Productivity: Do Low Real Wages Explain the Slowdown?

GDP per Worker, 1947Q1 to 2016Q2,rev

A.  Introduction, and the Record on Productivity Growth

There is nothing more important to long term economic growth than the growth in productivity.  And as shown in the chart above, productivity (measured here by real GDP in 2009 dollars per worker employed) is now over $115,000.  This is 2.6 times what it was in 1947 (when it was $44,400 per worker), and largely explains why living standards are higher now than then.  But productivity growth in recent decades has not matched what was achieved between 1947 and the mid-1960s, and there has been an especially sharp slowdown since late 2010.  The question is why?

Productivity is not the whole story; distribution also matters.  And as this blog has discussed before, while all income groups enjoyed similar improvements in their incomes between 1947 and 1980 (with those improvements also similar to the growth in productivity over that period), since then the fruits of economic growth have gone only to the higher income groups, while the real incomes of the bottom 90% have stagnated.  The importance of this will be discussed further below.  But for the moment, we will concentrate on overall productivity, and what has happened to it especially in recent years.

As noted, the overall growth in productivity since 1947 has been huge.  The chart above is calculated from data reported by the BEA (for GDP) and the BLS (for employment).  It is productivity at its most basic:  Output per person employed.  Note that there are other, more elaborate, measures of productivity one might often see, which seek to control, for example, for the level of capital or for the education structure of the labor force.  But for this post, we will focus simply on output per person employed.

(Technical Note on the Data: The most reliable data on employment comes from the CES survey of employers of the BLS, but this survey excludes farm employment.  However, this exclusion is small and will not have a significant impact on the growth rates.  Total employment in agriculture, forestry, fishing, and hunting, which is broader than farm employment only, accounts for only 1.4% of total employment, and this sector is 1.2% of GDP.)

While the overall rise in productivity since 1947 has been huge, the pace of productivity growth was not always the same.  There have been year-to-year fluctuations, not surprisingly, but these even out over time and are not significant. There are also somewhat longer term fluctuations tied to the business cycle, and these can be significant on time scales of a decade or so.  Productivity growth slows in the later phases of a business expansion, and may well fall as an economic downturn starts to develop.  But once well into a downturn, with businesses laying off workers rapidly (with the least productive workers the most likely to be laid off first), one will often see productivity (of those still employed) rise.  And it will then rise further in the early stages of an expansion as output grows while new hiring lags.

Setting aside these shorter-term patterns, one can break down productivity growth over the close to 70 year period here into three major sub-periods.  Between the first quarter of 1947 and the first quarter of 1966, productivity rose at a 2.2% annual pace.  There was then a slowdown, for reasons that are not fully clear and which economists still debate, to just a 0.4% pace between the first quarter of 1966 and the first quarter of 1982.  The pace of productivity growth then rose again, to 1.4% a year between the first quarter of 1982 and the second quarter of 2016.  But this was well less than the 2.2% pace the US enjoyed before.

An important question is why did productivity growth slow from a 2.2% pace between the late 1940s and mid-1960s, to a 1.4% pace since 1982.  Such a slowdown, if sustained, might not appear like much, but the impact would in fact be significant.  Over a 50 year period, for example, real output per worker would be 50% higher with growth at a 2.2% than it would be with growth at a 1.4% pace.

There is also an important question of whether productivity growth has slowed even further in recent years.  This might well still be a business cycle effect, as the economy has recovered from the 2008/09 downturn but only slowly (due to the fiscal drag from cuts in government spending).  The pace of productivity growth has been especially slow since late 2010, as is clear by blowing up the chart from above to focus on the period since 2000:

GDP per Worker, 2000Q1 to 2016Q2,rev

Productivity has increased at a rate of just 0.13% a year since late 2010.  This is slow, and a real problem if it continues.  I would hasten to add that the period here (5 1/2 years) is still too short to say with any certainty whether this will remain an issue.  There have been similar multi-year periods since 1947 when the pace of productivity growth appeared to slow, and then bounced back.  Indeed, as seen in the chart above, one would have found a similar pattern had one looked back in early 2009, with a slow pace of productivity growth observed from about 2005.

