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Thursday, September 8, 2011

The Income Gap

We have a reader request this week!  This one comes from Mike F. via facebook.  Mike wants to know about "the income gap and how it happened."


           As of late, there's been a lot of buzz about the “income gap” in the US - the disparities in income between the wealthiest Americans and the rest of us.  On the surface it seems like a pretty straight forward issue.  "He's got more money than me and that's that...right?"

Kind of.  Once we delve a bit into the topic, I think you'll find it to be pretty involved.  Simple and satisfying explanations are disappointingly rare.

Doesn't mean I'm not going to kill myself trying, though.  So here goes...

                                           CHAPTER ONE

A good place for us to start an analysis of the income gap is to first see if we can find it.  I’ll start out by examining the “average” American’s income.

When we hear the word “average,” we typically think of a “mean” value, aka 'add them all up and divide by how many there are.'  The problem with that is in the presence of outliers (data points that are far away from the typical ones), the mean tends to not be a particularly great summary of our data set.

Say five people take an exam, and their scores are: 25, 27, 29, 31 and 100.  The mean score would be 42.4.  42.4 is a poor choice for a number to represent the "typical" score, since not a single person got a 42.4 (or anything around there) on the test!

The “median” average, however, is 29, and it summarizes the typical score much better.  The median is just the “middle” value, once we’ve lined all the values up in order (in this case, the 3rd out of 5).  It isn’t affected by the outlier, the one guy who got a 100.

Actually, if we have both the mean and the median of a data set, we can always determine which direction the numbers are skewed.  If mean > median, the numbers are skewed high.  If mean < median, they’re skewed low.  (Try it out!  Calculate the mean and median for the sets {50, 55, 52, 51, 3} and for {123, 99, 100, 510, 116} and compare the them.)

So imagine me lining up every working American (it's about 130 million people) in order of lowest annual income to highest.  The 65 millionth individual, the one right in the center of the line, his income is "national median income." 

Neat thought experiment, but how can we know what that income would be?

Well, since 1878, the US has published annually something called the "US Statistical Abstract," a collection of all the statistics the government gathered that year.  Traditionally published as an encyclopedic set of books, it's now just an online open data base.  Check it out here.

I pulled the following table from the USSA.  It charts the national median income over the last 30 years.  Keep in mind these numbers are all inflation adjusted.

*Boxed area is where I want to draw your attention

Adjusted for inflation, the median national income has grown a bit since 1980.  That's encouraging!  At least through the course of recent history, the middle-class American has gotten better off, in terms of income. 

(We can also see here that the 00s has been pretty much a lost decade for those right in the middle.  With just a little fluctuation, we’ve hovered right around $51k/year for the “central” American since 2000.  It's better than an overall loss over time, but still, a zero growth decade is rare, and it sucks.)

But hold on a sec!  I should mention there's one very important piece of information I didn't give you about the above table.  It's showing income per household.  It doesn't take into account the increasing number of single parent households, or the rise of "two parents who work" families, or the net effect of those two demographic trends.  Do the two effects cancel each other out? 

It's a valid question, and there's probably enough meat on it to write a PhD dissertation.  We'll just have to skip it for now.  But do keep it in mind as we continue...

                                            CHAPTER TWO

Ok, so the "midpoint" (aka median) American household's income has stayed relatively constant over the last decade.  Its actually had some net growth, at least over my lifetime.  But what about those above and below the middle?

There's some real telling statistics in the chart below.  I’ve boxed over two rows, each showing the percent of total national income as it goes to specific quintiles (remember that imaginary queue, with each American lined up by income?  If we divided that line up into 5 equal segments, each segment would be a "quintile").

Take a few minutes to digest this one... 

First off, look at the 00s.  A lot of the ‘06-‘08 weird volatility can be contributed to the financial crisis and the subsequent recession.  But overall, since 2000, the percentages have stayed relatively static. 

But do notice one clear trend:  Since 1970, the percentages of income received by the lower four quintiles have slowly shrunk, albeit at very different speeds (the share for "Lowest 5th" fell from 4.1% in 1970 down to 3.4% in 2008, "Second 5th" from 10.8% down to 8.6%, etc.).  

The lower four quintiles earned a slightly larger share of all the income earned in 1970 than they did in 2008.

