Western European workers whose main advantage was their proximity to rich consumers.
This has made life very difficult for potential Trump/Sanders voters. It is also an inevitable phenomenon, finite in duration and probably nearing its end, which would not have been solved by a rise in protectionism. Had such a rise occurred the West’s economy would have been hollowed out, with more and more of its production becoming completely uneconomic while China and other emerging markets acquired the capability to produce more and more of the world’s GDP at lower and lower costs. We have essentially seen this movie before; it was the fate of the Soviet Union and its allied Comecon bloc, and we know how it ended.
However the populists do have a point in one respect: Establishment foolishness has also contributed to their decline in living standards and the insecurity of their employment. Ultra-low interest rates, pursued with ever greater enthusiasm by Fed chairmen since Alan Greenspan in 1995, have artificially narrowed the differential between U.S. borrowing costs and emerging markets’ borrowing costs. This has enhanced the cost differential between Western and emerging market production, force-feeding globalization and worsening its impoverishing effect in the West. The other effects of funny money have also been pernicious for Trump/Sanders voters, raising asset prices, enriching the 1% and diverting manufacturing investment into unproductive real estate and tech startup speculation. The Trump/Sanders’ voters instincts are not wrong, they have indeed been ripped off by elite policies; they have simply misidentified the policies that are to blame.
A second area where popunomics is damaging is that of social programs. Those programs that mostly genuinely help the very poor have no particular populist salience, even being mildly unpopular, but Social Security and Medicare, universal programs targeted at old age, are politically untouchable. Their actuarial deficits and distortion of the healthcare market are problems that it appears impossible to address. Indeed, budget deficits as a whole, which used to be a salient issue with the electorate, have now fallen victim to popunomics and have barely been addressed in the current Presidential campaign.
The same process appears to have occurred in Japan, where prime minister Junichiro Koizumi’s attempt to get Japanese public spending under control proved short-lived and the current Abe government, although nominally from the conservative side in politics, is committed to continual budget deficits and “stimulus” programs, financed by central bank money printing. Schemes that appear to give the populace something for nothing and push costs off into the future are a popunomics elixir.
Taxing the rich, far beyond the level that yields additional revenue, is also a popunomics staple. The 98% marginal tax rates of investment income in 1970s Britain and the 75% tax on income plus an additional tax on wealth in France were vote-winners, and such schemes are abandoned only very reluctantly by a mass electorate. As Lord Salisbury wrote in 1859: “The classes that represent civilization, the holders of accumulated capital and accumulated thought, have a right to require securities to protect them from being overwhelmed by hordes who have neither knowledge to guide them nor stake in the Commonwealth to control them.”
James Madison intended the Constitution to erect such barriers, but popunomics has always opposed them, and since the crash of 2008 popunomics has increasingly tended to prevail. In former days, Swiss bank accounts provided a key civil liberty by giving the rich some protection against populist looting, but the advent of universal data and intrusive Revenue agents has eliminated even this protection.
Popunomics has further elements, equally damaging economically, which from time to time become prominent. Minimum wages are in general a popunomics idea; in difficult times they are set far above the level at which they suppress job opportunities for the modestly skilled. Heavy union protections against job losses are a popunomics idea which became fashionable in the 1930s and remained salient during the decades of U.S. economic supremacy; they have been partly driven out by globalization, but will return should protectionism come into vogue. Draconian financial regulation, with taxes on short-term trading profits also have considerable popunomics appeal; like most other forms of regulation (by no means all of which are popunomic) they do huge economic damage, almost all of it hidden.
Finally, low mortgage rates and subsidies or – God help us – government guarantees for home ownership have huge appeal to a populace for whom an overpriced house, preventing them from distant job searches and tying up their assets, is the only form of saving they truly understand. In this respect Germany benefits hugely from its undeveloped mortgage market where at least until recently down-payments of 30-40% were normal. As we learned in 2007-08, the costs of this policy, to the economy as a whole and homeowners in particular, greatly exceed its benefits.
There are reasonable disagreements to be had about the size of government, and popular pressure is useful in battling the evils of elite domination, such as cronyism and subservience to fashionable but damaging economic fads. Nevertheless the economic ideas of a mass electorate – what they think they know – are mostly damaging to the general welfare and should be resisted.
For more blog postings from me, see TONGUE-TIED, EDUCATION WATCH INTERNATIONAL, GREENIE WATCH, POLITICAL CORRECTNESS WATCH, AUSTRALIAN POLITICS, and Paralipomena (Occasionally updated) and Coral reef compendium. (Updated as news items come in). GUN WATCH is now mainly put together by Dean Weingarten. I also put up occasional updates on my Personal blog and each day I gather together my most substantial current writings on A WESTERN HEART.
List of backup or "mirror" sites here or here -- for when blogspot is "down" or failing to update. Email me here (Hotmail address). My Home Pages are here (Academic) or here (Pictorial) or here (Personal)
Posted by JR at 1:35 AM