There has been a good deal of work done by excellent economists on why productivity growth has been what it was, and what it might be in the future.  But there is no consensus.  Robert J. Gordon of Northwestern University, considered by many to be the “dean in the field”, takes a pessimistic view on the prospects in his recently published magnum opus “The Rise and Fall of American Growth”.  Erik Brynjolfsson and Andrew McAfee of MIT, in contrast, argue for a more optimistic view in their recent work “The Second Machine Age” (although “optimistic” might not be the right word because of their concern for the implication of this for jobs).  They see productivity growth progressing rapidly, if not accelerating.

But such explanations are focused on possible productivity growth as dictated by what is possible technologically.  A separate factor, I would argue, is whether investment in fact takes place that makes use of the technology that is available.  And this may well be a dominant consideration when examining the change in productivity over the short and medium terms.  A technology is irrelevant if it is not incorporated into the actual production process.  And it is only incorporated into the production process via investment.

To understand productivity growth, and why it has fallen in recent decades and perhaps especially so in recent years, one must therefore also look at the investment taking place, and why it is what it is.  The rest of this blog post will do that.

B.  The Slowdown in the Pace of Investment

The first point to note is that net investment (i.e. after depreciation) has been falling in recent decades when expressed as a share of GDP, with this true for both private and public investment:

Domestic Fixed Investment, Total, Public, and Private, Net, percentage of GDP, 1951 to 2015, updated Aug 16, 2016

Total net investment has been on a clear downward trend since the mid-1960s.  Private net investment has been volatile, falling sharply with the onset of an economic downturn and then recovering.  But since the late 1970s its trend has also clearly been downward. Net private investment has been less than 3 1/2% of GDP in recent years, or less than half what it averaged between 1951 and 1980 (of over 7% of GDP).  And net public investment, while less volatile, has plummeted over time.  It averaged 3.1% of GDP between 1951 and 1968, but is only 0.5% of GDP now (as of 2015), or less than one-sixth of what it was before.

With falling net investment, the rates of growth of public and private capital stocks (fixed assets) have fallen (where 2014 is the most recent year for which the BEA has released such data):

Rate of Growth In Per Capita Net Stock of Private and Government Fixed Assets, edited, 1951 to 2014

Indeed, expressed in per capita terms, the stock of public capital is now falling.  The decrepit state of our highways, bridges, and other public infrastructure should not be a surprise.  And the stock of private capital fell each year between 2009 and 2011, with some recovery since but still at almost record low growth.

Even setting aside the recent low (or even negative) figures, the trend in the pace of growth for both public and private capital has declined since the mid-1960s.  Why might this be?

C.  Why Has Investment Slowed?

The answer is simple and clear for pubic capital.  Conservative politicians, in both the US Congress and in many states, have forced cuts in public investment over the years to the current low levels.  For whatever reasons, whether ideological or something else, conservative politicians have insisted on cutting or even blocking much of what the United States used to invest in publicly.

Yet public, like private, investment is important to productivity.  It is not only commuters trying to get to work who spend time in traffic jams from inadequate roads, and hence face work days of not 8 1/2 hours, but rather 10 or 11 or even 12 hours (with consequent adverse impacts on their productivity).  It affects also truck drivers and repairmen, who can accomplish less on their jobs due to time spent in jams.  Or, as a consequence of inadequate public investment in computer technology, a greater number of public sector workers are required than otherwise, in jobs ranging from issuing driver’s licenses to enrolling people in Medicare.  Inadequate public investment can hold back economic productivity in many ways.

The reasons behind the fall in private investment are less obvious, but more interesting. An obvious possible cause to check is whether private profitability has fallen.  If it has, then a reduction in private investment relative to output would not be a surprise.  But this has in fact not been the case:

Rate of Return on Produced Assets, 1951 to 2015, updated

The nominal rate of return on private investment has not only been high, but also surprisingly steady over the years.  Profits are defined here as the net operating surplus of all private entities, and is taken from the national account figures of the BEA.  They are then taken as a ratio to the stock of private produced assets (fixed assets plus inventories) as of the beginning of the year.  This rate of return has varied only between 8 and 13% over the period since at least 1951, and over the last several years has been around 11%.

Many might be surprised by both this high level of profitability and its lack of volatility.  I was.  But it should be noted that the measure of profitability here, net operating surplus, is a broad measure of all the returns to capital.  It includes not only corporate profitability, but also profits of unincorporated businesses, payments of interest (on borrowed capital), and payments of rents (as on buildings). That is, this is the return on all forms of private productive capital in the economy.

