Changing Income Distributions
Jarrod Wilcox, November 11, 2002

Income distributions have been changing, for good or ill, with important consequences.  What we can do here is summarize the available facts of change, assess the likelihood of its continuation and reversal, and speculate on possible investment consequences.

Available Data

One fact readily available is that in the last decade, there has been increasing publicity given to rising income inequality in the US.  Is there any substance to the argument?  The data that follows are from the non-partisan US Congressional Budget Office study "Effective Federal Tax Rates, 1979-1997," published October 2001.  The study is based on both Census Survey and IRS data.

The chart at right indicates that the bottom 60% of households experienced very modest gains in pre-tax real income over an eighteen-year period.  Pre-tax income  for the lowest 20% actually fell.

On the other hand, pre-tax real income for the top 1% more than doubled.  Lest we think that good fortune for the top 1% was simply the result of gains from stocks during a bull market, the chart ends in 1997 well before the speculative peak.

Pre-tax income tells us quite a bit about the economic forces at work, but to understand the potential impact on spending and political trends, we need to take into account the federal government's effort to redistribute income.  The CBO table that follows takes into account individual and corporate income taxes, excise taxes, and social welfare taxes.  The section on numbers of households has been omitted.

The chart below plots the after-tax income distribution from the table by quintiles.  The middle three quintiles, 60% of households, have increased their after-tax income dispersion while experiencing  modest growth.  The bottom quintile, while no worse off in absolute terms after-taking account of full federal government effects, has not shared in the fruits of economic improvement.  The top quintile of households has clearly pulled ahead, even on an after-tax basis.  This acceleration does not take into account the changes in federal tax rates enacted in 2001.

The dynamic at the top end of the income distribution is much stronger.  The chart breaks out after-tax income for the top 1%, top 5%, and top 10% of households as compared to the middle quintile.

The chart shows that the farther up the ladder one goes, the more dramatic has been the increase in relative income within the US, even after taking into account the progressive nature of the federal tax system.

What about the rest of the world?  On the one hand, some argue that globalization is leaving many poor people behind, and there is evidence for that in Africa as a whole, and in pockets within many countries.  On the other hand, China, a huge population earning relatively low wages, is increasing its average income levels very rapidly.  It seems likely that it's people's surging economic progress is resulting in a net decrease in income inequality for the world as a whole.  And there are similar success stories on a smaller scale in other late-blooming economies.

In summary, the evidence for increasing income inequality in the US, particularly evident in the takeoff of incomes for the top 1% of households, is unambiguous.  It is not clear that this trend holds universally, so we will limit our further discussion to the US.

Continuation or Reaction?

The alarmist political view that the middle class is being hollowed out, leaving only the poor and the rich, is not supported.  But the data do suggest increasing segmentation by income level of US retail markets, products and services.  It helps explain the increased sales both of Wal-Mart and luxury home builders.  Presumably, much of this is already built into the price of their common stocks.  At the same time, the political process continues to hold the line on tax rates for the most affluent.  This assertion was not contradicted by this month's mid-term elections, which saw the Republican party regain control of the US Senate.  It seems likely that there will be an attempt to make the tax rate reductions enacted in 2001 permanent, reinforced by the perceived need to fight recession.  The question for investors, looking beyond the reduction in income caused by the recent recession and decline in the stock market, is whether the income distribution trends of the last two decades are likely to continue over a longer span.  My belief is that the gap in income will continue to grow, which will eventually cause enough social disequilibrium to bring it to a stop.  However, this may not happen for a considerable period, and it is not clear whether the end will be a gradual adjustment to a new equilibrium higher disparity, or whether there will have been an overshoot that causes a substantial reversal.

Technology introduction is often cited as the source of growing income inequality -- as in references to a greater dispersion of abilities for intellectual work than for manual labor.  (It is amusing that smart people tend to accept this flattering argument so readily.)  However, I believe the main causes for greater US income inequality over the historically short period of the last two decades are those that follow.

Republicans, especially supply-siders from past years, can point to positive feedback, or a virtuous circle.  The Reagan tax cuts allowed greater savings by high-income families, who save most anyway, as well as supply-side success in increasing economic growth.  The higher savings were invested productively, and paid off in later capital gains.  At the same time, the demonstration of economic success allowed a political climate generally favorable to business interests, feeding back again to greater relative success by those who control businesses, and accounting for the large gains of the top 1%.

