Why is the top one percent earning more?

by on July 17, 2006 at 1:54 am in Economics | Permalink

Brad DeLong writes:

The big rise in inequality in the U.S. since 1980 has been
overwhelmingly concentrated among the top 1% of income earners: their
share has risen from 8% in 1980 to 16% in 2004. By contrast, the share
of the next 4% of income earners has only risen from 13% to 15%, and
the share of the next 5% of income earners has stuck at 12%. The top 1%
have gone from 8 to 16 times average income, the next 4% have gone from
3.2 to 3.7 times average income, and the next 5% have been stuck at 3
times average income.

It’s hard to attribute this pattern to a rise in the premium salary
earned by the well-educated by virtue of the skills their formal
education taught them. Such a rise in the education premium would
produce a much smoother rise in relative incomes among the whole top
tenth of the income distribution. The cross-percentile pattern doesn’t
fit.

It is especially hard because most theories of the rising education
premium attribute it to skill-biased technological change generated by
the high-tech computer industrial revolution. But the high-tech boom’s
effects on overall productivity became large only in the second half of
the 1990s, well after the biggest increases in inequality. The timing
doesn’t fit either.

Something else is going on.

Leisure time improvements, opportunities like the Internet, and CPI quality mismeasurement have made the lot of the bottom tiers somewhat better than these statistics indicate.  (The absorption of would-have-been real wage gains into more expensive health benefits is another relevant factor.)  Still the relative pattern is undeniable.

My intuition is that there has been an increase in the ability of very smart and very wealthy people to buy up undervalued assets and turn them into greater value.  Improvements in capital markets and market liquidity are behind this trend, as well as the mere demonstration effect that many people have tried this and succeeded.  Julio Rotemberg remains an underappreciated economist.  American entrepreneurs were building up capabilities which exploded in value once the economy stabilized in the early 1980s.  Michael Milken-as-we-knew-him could not have existed in 1973.

Note two features of this hypothesis: First, it is correlated with but not coincident to productivity improvements, which will follow with some lag, thus fitting the data.  The capital gains come before the improvements.  Second, it might explain the non-linearity of the spike in incomes.  A modest multi-millionaire is not wealthy enough to play at T. Boone Pickens or Warren Buffett.  He can "go along for the ride" in a hedge fund, but won’t reap most of the value from the major arbitrage opportunities.  Those end up concentrated in a relatively small group of people and of course this tendency may be self-reinforcing with the accumulation of wealth and arbitrage expertise.

It might also help explain why the Bush changes in marginal tax rates seem to have produced more revenue than had been expected (yes I know about the weird baselines and projections and the like, but still it was a surprise and a welcome one).  It is not a classic supply-side substitution labor supply effect, but rather a wealth effect.  The very wealthy can put their assets to especially productive uses, or at least especially high capital-gains-producing uses.  That puts high capital gains revenue, high productivity, and growing disparity of incomes all together in the same pot.  Sound familiar?

Addendum: Here is Brad DeLong on press coverage of the revenue boost, and also on the small size of the self-financing effect; we also thank him for the endorsement (though note I’ve never been a member of any political party).

1 joan July 17, 2006 at 4:33 am

There was a jump in the income share of the top 1% right after the cut in the marginal tax rates in 1987. This was probably due to a decrease in the use of tax shelters. This accounts for only a part of the increase in income share. Also the total compensation for the 5 top positions at us companies has gone from 5% of profits to 10% during this period. Perhaps the lower marginal rates has made high compensation more valuable, so they put more effort in to increasing their pay. There is a lot of information about the top 1% of income at Visualizing Economics http://blog.mulbrandon.com/

2 KipEsquire July 17, 2006 at 10:31 am

Let’s also not forget that the “top 1% of income earners” is not a static concept. A person is very likely to be, say, “top 1%” one period and only “top 10%” the next. Indeed, professional investors may well end up in the “bottom 10%” if they have a bad year.

Moreover, the fluidity and dynamism of the distribution of income is far greater in the (more capitalist) U.S. than elsewhere (i.e., there is far greater potential for upward mobility in the U.S.).

3 Jason Briggeman July 17, 2006 at 12:34 pm

Sounds like a proposal that there are returns to scale in individual wealth.