The real rates of return have been more volatile, and were especially low between 1974 and 1983, when inflation was high.  They are measured here by adjusting the nominal returns for inflation, using the GDP deflator as the measure for inflation.  But this real rate of return was a good 9.6% in 2015.  That is high for a real rate of return.  It was higher than that only for one year late in the Clinton administration, and for several years between the early 1950s and the mid-1960s.  But it was never higher than 11%.  The current real rate of return on private capital is far from low.

Why then has private investment slowed, in relation to output, if profitability is as high now as it has ever been since the 1950s?  One could conceive of several possible reasons. They include:

a)  Along the lines of what Robert Gordon has argued, perhaps the underlying pace of technological progress has slowed, and thus there is less of an incentive to undertake new investments (since the returns to replacing old capital with new capital will be less).  The rate of growth of capital then slows, and this keeps up profitability (as the capital becomes more scarce relative to output) even as the attractiveness of new investment diminishes.

b)  Conservatives might argue that the reduced pace of investment could be due to increased governmental regulations, which makes investment more difficult and raises its cost.  This might be difficult to reconcile with the rate of return on capital nonetheless remaining high, but in principle could be if one argues that the slower pace of new investment keeps up profitability as capital then becomes more scarce relative to output. But note that this argument would require that the increased burden of regulation began during the Reagan years in the early 1980s (when the share of private investment in GDP first started to slow – see the chart above), and built up steadily since then through both Republican and Democratic administrations.  It would not be something that started only recently under Obama.

c)  One could also argue that the reduced investment might be a consequence of “Baumol’s Cost Disease”.  This was discussed in earlier posts on this blog, both for overall government spending and for government investment in infrastructure specifically.  As discussed in those posts, Baumol’s Cost Disease explains why activities where productivity growth may be relatively more difficult to achieve than in other activities, will see their relative costs increase over time.  Construction is an example, where productivity growth has been historically more difficult to achieve than has been the case in manufacturing.  Thus the cost of investing, both public and private, relative to the cost of other items will increase over time.  This can then also be a possible explanation of slowing new investment, with that slower investment then keeping profitability up due to increasing scarcity of capital.

One problem with each of the possible explanations described above is that they all depend on capital investments becoming less attractive than before, either due to higher costs or due to reduced prospective return.  If such factors were indeed critical, one would need to take into account also the effect of taxes on investment returns.  And such taxes have been cut sharply over this same period.  As discussed in an earlier blog post, taxes on corporate profits, for example, are taxed now at an effective rate of less than 20%, based on what is actually paid after all the legal deductions and credits are included.  And this tax rate has fallen steadily over time.  The current 20% rate is less than half the effective rate that applied in the 1950s and 1960s, when the effective rate averaged almost 45%.  And the tax rate on long-term capital gains, as would apply to returns on capital to individuals, fell from a peak of just below 40% in the mid-1970s to just 15% following the Bush II tax cuts and to 20% since 2013.

Such sharp cuts in taxes on profits implies that the after-tax rate of return on assets has risen sharply (the before-tax rate of return, shown on the chart above, has been flat).  Yet despite this, private investment has fallen steadily since the early 1980s as a share of GDP.

Such explanations for the reason behind the fall in private investment since the early 1980s are therefore questionable.  However, the purpose of this blog post is not to debate this. Economists are good at coming up with models, possibly convoluted, which can explain things ex post.  Several could apply here.

Rather, I would suggest that there might be an alternative explanation for why private investment has been declining.  While consistent with basic economics, I have not seen it before.  This explanation focuses on the stagnant real wages seen since the early 1980s, and the impact this would have on whether or not to invest.

D.  The Impact of Low Real Wages

Real wages have stagnated in the US since the early 1980s, as has been discussed in earlier posts on this blog (see in particular this post).  The chart below, updated to the most recent figures available, compares the real median wage since 1979 (the earliest year available for this data series) to real GDP per worker employed:

Real GDP per Worker versus Real Median Wage, 1979Q1 to 2016Q2, rev

Real median wages have been flat overall:  Just 3% higher in 2016 than what they were 37 years before.  But real GDP per worker is almost 60% higher over this same period.  This has critically important implications for both private investment and for productivity growth. To sum up in one line the discussion that will follow below, there is less and less reason to invest in new, productivity enhancing, capital, if labor is available at a stagnant real wage that has changed little in 37 years.