Democrats, on the other hand, might prefer this explanation.  Consider an increase in economic scope -- with local production and sale relatively less important.  Before television, minor baseball leagues that brought sports entertainment to many smaller cities thrived.  After television, most of these lesser leagues, with less talented players and smaller audiences, dried up.  The result was a relatively few baseball players in the biggest cities getting extraordinary pay.  For similar reasons, McDonald's displaces inexpensive local restaurants and American movies displace French movies.  Even if all for the greater good, it is painful to some.  It gets worse when it comes to breaking down barriers between populations with very different living standards.  During the transition, even the most productive economic units can be displaced.

Globalization is here.  The less-advanced countries, if they adopt modern methods, increase relative productivity faster than wages.  This has meant the sacrifice of the most easily reproduced and tradable elements of the US manufacturing sector, even where they were highly productive.  For many, better-paying manufacturing jobs have had to be replaced by lower-paying local service jobs.  In contrast, the owners and higher-level executives and professionals of large, successful businesses that can exploit international opportunities face increased income from globalization.

One could argue that the virtuous circle set going by the Reagan tax cut may have finally played itself out.  One suspects that the recent binge of investment during peak prosperity and under the influence of a speculative environment may have been somewhat less focused on productive uses.  But there is no evidence that the rate of introduction of new technology is slowing down.  More importantly for the intermediate term, the impact of globalization is likely to continue or even increase.  The income disparities between rich and poor countries that are now subscribing to market oriented economies are still enormous.  The buildup of experience and capacity in China will continue.  Russia is now on an upward path, and India and many smaller-population developing countries are also making progress.  If you think the latter is a fantasy, consider that, at least anecdotally,  both Russia and India are making inroads in computer software, courtesy of the Internet. For a long time, their wages will be lower than US minimum wages, but their productivity will go up much faster. Consequently, it is extremely likely that economic pressures will continue also over the next several decades to work for greater income dispersion within the US....

Which leaves the political process.  As income disparities increase, in the absence of countervailing economic forces, political resistance eventually rises so as to reach a new social equilibrium.  We already have seen evidence of this in the form of independent and third party candidacies for public office, protests against business influence on the political process, protests against globalization, and, among a small but possibly growing minority, protests against corporations and capitalism in general.  As this energy filters through moderating elements, it joins with the average person's desire to somehow exact retribution from wealthy businessmen who have been caught with their hands in the till or breaking the rules.  It results in less cooperation between political parties in the legislative process.  The current final legislative impact is indirect -- slowdowns in efforts to broaden free trade zones and trade agreements, stronger campaign financing laws, stronger SEC regulation of corporate zeal to put an optimistic face on accounting reports, stronger pension fund regulation, and efforts to require companies to expense stock options when issued.  The immediate apparent cause for some of these initiatives may be a scandal, but their underlying staying power is likely related to unease over income distributions.  If the hypothesis of continuing acceleration in the impact of globalization is correct, eventually, more direct action through re-raising top marginal income tax rates and through reinstitution of estate taxes is likely.

Possible Investment Consequences

What are the implications for investors?

"Owners" should react in only a few simple ways, because they should be committed to broadly diversified index funds.  Increased globalization does not hurt the US economy as a whole, and has no clear-cut effects on a broad market index, except perhaps to slightly help its long-run growth.  However, savers with jobs in industries subject to potential competition from abroad from lower-wage countries should not expect that threat to go away.  This concern may be reflected in an increased savings rate.  And when doing long-term financial planning,  it would be wise not to count on the permanent elimination of inheritance taxes.

Long-term investors whose avocation is the stock market should be alert for opportunities to invest in emerging markets at reasonable prices, presumably through efficient vehicles such as I-shares.  Winner and loser industries in the US, to the extent they are affected by foreign sales or foreign competition, may well continue to be winners and losers.  In the nearer term, the possibility of a requirement to expense options may deflate earnings and slow IPO opportunities for technology companies.  Currently, issuing long-term stock options can be a low-cost way to compensate employees because they can compound tax-free until exercised.  In general, the recent success of the Republican party in the 2002 congressional elections should not be regarded as securing a pro-business environment for a lengthy period.

Professional investors might consider whether there will be continued fundamental change in the structure and practices of the financial services industry, and whether some of this will be encouraged by a political spotlight and shift in public opinion whose underlying energy is drawn from unease over growing compensation.  What its shape will be is too vague for further speculation here, though part of it may perhaps be seen in the increasing popularity of index funds, ETF's and risk management.

In summary, the growth of the incomes of the economic elite in the US during the last decades, especially the top 1%, has leapt far ahead.  It is a trend that will plausibly continue, once we are past the current recession and bear market in equities which hamper bonuses and capital gains, primarily because of the indirect effects of continued globalization.  Eventually it will cease, as political resistance grows.   I have speculated as to several possible outcomes, the clearest being a continued effort at "reform" and an eventual return to higher marginal tax rates and a reinstitution of estate taxes.