The Social Compact is Broke and Getting Broker

An article in a recent Time magazine which addressed the extensive riots in London, England used the tag “they should have seen it coming” regarding British officialdom because the Gini coefficient for Britain was 0.32, the second highest in Europe. The Gini coefficient is a measure of income disparity with 0 being perfect sharing and 1 being absolute plutocracy. In other words, they claimed that British officials should have realized that the frustrations of the poorer segments of British society were bound to boil over at some point. What the article failed to mention is that the Gini coefficient for the U.S. is rapidly closing in on . . . wait for it . . . 0.5. Let the riots begin!

Seriously, I want to make the case that this, income disparity, is the most significant internal problem facing the U.S. in decades. And it is the only problem that our politicians should be working on right now.

Signs the Apocalypse is Upon Us
You’d have to be dead or completely politically oblivious to have missed the fact that the middle class in this country has had little to no improvement in income in over forty years. Here is a graphic, courtesy of dshort.com, stating the obvious.

The “quintiles” mentioned are one fifth of all incomes in the U.S. Note that the bottom three quintiles, representing 60% of all incomes in the U.S., have barely changed in 45 years. This in itself is not catastrophic except that the top quintile is doing very well, the top 5% is doing extremely well, and the graph would have to be extended a great distance upward to graph the top 1%’s income growth. In other words, there has been a great deal of wealth created in the past 45 years, but you haven’t shared in it. It has been scooped up by the already very wealthy.

This is not unprecedented. There have been periods in this country where similar income disparity has existed. And it has been the role of government to provide rules requiring more equitable distribution of wealth. I can hear conservatives cringing over the use of the term “equitable distribution of wealth” because to them it means the same as “confiscation.” I will attempt to explain why this is incorrect.

Part of the social compact that is collapsing is the unwritten rule that, if American workers became more productive, they would benefit accordingly. So, lets look at American worker productivity over a similar time period. Here is a recent graph (from the Real-World Economics Review Blog, a worthy WordPress blog):

I don’t want to get bogged down in the details here, especially the green lines on the graph. Other details I don’t want to get bogged down in include facts like businesses invest capital in more productive equipment, so these productivity gains are not entirely due to individual worker effort, etc. What the purple line shows is that from the late 60’s to roughly 2010, the same period as the previous graph, worker productivity more than doubled. This means the same work could be done by half as many employees, or twice as much work could be done by the same number of employees at the end of this period. Obviously companies profit more on these terms as labor costs are a big ticket item in any business. The old social compact was that labor would share in the gains. How much of a share is debatable. There were times post WWII that productivity and wages were in lock step, obviously such is not the case now in that labor is getting almost no part of the gains from increased productivity.

May I Have the Envelope, Please?
So, what happens if this continues? Are there any brakes on this runaway train? Right now wealth is accumulating at an alarming rate in a very small segment of the population. That segment is flooding politicians with money and seems bent on not yielding any of its advantages. Government, the only Great Equalizer available, is under unrelenting attack by these moneyed interests.

The questions are: will people learn to vote their real economic interests instead of the phony ones promoted through big doses of political money? Will populist politicians seize a moment to carve out a new niche in politics to offset the effects of rampant greed? Will the idea of American, the so-called American Dream (work hard, play by the rules, succeed), survive?

Progressive Failure

By now most of us are aware that the middle class as we know it was created after WWII. With much of the world’s economies in ruins, the US had access to every market in the world and huge leverage. Winning the war gave us a tremendous confidence and feeling of our own manifest destiny. The feeling that “we were all in this together” created the greatest expansion of the middle class this country has ever seen.  So what happened? Why is the middle class shrinking so?

Certainly a couple of pillars holding up the middle class have been toppled: the concept of progressive taxation and a distinction between money earned by labor and money earned by lending.
The federal income tax goes back to the Civil War, so it is hardly a new concept. Part of what makes the income tax acceptable—not desirable, but acceptable—was the concept that the rate wasn’t flat, that people with more means would pay a higher rate. This was a factor in gaining acceptance for such a tax from those who were of small means. Poor people begrudged any tax because they had little money, but knowing that richer people paid more helped. Obviously politicians weren’t stupid. Like Willie Sutton, who was claimed to have said that he robbed banks “because that’s where the money was” (he denied he said that) asking rich people to chip in more made sense because they had more.

Thus was born “progressive taxation.” The more income you made, the higher percentage of that income you paid. This idea was well crafted because the tax on a poor person’s $15,000 of income was exactly the same as on a rich person’s first $15,000. Everyone was treated the same. People of more means made more money and paid more tax and the more they made, the higher the rate went. During Eisenhower’s administration the top tax rate was 91%. Now some people think that rich people paid 91% on all of their income but this is not true, that was the highest marginal rate and it didn’t kick in until someone had earned a very large sum of money. When Ronald Reagan took office, the highest marginal tax rate was 70%. Currently Republicans are fighting the automatic repeal of the Bush tax cuts in which the highest marginal tax rate will return from 35% to just under 40%.

So, how is this working?

Please be aware that when discussing this topic those who are trying to undermine progressive taxation will blow smoke by stating things that are true but misleading, like “the rich are paying the lion’s share” of income taxes, which is true but misleading. The very rich are paying the greatest share of income taxes (compared to any equal sized segment) but that is because they have a disproportionate share of the income. When the numbers are crunched and you look at what the poor, the middle class, and the rich are paying it breaks down about like this.

The poor pay about 18% of their income in the form of federal taxes.
The middle class pays about 23% of their income in the form of federal taxes.
And the very rich pay about 18% of their income in the form of federal taxes.

Whoops, is that a typo? Isn’t the rate for the rich supposed to go up from those of us in the middle class? Uh, yes, but. . . .

There are a number of reasons for the rich currently paying the same rate as the poor. One is those marginal tax rates. The highest rates have been lowered and lowered. Another is what are called “tax loopholes” which are nothing but special tax favors written into law. The vast bulk of the US tax code is special tax “favors” written for wealthy individuals and corporations. And, there is a third thing.

There used to be an unwritten morale principle that taxes on investment income should never be lower than the taxes on money earned by the sweat of your brow. Ronald Reagan agreed that investment income (capital gains) should be treated as “ordinary income” with regard to taxation. This was not acceptable to the Bush administration, though, which pushed capital gains taxes back to 15%, which corresponds to the rate on the very lowest income bracket. (This is the opposite of progressive taxation; this is regressive taxation.) This is a primary cause of the very wealthy paying taxes at the same rate as the poor. Much of their income comes from investments.

Consequently, the rich are getting richer and . . . well, you know the rest.

The rich are accumulating wealth at an astonishing rate. And they are using that wealth to buy politicians of all stripes to make sure that the rules don’t change, or if they do they only change to be more in their favor.
The very wealthiest Americans are earning an even greater share of the total income of the country. The middle class has seen its real income (corrected for inflation) shrink. And with the shrinking income of middle class people, we are buying less and less and hence we have a “demand problem” in our economy, e.g. not enough customers. Which is the excuse that corporations use to lay off even more people and squeeze their remaining employee’s wages to extract even greater profits than they were.

If you project this pattern into the future you will find a country whose government is of rich people, by rich people, and for rich people. And the rest of us will just have to be happy we have jobs at all.