4 save_the_rustbelt July 17, 2006 at 12:51 pm

Some other thoughts:

1) the wealthy largely own the federal government, in terms of lobbying power

2) the relative strength of workers has greatly diminished, the labor market is still very slack (at least in the real world, if not Washington)

3) the affluent are often able to direct economic benefits in their own direction, e.g., trial lawyers

4) globalization has destroyed many high value manufacturing jobs and replaced same with lower value service jobs

5) the “Bush recovery” has been very uneven, many states are in the 5th year of a 1 year recession (maybe not the technical definition of recession, but enough to be setting bankruptcy and foreclosure records)

Just a few observations.

5 Joshua Herzig-Marx July 17, 2006 at 1:24 pm

After reading through the responses, I agree that single year rates can be misleading as many individuals may end up in the top 1% after cashing out an asset in which they had been investing earnings. For example, the small business owner who takes a smaller salary but sells for half a million dollars. A more interesting measure would look at lifetime earnings by some population cohort.

Cost of living tends to have a more egalitarian distribution than earnings. Within a geography, health care, food, and transportation costs tend to be fairly equal. If anything, the wealthy tend to have better prices in the form of cheaper food, lower interest rates, and generally more choice (which may be offset through upscale brands, etc.).

Finally, it’s worth noting that an increase in earning is very different from an increase in utility. In fact, those who make the most are best able to lose the most. I can’t spend $300k a year – therefore, it’s easy for me to set aside a third of that for a risky investment. Even if I make $100k per year–a very nice salary–I’ll be much less able to afford to lose any of that. My investments will be less risky and therefore, in general, less profitable.

Keeping in mind that I have absolutely no hard data to back me up, I think that Professor Cowen touches on one primary cause in mentioning, “[A]n increase in the ability of very smart and very wealthy people to buy up undervalued assets and turn them into greater value.† I’m not sure that smarts enters into the equation. What the wealthier have (and the wealthiest have lots of) is sufficient liquidity to take advantage of opportunities. Some of these opportunities will come in the form of real or financial assets, but others will take the form of moving cross country to follow job prospects, taking a few years off of school, or even deferring salary in the first place to start a company. See above with regard to risk and reward.

There’s also the nasty possibility of rent seeking behavior. Given the constant news of government bribery scandals and under performing firms getting generous government contracts we would expect that some amount of that excess income could be invested in bribery, graft, and lobbying.

Closely related is the principal-agent problem. Especially in an economy with rapidly advancing communications and information technologies, we would expect the cost (in terms of time as well as dollars) of identifying opportunities to increase. The “agents† in our economy: lawyers, Realtors, other professionals and elected officials have pursued their own rent seeking behavior and those with the least excess are least well able to discern good advice from bad. Scandals with Ameriprise Financial, Physician owned hospitals providing sub-par care, trial lawyers who take too large a share of a settlement, and graft-seeking congresspeople are some recent examples.

I see nothing inherently wrong with hard work and success rewarded with wealth and I’m confident that most of the wealthy in this country have honestly earned that status. At the same time, concentration of wealth introduces and encourages some (economically) bad behaviors and it behooves us all to identify and correct them.

6 spencer July 17, 2006 at 1:44 pm

Kipesquire there is a whole body of research on income mobility that
looks at individuals lifetime income compared to the lifetime earnings of
the father and finds that income mobility in the US is significantly less
then in Canada, Northern Europe, and the UK and significantly less then we use
to think.

The point that nobody seems to be discussing about the issue of income inquality
is the impact on savings and investment. Economic theory says that if
income inequality increases it generally leads to greater savings and
investment. But that has not happened in the US. since income inequality
started rising around 1980 the personal savings rate has collapsed
and the role of individuals in investment — s-corps, partnerships,
household, etc — has been approximately cut in half to only 11%
of nonresidential fixed investment as compared to 82% for corporations
and 7% for nonprofits.

7 Half Sigma July 17, 2006 at 2:40 pm

I agree with Peer Schaeffer’s comment, increased immigration causes an increase in the labor/capital ratio, making labor less valuable in relation to capital.

People at the bottom have it worse today because the cost of housing has risen faster than inflation year after year. (Or another way of stating that is inflation has been undermeasured year after year.)

8 David Wright July 17, 2006 at 3:36 pm

Peter Schaeffer: I recall you made an insightful comment once on the economics of immigration, but this one is anything but. The interesting datum that DeLong highlights is this: the increasing income share of the top quintile is really concentrated in the top 1%; the 19% below them (who are, I might add, still among the most well-off people in our society) haven’t seen that much change. Now, unless lawyers and middle-managers are streaming across our borders (but corporporate executives aren’t), you will have a hard time explaining that datum as an effect of immigration. Please go back to your study and think like an economist instead of like someone with an axe to grind.