Meanwhile, the percentage controlled by the top quintile (or "the top 20% of the workforce," right?  1/5 = .2=20%) has been creeping upwards, by about 6.7% over the last 40 years. 

Most notable is the percentage of income earned by the top 5%, which has gone from 4 times the income of the bottom 20% in 1970 to 7 times in 2008.

A word of caution: this is just percentage received RELATIVE  to that of the other quintiles.  Now, that doesn't mean that earnings have been "diverted" to the upper crust, or that any one quintile’s actual income has shrank.  It just means that compared to the growth in all other quintiles, the top one has grown faster.

Remember, for example, we saw in the first table that median income (a value what would fall the 3rd quintile, right?  3 is the "middle" of 1 through 5) has actually increased.  But on this table, we see the 3rd quintile's percentage share of earnings decreased. 

So the size of the pie has grown.  But the size of the slices, proportionate to each other, has not remained constant.  We all end up with more pie.  It's just that some ended up with much more. 


But guess what?  There's a problem with THIS analysis too.  Maybe some of you have already picked up on it.  So far I've only looked at household income.  Income is only a rough approximation of a person's actual economic wellbeing, because we don't know how far those paychecks went in the year they were earned! 

For example, if income remains constant over a 10 year period, but the price of food, clothing and housing falls during the same time span, the individual will actually "feel" richer by the decade's end.  They make the same pay.  But the cost of the life they want has fallen. 

And what if the price of college tuition, or the interest rate on home loans went up during those 10 years?  Those expenses would eat into the median earner's income.  On paper, their income would be static, but in reality they would have actually have access to less and less disposable cash.  

So what might make a more efficient estimator of economic standing, then?  Let's try another measure entirely: family net worth.

Family net worth tallies up the value of everything a family owns: houses, vehicles, businesses, etc. and subtracts from that the value of what they owe: their debts, mortgages, etc.

            What's cool about this particular table is it gives us both the mean and median.  Remember what we can learn from comparing the two?

In 1998 the national mean net worth was 3.9 (356.7/91.3) times the median.  In 2007, it was 4.6 (556.3/120.3).  This tells us that there are a lot of net worth outliers on the upper end, and that the skew is getting more extreme.  The gains in wealth of the ones on the high spectrum outweighed the gains of those on the lower end.

Of course, using family net worth has problems too!  For example, before the real estate market bubble burst, a family's net worth could have been artificially inflated by their home's inflated value.  Looking at their worth, they would seem to be well off.  But ultimately, that home would turn into a major detractor from their net worth. 

Or we could go the other way.  Net worth subtracts your debts from your assets, so it counts debt "against" you.  But some debts generate positive economic returns in the long-run.  For example, Americans might have more personal debt because more of them are going to college, or starting businesses.  Both activities require big borrowing, but they are good things, from an economic aspect and a social one.  
The important thing to notice is that no matter how we attack this question we get the same general answer: some people are getting really rich, while most of us are just getting kinda rich.  But to what degree, in what way, and how worried we should be about it, well that's completely a matter of interpretation.

Let’s take a second to regroup.  Given the data, what’s the story we're seeing?

The middle American has not lost income in recent history, and has gained a bit over the last few decades.

But the total earnings of the wealthiest are growing to larger and larger multiples of the rest of our paychecks. 

I would interpret this to indicate rise of a group of “super rich.”  A very small portion of the population that earns a hell of a lot more than the vast majority of Americans. 

Don’t mistake this for an indicator that the rest of us are getting poorer!  On the contrary, the position of us here in the middle has improved in the span of a generation.  All Americans are better off today than they were a few decades ago. 

But the top earners are much better off. 

Now comes the big question everyone’s been dying to ask: how did this happen?  And here’s the unsatisfying answer: no one is sure.

Just as a medical symptom is the end result of millions of independent tiny chemical reactions in the body, or entire storms are started by the beat of the proverbial butterfly's wings, many economic outcomes are the fallout of hundreds, maybe thousands of seemingly unrelated variables. 

The phenomenon of the “super rich” is no exception.  They've come in and out of existence throughout history (think robber barons of the 1800s, or the aristocratic land holders in the industrial revolution).  And right now, they're back in style.  And it's likely due to dozens of different factors.  

For example:
-    The new species of “super sized” firms.  Organizations with a presence in every nation of the globe, involved in varied products and services (your Facebook, McDonalds, IBM and the like) are just bigger than any corporations of the past.  They earn more because they are more.  But they usually don't have any more people at the top than any other firm, generating incredibly high earnings per exec.

