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Affluent Christian Investor | January 27, 2021

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The History Of Income Inequality And Popping Economic Bubbles

A Pile of Cash
(Photo by 401(K) 2012) (CC BY) (Resized/Cropped)

In a significant study by economists Thomas Piketty and Emmanuel Saez, they explain the economic impact historically on capital and upper income Americans:

We find that top capital incomes were severely hit by major shocks in the first part of the century.  The post-World War I depression and the Great Depression destroyed many businesses and thus significantly reduced top capital incomes.   The wars generated large fiscal shocks, especially in the corporate sector that mechanically reduced distributions to stockholders.  We argue that top capital incomes were never able to fully recover from these shocks, probably because of the dynamic effects of progressive taxation on capital accumulation and wealth inequality.  We also show that top wage shares were flat from the 1920s until 1940 and dropped precipitously during the war.  Top wage shares have started to recover from the World War II shock in the late 1960s, and they are now higher than before World War II.[1]

Piketty and Saez research and observe exactly what is indicated above – that while there has been a significant increase in the difference in income between the top 1 percent and the bottom 99 percent since the 1970s, it is largely due to the significant decrease from the 1930s. It then remained generally flat until the post-WWII period of the late 60s and 70s. From their investigations, they also conclude that “the composition of income in the top income groups has shifted dramatically over the century.”[2]

Another discovery is that the top income levels are now made up of a significant percentage of “working rich,” that is wage earners—which are not traditional capitalists, but high paid executives who have worked their way up from lower or middle income levels into the upper income quintiles. This illustrates the extensive income mobility for citizens of the United States, which will be addressed below. Moreover, they learned that, across the board of the upper 10 percent of income earners, the percent of income earned by the wage earners increased.[3] In summary, wage earners gained a substantial share of the total income during the 20th century. Piketty and Saez reported that:

In 1998 the share of wage income has increased significantly for all top groups.  Even at the very top, wage income and entrepreneurial income form the vast majority of income.  The share of capital income remains small (less than 25 percent) even for the highest incomes.  Therefore, the composition of high incomes at the end of the century is very different from those earlier in the century.  Before World War II, the richest Americans were overwhelmingly rentiers deriving most of their income from wealth holdings (mainly in the form of dividends)….in 1998 more than half of the very top taxpayers derive the major part of their income in the form of wages and salaries.[4]

This data is critical information as it shows that productivity improvements drove the ability to earn at the highest income levels. In short, salaried managers — many who were previously in engineer and operational roles — drove up their value by exhibiting these specific skills abilities, which translated to much higher incomes. This, in turn, also raised the income levels of middle and lower level managers. The middle class made considerable gains.

According to Piketty and Saez, up until 1940, the top 1 percent’s income composed mostly of capital income, while the rest of the top ten percent had incomes composed of wages. Then, during the significant downturns, those incomes which were mainly capital suffered the worst, while those in the top percentages comprised of wage earnings remained reasonably nominal in their income loss. However, the capital based income earners did recover at a more rapid rate during the recovery cycles of the 1920s and mid-1930s. [5]

Piketty and Saez also found that “[t]he negative effect of the wars on top incomes is due in part to the large tax increases enacted to finance them.” Moreover, “[d]uring both wars, the corporate income tax (as well as the individual income tax) was drastically increased and this mechanically reduced the distribution to stockholders. […] [D]uring World War II, corporate profits surged, but dividend distributions stagnated mostly because of the increase in the corporate tax (that increased from less than 20 percent to over 50 percent) but also because retained earnings increased sharply.”[6]

The sharp tax increase during these periods was instituted against the higher income quintiles significantly to the level where the top 10 percent paid 55 percent of the total federal tax liabilities, while the top 1 percent of income earners paid 28.1 percent of all federal taxes according to the Congressional Budget Office (CBO), [7] compared to less than 20 percent in the 1970s.[8] The CBO states that, “[t]he federal tax system is progressive – that is, average tax rates generally rise with income. […] [T]he top 1 percent faced an average rate of 29.5 percent,” compared to the bottom 20 percent average of only 4 percent.[9] In fact, in a study on the macroeconomic effects of tax changes, Christina and David Romer, economists at the University of California, Berkeley, concluded that the “baseline specification suggests that an exogenous tax increase of one percent of GDP lowers real GDP by roughly three percent.”[10] This conclusion parallels economist Arthur Laffer’s Laffer Curve[11] and the potential negative impact on federal revenue when raising tax rates.

Author and global investor Hunter Lewis perhaps summarizes it best and alludes to the catastrophic results of economic bubbles when writing for the Mises Institute. Lewis concludes:

The amount of U.S. income controlled by the top 10 percent of earners starts at about 40 percent in 1910, rises to about 50 percent before the Crash of 1929, falls thereafter, returns to about 40 percent in 1995, and thereafter again rises to about 50 percent before falling somewhat after the Crash of 2008.  Let’s think about what this really means.  Relative income of the top 10 percent did not rise inexorably over this period.  Instead it peaked at two times: just before the great crashes of 1929 and 2008.  In other words, inequality rose during the great economic bubble eras and fell thereafter.[12]

[1] Thomas Piketty and Emmanuel Saez, February 2003, “Income Inequality in the United States, 1913-1998,” (The Quarterly Journal of Economics, Vol. CXVIII, Issue 1), p. 3.

[2] Thomas Piketty and Emmanuel Saez, February 2003, “Income Inequality in the United States, 1913-1998,” (The Quarterly Journal of Economics, Vol. CXVIII, Issue 1), p. 3.

[3] Thomas Piketty and Emmanuel Saez, February 2003, “Income Inequality in the United States, 1913-1998,” (The Quarterly Journal of Economics, Vol. CXVIII, Issue 1), p. 15, see Table III, Income Composition by Size of Total Income, 1916-1998.

[4] Thomas Piketty and Emmanuel Saez, February 2003, “Income Inequality in the United States, 1913-1998,” (The Quarterly Journal of Economics, Vol. CXVIII, Issue 1), p. 17.

[5] Thomas Piketty and Emmanuel Saez, February 2003, “Income Inequality in the United States, 1913-1998,” (The Quarterly Journal of Economics, Vol. CXVIII, Issue 1), p. 13.  Also see Figure II on page 12.

[6] Thomas Piketty and Emmanuel Saez, February 2003, “Income Inequality in the United States, 1913-1998,” (The Quarterly Journal of Economics, Vol. CXVIII, Issue 1), p. 13.

[7] Congressional Budget Office, June 1, 2010 (accessed May 24, 2012), “Average Federal Taxes by Income Group,” [http://www.cbo.gov/publication/42870].

[8] Peter Wehner and Robert P. Beschel, Jr., Spring 2012, “How to Think about Inequality,” National Affairs, Number 11, p. 98.

[9] Congressional Budget Office, June 1, 2010 (accessed May 24, 2012), “Average Federal Taxes by Income Group,” [http://www.cbo.gov/publication/42870].  2007 data.

[10] Christina D. Romer and David H. Romer, June 2010, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” (American Economic Review, Vol. 100, No. 3), p. 799, [http://emlab.berkeley.edu/users/dromer/papers/RomerandRomerAERJune2010.pdf].

[11] Arthur B. Laffer, June 1, 2004, “The Laffer Curve: Past, Present, and Future,” Executive Summary Backgrounder, (Washington DC: The Heritage Foundation).

[12] Hunter Lewis, April 26, 2014, “Thomas Piketty on Inequality and Capital, Mises Daily,” [http://mises.org/daily/6736/Thomas-Piketty-on-Inequality-and-Capital].

 

 

Originally published on Townhall Finance.

 

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