9 Peter Schaeffer July 17, 2006 at 7:37 pm

David Wright,

I am quite familiar with Piketty/Saez data showing the extreme concentration of income gains (top 5%, 1%, 0.1%, 0.01%) over the prior decades. Indeed you can find some of the graphs on my Flickr site (http://www.flickr.com/photos/peter_schaeffer/sets/797845/). I am not asserting a differential immigration flow separating abundant lawyers and middle managers and relatively scarce executives. What I am alleging is that the explosion in senior execution compensation (amply documented everywhere) is enabled by declining labor costs driven by Open Borders. This is a species of the agency problem long known to affect corporate compensation. Stated differently, CEOs pay themselves (de facto via CEO appointed boards) 262 times as much as the average worker because the can. Why can they? Well they don’t need to raise wages to even come close to matching productivity gains because†¦ of Open Borders.

10 Peter Schaeffer July 18, 2006 at 12:32 am

David Wright,

In my opinion, the correct formulation should be. Potential corporate earnings rise because of declining wages, undermined by Open Borders. Actual earnings stay flat (there is a post-2000 potential trend towards rising capital shares) as the incremental returns are captured by the senior executive group. This is not a hypothetical point. L. Bebchuck and Y. Grinstein found that top-five (the five most senior corporate executives) earnings rose from 5% of total corporate earnings in 1993 to 10% in 2003. See http://www.law.harvard.edu/faculty/bebchuk/pdfs/Bebchuk-Grinstein.Growth-of-Pay.pdf for the details.

I would argue, the missing link is to be found in your use of the word “market†. There is a certainly a market for professional labor. Overall, the impact of immigrating “lawyers, managers, and other professionals† has been modest with respect to the entire economy. However, the existence of a “market† for senior executive talent is more questionable. B & G raise important doubts. So does C. Spatt over at the SEC (see http://www.sec.gov/news/speech/spch120304cs.htm).

This can be stated fairly simply. Rising productivity and declining wages have produced potentially large gains in capital returns. The relative abundance of capital combined with self-perpetuating boards and senior executive groups leads to systematic diversion of gains to tiny segments of the population (the “top five†).

However, this is not just a question of corporate compensation. Housing provides another strong example of how immigration creates income concentration. Edward Glaser (Harvard) has shown that historically houses sold for roughly the cost of construction. In congested areas impacted by immigration (California, parts of the East Coast), this is far from the case. House prices are determined by “what the market will bear†. Since construction labor costs are falling (Open Borders) and population density is soaring (the US has a third world population growth rate; the densest cities in America are in the West), the delta between rising prices and falling costs shows up as escalating land prices. Indeed, in many parts of California, the actual house accounts for only a tiny fraction of the value of the property.

Since the gains from land ownership (and/or property development) are highly concentrated, Open Borders manages to simultaneously reduce mainstream wages, make housing markedly less affordable, and concentrate incomes.

11 Flynn July 18, 2006 at 7:41 am

Try doing the correlation with the advent of VisiCalc and Lotus 1-2-3. Productivity returns from information technology showed up MUCH earlier than the 90s. It was just only in some specialized disciplines — precisely those that became that top 1%.

12 Foobarista July 18, 2006 at 2:20 pm

As for data, more data which breaks out how the top 1% get their income would be good, ie what percentage from salary, stock option exercise, and other employment compensation versus business/partnership income, capital gains income, other investment income, etc.

For all the talk of CEOs, the total universe of senior managers who are paid enough to be in the top 1% by virtue of their compensation packages must be a couple hundred thousand people at most, while 1% of the US population is 3 million – 1% of US households is about 1.2 million – so there’s clearly more going on than just this.

13 Sandy P July 19, 2006 at 1:53 am

Is this adjusted for population?

1980 – we tail-end boomers (and are tharer a lot of us) were either beginning to work or 1/2 way thru college. We’ve been working in a whole lotta industries that were pie-in-the-sky back in 1980. Heck, my family didn’t buy a microwave until 1978 and my mom didn’t have a use for a VCR (1982) until it dawned on her what she could record…..

Thank you, Ronnie. Some of us remember.

14 Sandy P July 19, 2006 at 8:47 pm

He also said this guy’s been making this prediction a long time.

15 Chris Paul April 18, 2008 at 3:05 am

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