-    The superstar effect.  Some argue that the reason corporate execs are astronomically well paid for the same reason sports stars are.  First, there's plenty of money to be made in the industry.  Second, the overhead is the same no matter if you have a fantastic team or a lousy one.  So bidding wars for top talent break out all the time, and the sky's the limit.

-    The wealthy probably fared the stagnant 00s and the recession better.  They are more likely to be professionals, doctors, lawyers, executives, and the like, whose pay and employment status was unlikely affected by cost cutting measures seen during the recession.  They would have had more savings and credit to fall back on during those years as well.

-    Increasing Returns to Scale Industries.  Oh boy.  How do I explain this in just a few sentences?  The braver of you can read here.  The gist: in some industries - tech, engineering, dotcom are just a few examples - expanding firms make profits that grow proportionally faster than a company's growth in size.  Basically, a company twice the size of yours can make three, four, or even a hundred times more revenue, if you guys are operating in IRS industries.  Over time, companies in these industries tend crowd each other out as they grow, even if their customer base stays the same, until only one or two are left standing.  Same size market, fewer producers in it, more earnings per firm, and the wealth gets clumped up in the hands of fewer producers.


The reason that it might feel like we in the middle are falling behind, not that those at the top are just getting farther ahead, is what development economists sometime refer to as “the Tunnel Effect.”  

          Imagine that you're stuck in a car inside of a tunnel with hundreds of other vehicles.  A stalled truck or leaky hydrant is blocking off the tunnel's exit, leaving everyone idling in the tunnel.

Suddenly, one lane is cleared.  The cars in that lane begin to file out of the tunnel.  Traffic is on the move again!

But for the person sitting in the still unmoving lane, it won't feel like progress is being made.  He'll see himself as “falling behind the cars in the advancing lane.  His turn is coming.  But for now, he'd describe his forward movement as “below average.”

Economic advancements rarely affect all parts of an economy at the same time, in the same way, and to the same extent.  A good chunk of the income gap may just be explained by the rapid rise of new sectors (like dotcoms, technology, or certain types of finance), which have skyrocketed those who lead them to extreme heights.  When comparing our income to theirs, we feel like we're just plummeting downward instead.

It should come as no surprise than that so many of the world's billionaires work in the newer sectors of our economy, your Zuckerbergs, Jobses, and Gates.  In fact, researchers at the University of Texas have found that if you ignore the incomes earned in the financial districts of New York and the tech/dotcom districts of West Coast there is barely any evidence of an income gap in the US at all!    

Honestly, there is a ton out there on the nouveau super rich and how they came to be.  I'll post some links to get you started, but just start Googling it and see what you find. 

Please share articles and stories you find in the comments section below!!

          Personally, I would be surprised to find that the super rich phenomenon can be explained by any one thing.  It's more likely the sum result of dozens of new economic realities.  Some people become billionaires for one reason, some become billionaires for completely different ones.


           So when you hear commentators discuss economic inequality, it's incredibly important that we pay close attention to what measures they are talking about. 

Is it the mean or median?  Are we talking about holdings or just income?  Have the figures been adjusted for inflation?  What about the wealth not reflected in our pay, like access to Medicaid/Medicare, food stamps, or unemployment insurance?  Has that been taken into account?  Has the price of education and food increased faster than the increase in my hourly wage?  And what affect has my taxes had on all this?

With so many data points, we can connect the dots in many different ways, and construct a variety of pictures of the income gap and how it came to be. 

It's easy to say the distribution of wealth “has changed” over the last few decades.  But how it has and why is deceptively tricky to pin down. 

            When talking about how tricky it can be to study income inequalities, The Economist nailed it when they said:

"The exact size of that gap depends on how you measure it. Look at wages, the main source of income for most people, and you understate the importance of health care and other benefits.  Look at household income and you need to take into account that the typical household has fallen in size in recent decades, thanks to the growth in single-parent families.  Look at statistics on spending and you find that the gaps between top and bottom have widened less than for income.  But every measure shows that, over the past quarter century, those at the top have done better than those in the middle, who in turn have outpaced those at the bottom.  The gains of productivity growth have become increasingly skewed."

Articles to check out

And here's two excellent, easy to read reports on the topic from the Census Bureau itself:

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