How the Government Can Save the Middle Class and Reverse Income Inequality

The growing income inequality in America is a significant issue and requires serious discussion, not so much to identify where to place blame, but rather to identify how to respond to this growing divide and its consequences. Here are a few notes to consider on income inequality:  

It is growing. There are many measures that indicate the substantial growth of income inequality. From 1979 to 2007, the lowest quintile (fifth) of Americans have seen their income grow by 18%, whereas the highest quintile of Americans have seen their income grow by 275%, with the top 1% making up a large proportion of that growth.

Since 1996, the divide has grown more significantly – The lowest 20% of earners saw their after-tax income reduced by 6% and middle incomes grew by about 10% during this time, while the incomes of the top 20% rose by 38% and the incomes of the top 1% saw a 74% rise in after-tax income.  The incomes of the richest 0.1% nearly doubled (96% increase).

As a contrast, average family income annual growth rates from 1947-1973 were about 2.5%. From 1979-2007, those growth rates shrank to 1%, while the top 1% saw its growth rate increase from just over 1% in the former period to almost 4% in the latter. Furthermore, if median incomes had matched per capita GDP rate growth from 1979-2007 (as it did from 1947-1973), then median family incomes would have been $91,000 in 2007, rather than $61,000.

It is the government’s fault. The combination of a long program of tax cuts and financial deregulation, policies which have disproportionately favored the rich, contributed to the growth in the income divide, while the government did little to promote policies that could have strengthened the middle class. In 1986, former President Ronald Reagan signed legislation that increased the capital gains tax to 28%, eliminating the divide between the highest capital gains tax rates and the highest salaried income tax rates. This legislation slowed the increase in income inequality. However, this was short lived, and income inequality began to grow steadily until 2003, when former President George W. Bush cut tax rates broadly and decreased the top capital gains rate to a historically low 15%, causing the income divide to significantly expand.

The problem with the cuts in capital gains taxes, among other past tax cuts, is that it disproportionately affects the richest Americans. In 2008, the 400 richest taxpayers received only 8% of their income in the form of salaries and wages, while they received 60% in the form of capital gains. The overwhelming majority of Americans earned 72% of their income through salaries and wages, while only receiving 5% in the form of capital gains. This trend is not a recent one – more than 80% of the capital gains income realized over the past 20 years has gone to 5% of the population, and about half of all earnings have gone to the top 0.1%.

Those who argue for cuts to capital gains suggest that a high rate on such income discourages investment and limits job growth. However, under historically low tax rates during George W. Bush’s tenure, neither job growth nor economic growth rates came close to those sustained under the higher tax rates of the Clinton Administration. Indeed, the connection between lower tax rates and higher growth is not supported in recent U.S. economic history.

But not entirely. The government clearly had a role in exacerbating the income divide. However, data on the income divide show that it would have grown – albeit more slowly – even if tax policies hadn’t changed. The stagnation and reduction of middle and lower incomes would have occurred without the shifts in tax or deregulatory policy. Larger global and national economic trends have led to the stagnation and reduction of middle and lower incomes. These trends include: the combined effects of technological development, globalization and trade on middle and lower class workers; the upward pressure on salaries of advanced degree jobs in technology, finance, and business; the decline of labor unions, and the stagnation in the real minimum wage, among other trends.

These trends paint a familiar picture of the shift in employment opportunities from lower income blue-collar manufacturing jobs to higher income white-collar professions. The government has done little to aid in the shift of workers from low-technology manufacturing to high-technology manufacturing, or in a shift from blue-collar to white-collar professions. In order to reduce the divide and resuscitate the economy, more has to be done to revamp and reinvigorate the skills and opportunities of the middle class.

It does affect social mobility. In a recent report on income inequality, Alan Krueger, the Chairman of the Council for Economic Advisors puts the growth of the income divide in stark terms. “The share of all income accruing to the top 1% increased by 13.5 percentage points from 1979 to 2007. This is the equivalent of shifting $1.1 trillion of annual income to the top 1 percent of families. Put another way, the increase in the share of income going to the top 1 percent over this period exceeds the total amount of income that the entire bottom 40 percent of households receives,” he wrote. Krueger goes on to suggest that because the top 1% save their income at a much higher rate than the average (50% versus 10%) the shift of $1.1 trillion to the top 1% represents a loss of some $440 billion of additional consumption, representing an unrealized 5% increase in economic growth.

Furthermore, Krueger reports on what he has dubbed the ‘Great Gatsby Curve,’ a chart that models the relationship between inequality and social mobility. The model suggests a negative relationship between the two: as inequality grows, social mobility shrinks. What is important to note is that higher income inequality now affects social mobility into the future, as the divide in earnings represents a divide in the potential amount of resources individuals can invest in the next generation at each level of income. While we should see the loss of economic growth potential in the income divide, we should also see a significant reduction in resources toward the development of human capital at the lower income levels. Social mobility is precisely what is meant by the American dream, a goal that has been weakened for large swaths of the population over the last thirty years.

We can, and should, remedy it. Capitalism necessarily promotes a sustained unequal distribution of resources, as those with the most resources have a greater opportunity to invest in their kids and grow their wealth. Social mobility is ensured by the adherence to a set of rules and principles enforced by the government to provide every individual with an equal opportunity to participate and advance in the marketplace. The tax system has historically been used to reduce the growth in income divide by utilizing a progressive technique.

Those who point to the glory days of the middle class should pay homage to the success of government policy in engineering such conditions, not the marketplace for organically promoting middle class earners or social mobility. Those who argue for lower taxes are not arguing a traditionalist line: taxes are lower today than at any time since 1950. Those who argue for even lower taxes are arguing for a policy orientation substantially different from that experienced during the heyday of the middle class and past periods of sustained economic growth. Rediscovering a more progressive tax structure, with increased taxes on the top earners and more traditional tax rates on estates and capital gains, is an appropriate measure to recover income equality, reduce the federal deficit, and promote greater investment in American’s future generations.

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