Traditional economics, as commonly taught, would find it difficult to explain the observed stagnation in real wages while productivity has risen (even if at a slower pace than before). A core result taught in microeconomics is that in “perfectly competitive” markets, labor will be paid the value of its marginal product.  One would not then see a divergence such as that seen in this chart between growth in productivity and a lack of growth in the real wage.

(The more careful observers among the readers of this post might note that the productivity curve shown here is for average productivity, and not the marginal productivity of an extra worker.  This is true.  Marginal productivity for the economy as a whole cannot be easily observed, nor indeed even be well defined.  However, one should note that the average productivity curve, as shown here, is rising over time.  This can only happen if marginal productivity on new investments are above average productivity at any point in time.  For other reasons, the real average wage would not rise permanently above average productivity (there would be an “adding-up” problem otherwise), but the theory would still predict a rise in the real wage with the increase in observed productivity.)

There are, however, clear reasons why workers might not be paid the value of their marginal product in the real world.  As noted, the theory applies in markets that are assumed to be perfectly competitive, and there are many reasons why this is not the case in the world we live in.  Perfect competition assumes that both parties to the transaction (the workers and employers) have complete information on not only the opportunities available in the market and on the abilities of the individual worker, but also that there are no costs to switching to an alternative worker or employer.  If there is a job on the other side of the country that would pay the individual worker a bit more, then the theory assumes the worker will switch to it.  But there are, of course, significant costs to moving to the other side of the country.  Furthermore, there will be uncertainty on what the abilities of any individual worker will be, so employers will normally seek to keep the workers they already have to fill their needs (as they know what these workers can do), than take a risk on a largely unknown new worker who might be willing to work for a lower wage.

For these and other reasons, labor markets are not perfectly competitive, and one should not then be surprised to find workers are not being paid the value of their marginal product.  But there is also an important factor coming from the macroeconomy. Microeconomics assumes that all resources, including labor resources, are being fully employed.  But unemployment exists and is often substantial.  Additional workers can then be hired at the current wage, without a need for the firm to raise that wage.  And that will hold whether or not the productivity of those workers has risen.

In such an environment, when unemployment is substantial one should not be surprised to find a divergence between growth in productivity and growth in the real wage.  And while there have of course been sharp fluctuations arising from the business cycle in the rate of unemployment from year to year, the simple average in the rate since 1979 has been 6.4%.  This is well in excess of what is normally considered the full employment rate of unemployment (of 5% or less).  Macro policy (both fiscal and monetary) has not done a very good job in most of the years since 1979 in ensuring there is sufficient demand in the aggregate in the economy to allow all workers who want to be employed in fact to be employed.

In such an environment, of workers being available for hire at a stagnant real wage which over time diverges more and more from their productivity, consider the investment decision a private firm faces.  Suppose they see a market opportunity and can sell more. To produce more, they have two options.  They can hire more labor to work with their existing plant and equipment to produce more, or they can invest in new plant and equipment.  If they choose the latter, they can produce more with fewer workers than they would otherwise need at the new level of production.  There will be more output per unit of labor input, or put another way, productivity will rise if the latter option is chosen.

But in an economy where labor is available at a flat real wage that has not changed in decades, the best choice will often simply be to hire more labor.  The labor is cheap.  New investment has a cost, and if the cost of the alternative (hire more labor) is low enough, then it is more profitable for the firm simply to hire more labor.  Productivity in such a case will then not go up, and may indeed even go down.  But this could be the economically wise choice, if labor is cheap enough.

Viewed in this way, one can see that the interpretation of many conservatives on the relationship between productivity growth and the real wage has it backwards.  Real wages have not been stagnant because productivity growth has been slow.  Labor productivity since 1979 has grown by a cumulative 60%, while real median wages have been basically flat.

Rather, the causation may well be going the other way.  Stagnant and low real wages have led to less and less of an incentive for private firms to invest.  And such a cut-back is precisely what we saw in the chart above on private (as well as public) investment as a share of GDP.  With less investment, the pace of productivity growth has then slowed.

