The Truth About Income Inequality

Ask almost any Democratic politician the most important economic facts about income distribution in America, and you are almost certain to hear the following three points: (1) incomes have fallen substantially over the past ten years; (2) labor's share of income has fallen significantly behind the pace of new productivity and innovation; and (3) income distribution has worsened dramatically over the past generation and over the past decade in particular, with people at the top getting a bigger fraction of total personal income.

Many Democrats believe that these three points are the economic equivalent of the "gospel truth." When politicians see truth, legislation is not far away. Thus, members of Congress have proposed new taxes redistributing income from richer to poorer Americans, new middle-class entitlements such as a public health care program, and the Employee Free Choice Act, which attempts to increase unionization by effectively taking away secret ballots in union elections.

A new economic study reveals that each of the three points of the politicians' economic "gospel truth" is grossly exaggerated and perhaps entirely wrong.

Entitled "Misperceptions about the Magnitude and Timing of Changes in American Income Inequality," it is just published by the prestigious National Bureau of Economic Research, the same scholarly institution that pinpoints the start and end of recessions. (It is available for purchase from www.NBER.org.)

The author of the study is Professor Robert J. Gordon of Northwestern University. He is a meticulous empirical economist who received his Ph.D. from MIT over forty years ago. His specialty is the measurement of inflation, unemployment, and productivity growth, and he has written over 100 academic articles and authored or edited five books.

The paper is cogent and easily accessible to all readers, even those without a background in economics. Washington politicians with no understanding of economics and little time have no excuse for not reading it.

Professor Gordon shows that income, properly measured, has not fallen in America. Moreover, supposed gaps between income and private sector productivity growth are greatly exaggerated. Finally, measures of income inequality have changed little over the past few decades. To the extent income distribution worsened, it all happened before 2000.

The conventional view is that income growth has seriously lagged productivity, so that increases in productivity yield returns to shareholders and corporate management but not to workers. However, Professor Gordon finds that labor incomes are higher than previously measured.

First, most measures of income are constructed on the basis of households. Since the number of people per household has been declining over time due to increasing divorce, longer life expectancy, and later marriage, income per person has increased faster than income per household.

Second, the most common inflation measure used, the Consumer Price Index for Urban areas, is too high, so incomes calculated by the CPI-U are too low. When the GDP deflator, the same measure used to calculate productivity, is used, then incomes adjusted for inflation are higher than would be the case otherwise for the bottom 90% of the income distribution.

Third, productivity measures generally cover only the nonfarm business sector, which represented just 76% of GDP in 2007. Less-productive sectors of the economy, such as government and households, are excluded. When these are included, total productivity is lower.

When these adjustments are made, the gap between income and productivity is far lower.

According to Professor Gordon, "Longer-term moving averages show no decline in labor's income share over the last four decades following a marked increase in the previous three decades going back to 1938. We also focus on measures of top pay, including CEOs, and these show no further increase of income shares between 2000 and 2006/7, prior to the 2007-08 stock market collapse that caused sharp declines in the top income shares."

The one group that has continued to expand income shares, according to Professor Gordon, is not the top one percent, but those in the 96th to 99th percentiles. The income share for this group increased from 10% in 1967 to 13% in 2006. 

While Professor Gordon doesn’t say so, it’s possible that some of this increase was due to the Tax Reform Act of 1986. It lowered top individual income tax rates from 50% to 28%. That change led some, possibly many, small businesses to report business earnings as personal rather than corporate income.  

Professor Gordon's analyses are compelling and realistic. The past decade has not been the greatest economic period in American history, but it has not been so much worse than previous periods. He examines changes in American demography (including changing household size, longer life-expectancy, more education, and migration to cities), he evaluates different price indexes, he graphs data, and he explains it all in easily-understood terms.

What should we make of Professor Gordon's research? First, the American economy is far more robust and resilient than often viewed. Over long periods of time, it survives the ebb and flow of growth and recession-and governmental policies, the good and the bad-largely intact.

Second, horror stories about worsening income distribution in America are largely scare tactics. New policies and laws in Washington should rise or fall on the merit of the underlying facts and ideas, not on the fear that American society is spiraling hopelessly into extremes of income distribution.

That realization alone should reduce the volume of proposed legislation in Congress.