As a reflection of this confusion, conservatives have denounced any effort to raise wages, asserting that if this is done, jobs will be lost as firms choose instead to invest and automate.  They assert that raising the minimum wage, which is currently lower in real terms than what it was when Harry Truman was president, would lead to minimum wage workers losing their jobs.  As a former CEO of McDonalds put it in a widely cited news report from last May, a $15 minimum wage would lead to “a job loss like you can’t believe.”   Fast food outlets like McDonalds would then find it better to invest in robotic arms to bag the french fries, he said, rather than hire workers to do this.

This is true.  The confusion comes from the widespread presumption that this is necessarily bad.  Outlets like McDonalds would then require fewer workers, but they would still need workers (including to operate the robotic arms), and those workers would be more productive.  They could be paid more, and would be if the minimum wage is raised.

The error in the argument comes from the presumption that the workers being employed at the current minimum wage of $7.25 an hour do not and can not possess the skills needed to be employed in some other job.  There is no reason to believe this to be the case.  There was no problem with ensuring workers could be fully employed at a minimum wage which in real terms was higher in 1950, when Harry Truman was president, than what it is now.  And average worker productivity is 2.4 times higher now than what it was then.

Ensuring full employment in the economy as a whole is not a responsibility of private business.  Rather, it is a government responsibility.  Fiscal and monetary policy need to be managed so that labor markets are tight enough to ensure all workers who want a job can get a job, while not so tight at to lead to inflation.

Following the economic collapse at the end of the Bush administration in 2008, monetary policy did all it could to try to ensure sufficient aggregate demand in the economy (interest rates were held at or close to zero).  But monetary policy alone will not be enough when the economy collapsed as far as it did in 2008.  It needs to be complemented by supportive fiscal policy.  While there was the initial stimulus package of Obama which was critical to stabilizing the economy, it did not go far enough and was allowed to run out. And government spending from 2010 was then cut, acting as a drag which kept the pace of recovery slow.  The economy has only in the past year returned to close to full employment.  It is not a coincidence that real wages are finally starting to rise (as seen in the chart above).

E.  Conclusion

Productivity growth is key in any economy.  Over the long run, living standards can only improve if productivity does.  Hence there is reason to be concerned with the slower pace of productivity growth seen since the early 1980s, and especially in recent years.

Investment, both public and private, is what leads to productivity growth, but the pace of investment has slowed since the levels seen in the 1950s and 60s.  The cause of the decline in public investment is clear:  Conservative politicians have slowed or even blocked public investment.  The result is obvious in our public infrastructure:  It is overused, under-maintained, and often an embarrassment.

The cause of the slowdown in private investment is less obvious, but equally important. First, one cannot blame a decline in private investment on a fall in profitability:  Profitability is higher now than it has been in all but one year since the mid-1960s.

Rather, one needs to recognize that the incentive to invest in productivity enhancing tools will not be there (or not there to the same extent) if labor can be hired at a wage that has stagnated for decades, and which over time became lower and lower relative to existing productivity.  It then makes more sense for firms to hire more workers with their existing stock of capital and other equipment, rather than invest in new, productivity enhancing, capital.  And this is what we have observed:  Workers are being hired, but productivity is not growing.

An argument is often made that if firms did indeed invest in capital and equipment that would raise productivity, that workers would then lose their jobs.  This is actually true by definition:  If productivity is higher, then the firm needs fewer workers per unit of output than they would otherwise.  But whether more workers would be employed in the economy as a whole does not depend on the actions of any individual firm, but rather on whether fiscal and monetary policy is managed to ensure full employment.

That is, it is the investment decisions of private firms which determine whether productivity will grow or not.  It is the macro management decisions of government which determine whether workers will be fully employed or not.

To put this bluntly, and in simplistic “bumper sticker” type terms, one could say that private businesses are not job creators, but rather job destroyers.  And that is fine.  Higher productivity means that a firm needs fewer workers to produce what they make than would otherwise have been needed, and this is important for ensuring efficiency.  As a necessary complement to this, however, it is the actions of government, through its fiscal and monetary policies, which “creates” jobs by managing aggregate demand to ensure all workers who want to be employed, are employed.

The Impact of Increased Inequality on the Social Security Trust Fund, and What To Do Now

Social Security Trust Fund to GDP, with benefit changes, 90% of Wages from 1984 or 2016, 1970 to 2090, revised

A.  Introduction

It is well known that with current Social Security tax and benefit rates, the Social Security Trust Fund is projected to run out by the 2030s.  The most recent projection is that this will happen in 2034.  And it is commonly believed that this is a consequence of lengthening life spans.  However, that is not really true.  Later in this century (in the period after the 2030s), life spans that are now forecast to be longer than had been anticipated before will eventually lead, if nothing is done, to depletion of the trust funds.  But the primary cause of the trust funds running out by the currently projected 2034 stems not from longer life spans, but rather from the sharp growth in US income inequality since Ronald Reagan was president.  Had inequality not grown as it has since the early 1980s, and with all else as currently projected, the Social Security Trust Fund would last to about 2056.

This particular (and important) consequence of the growing inequality in American society over the last several decades does not appear to have been recognized before.  Rather, the problems being faced by the Social Security Trust Fund are commonly said to be a consequence of lengthening life expectancies of Americans (where it is the life expectancy of those at around age 65, the traditional retirement age, that is relevant).  I have myself stated this in earlier posts on this blog.

But this assertion that longer life spans are to blame has bothered me.  Social Security tax rates and benefit formulae have been set based on what were thought at the time to be levels that would allow all scheduled benefits to be paid for the (then) foreseeable future, based on the forecasts of the time (of life expectancies and many other factors). Thus it is not correct to state that it is longer life spans per se that can be to blame for the Social Security Trust Fund running out.  Rather, it would be necessary for life spans to be lengthening by more than had been expected before for this to be the case.

This blog post will look first at these projections of life expectancy – what path was previously forecast in comparison to what in fact happened (up to now) and what is forecast (now) for the future.  We will find that the projections used to set the current Social Security tax and benefit rates (last changed in the early 1980s) had in fact forecast life spans which would be longer than what transpired in the 1980s, 1990s, and 2000s.  That is, actual life expectancies have turned out to be shorter than what had been forecast for those three decades.  However, life spans going forward are currently forecast to be longer than what had been projected earlier.  On average, it turns out that the earlier forecasts were not far off from what happened or is now expected through to 2034.  Unexpectedly longer life spans do not account for the current forecast that the Social Security Trust Fund will run out by 2034.

Rather, the problem is due to the sharp increase in wage income inequality since the early 1980s.  Only wages up to a ceiling (of $118,500 in 2016) are subject to Social Security tax.  Wages earned above that ceiling amount are exempt from the tax.  In 1982 and also in 1983, the ceiling then in effect was such that Social Security taxes were paid on 90% of all wages earned.  But as will be discussed below, increasing wage inequality since then has led to an increasing share of wages above the ceiling, and hence exempt from tax.  It is this increasing wage income inequality which is leading the Social Security Trust Fund to an expected depletion by 2034, if nothing is done.

This blog post will look at what path the Social Security Trust Fund would have taken had wage inequality not increased since 1983.  Had that been the case, 90% of wages would have been covered by Social Security tax since 1984, in the past and going forward.  But since it is now 2016 and we cannot change history, we will also look at what the path would be if the ceiling were now returned, from 2016 going forward, to a level covering 90% of wages.  The final section of the post will then look at what would happen if the wage ceiling were lifted altogether so that the rich would pay at the same rate of tax as the poor.

One final point for this introduction:  In addition to longer life spans, many commentators assert that it is the retiring baby boom generation which is depleting the Social Security Trust Fund.  But this is also not true.  The Social Security tax and benefit rates were set in full knowledge of how old the baby boomers were, and when they would be reaching retirement age.  Demographic projections are straightforward, and they had a pretty good estimate 64 years ago of how many of us would be reaching age 65 today.

B.  Projections of Increasing Life Spans for Those in Retirement

Life expectancies have been growing.  But this has been true for over two centuries, and longer expected life spans have always been built into the Social Security calculations of what the Social Security tax rates would need to be in order to provide for the covered benefits.  The issue, rather, is whether the path followed for life expectancies (actual up to now and as now expected for the future) is higher or lower than the path that had been expected earlier.

What we have seen in recent decades is that while life spans for those of higher income have continued to grow, they have increased only modestly for the bottom half of income earners.  Part of the reason for this stagnation of life expectancy for the bottom half of the income distribution is undoubtedly a consequence of stagnant real incomes for lower income earners.  As discussed in an earlier post on this blog, median real wages have hardly risen at all since 1980.  And indeed, average real household incomes of the bottom 90% of US households were lower in 2014 than they were in 1980.

Thus it is an open question whether life spans are turning out to be longer than what had been projected before, when Social Security tax and benefit rates were last adjusted.  The most recent such major adjustment was undertaken in 1983, following the report of the Greenspan Commission (formally titled the National Commission on Social Security Reform).  President Reagan appointed Alan Greenspan to be the chair (and later appointed him to be the head of the Federal Reserve Board), with the other members appointed either by Reagan or by Congress (with a mix from both parties).

The Greenspan Commission made recommendations on a set of measures (which formed the basis for legislation enacted by Congress in 1983) which together would ensure, based on the then current projections, that the Social Security Trust Fund would remain adequate through at least 2060.  They included a mix of increased tax rates (with the Social Security tax rate raised from 10.8% to 12.4%, phased in over 7 years, with this for both the old-age pensions and disability insurance funds and covering both the employer and employee contributions) and reduced benefits (with, among other changes, the “normal” retirement age increased over time).

It is now forecast, however, that the Trust Funds will run out by 2034.  What changed? The common assertion is that longer life spans account for this.  However, this is not true. The life spans used by the Greenspan Commission (see Appendix K of their report, Table 12) were in fact too high, averaging male and female together, up to about 2010, but are now forecast to be too low going forward.  More precisely, comparing those forecasts to those in the most recent 2015 Social Security Trustees Report:

Projected Life Expectancies at Age 65 - As of 1982 vs 2015, Up to 2090

 

The chart shows the forecasts (in blue) used by the Greenspan Commission (which were in turn taken from the 1982 Social Security Trustees Report) overlaid on the current (2015, in red) history and projections.  The life span forecasts used by the Greenspan Commission turned out actually to be substantially higher than what were the case or are forecast now to be the case for females to some point past 2060, higher up to the year 2000 for males, and based on the simple male/female average, higher up to about 2010 for all, than what were estimated in the 2015 report.  For the full period from 1983 to 2034 (using interpolated figures for the periods when the 1982 forecasts were only available for every 5 and then every 10 years), it turns out that the average over time of the differences in the male/female life expectancy at age 65 between the 1982 forecasts and those from 2015, balances almost exactly. The difference is only 0.01 years (one-hundreth of a year).

For the overall period up to 2034, the projections of life expectancies used by the Greenspan Commission are on average almost exactly the same as what has been seen up to now or is currently forecast going forward (cumulatively to 2034).  And it is the cumulative path which matters for the Trust Fund.  Unexpectedly longer life expectancies do not explain why the Social Security Trust Fund is now forecast to run out by 2034.  Nor, as noted above, is it due to the pending retirement of more and more of the baby boom generation.  It has long been known when they would be reaching age 65.

C.  The Ceiling on Wages Subject to Social Security Tax

Why then, is the Social Security Trust Fund now expected to run out by 2034, whereas the Greenspan Commission projected that it would be fine through 2060?  While there are many factors that go into the projections, including not just life spans but also real GDP growth rates, interest rates, real wage growth, and so on, one assumption stands out. Social Security taxes (currently at the rate of 12.4%, for employee and employer combined) only applies to wages up to a certain ceiling.  That ceiling is $118,500 in 2016. Since legislation passed in 1972, this ceiling has been indexed in most years (1979 to 1981 were exceptions) to the increase in average wages for all employees covered by Social Security.

The Greenspan Commission did not change this.  Based on the ceiling in effect in 1982 and again in 1983, wages subject to Social Security tax would have covered 90.0% of all wages in the sectors covered by Social Security.  That is, Social Security taxes would have been paid on 90% of all wages in the covered sectors in those years.  If wages for the poor, middle, and rich had then changed similarly over time (in terms of their percentage increases), with the relative distribution thus the same, an increase in the ceiling in accordance with changes in the overall average wage index would have kept 90% of wages subject to the Social Security tax.

However, wages did not change in this balanced way.  Rather, the changes were terribly skewed, with wages for the rich rising sharply since the early 1980s while wages for the middle classes and the poor stagnated.  When this happens, with wages for the rich (those earning more than the Social Security ceiling) rising by more (and indeed far more) than the wages for others, indexing the ceiling to the average wage will not suffice to keep 90% of wages subject to tax.  Rather, the share of wages paying Social Security taxes will fall.  And that is precisely what has happened:

Social Security Taxable Wages as Share of Total Wages, 1982 to 2090

Due to the increase in wage income inequality since the early 1980s, wages paying Social Security taxes fell from 90.0% of total wages in 1982 and again in 1983, to just 82.7% in 2013 (the most recent year with data, see Table 4.B1 in the 2014 Social Security Annual Statistical Supplement).  While the trend is clearly downward, note how there were upward movements in 1989/90/91, in 2001/02, and in 2008/09.  These coincided with the economic downturns at the start of the Bush I administration, the start of the Bush II administration, and the end of the Bush II administration.  During economic downturns in the US, wages of those at the very top of the income distribution (Wall Street financiers, high-end lawyers, and similar) will decline especially sharply relative to where they had been during economic booms, which will result in a higher share of all wages paid in such years falling under the ceiling.

Why did the Greenspan Commission leave the rule for the determination of the ceiling on wages subject to Social Security tax unchanged?  Based on the experience in the decades leading up to 1980, this was not unreasonable.  In the post-World War II decades up to 1980, the distribution of incomes did not change much.  As discussed in an earlier post on this blog, incomes of the rich, middle, and poor all grew at similar rates over that period, leaving the relative distribution largely unchanged.  It was not unreasonable then to assume this would continue.  And indeed, there is a footnote in a table in the annex to the Greenspan Commission report (Appendix K, Table 15, footnote c) which states:  [Referring to the column showing the historical share in total wages of wages below the ceiling, and hence subject to Social Security tax] “The percent taxable for future years [1983 and later] should remain relatively stable as the taxable earnings base rises automatically based on increases in average wage levels.”

Experience turned out to be quite different.  Income inequality has risen sharply since Reagan was president.  This reduced the share of wages subject to Social Security tax, and undermined the forecasts made by the Greenspan Commission that with the changes introduced, the Social Security Trust Fund would remain adequate until well past 2034.

Going forward, the current forecasts for the path of the share of wages falling under the ceiling and hence subject to Social Security tax are shown as the blue curve in the chart. The forecasts (starting from 2013, the year with the most recent data when the Social Security Administration prepared these projections) are that the share would continue to decline until 2016.  However, they assume the share subject to tax will then start a modest recovery, reaching a share of 82.5% 2024 at which it will then remain for the remainder of the projection period (to 2090).  (The figures are from the Social Security Technical Panel Report, September 2015, see page 64 and following.  The annual Social Security Trustees Report does not provide the figures explicitly, even though they are implicit in their projections.)

This stabilization of the share of wages subject to Social Security tax at 82.5% is critically important.  Should the wage income distribution continue to deteriorate, as it has since the early 1980s, the Social Security Trust Fund will be in even greater difficulty than is now forecast.  And it is not clear why one should assume this turnaround should now occur.

Finally, it should be noted for completeness that the share of wages subject to tax varied substantially over time in the period prior to 1982.  Typically, it was well below 90%.  When Social Security began in 1937, the ceiling then set meant that 92% of wages (in covered sectors) were subject to tax (see Table 4.B1 in the 2014 Social Security Annual Statistical Supplement).  But the ceiling was set in nominal terms (initially at $3,000), which meant that it fell in real terms over time due to steady, even if low, inflation.  Congress responded by periodically adjusting the annual ceiling upward in the 1950s, 1960s, and 1970s, but always simply setting it at a new figure in nominal terms which was then eroded once again by inflation.  Only when the new system was established in the 1970s of adjusting the ceiling annually to reflect changes in average nominal wages did the inflation issue get resolved.  But this failed to address the problem of changes in the distribution of wages, where an increasing share of wages accruing to the rich in recent decades (since Reagan was president) has led to the fall since 1983 in the share subject to tax.

Thus an increasing share of wages has been escaping Social Security taxes.  The rest of this blog post will show that this explains why the Social Security Trust Fund is now projected to run out by 2034, and what could be achieved by returning the ceiling to where it would cover 90% of wages, or by lifting it entirely.

D.  The Impact of Keeping the Ceiling at 90% of Total Wages

The chart at the top of this post shows what the consequences would be if the ceiling on wages subject to Social Security taxes had been kept at levels sufficient to cover 90% of total wages (in sectors covered by Social Security), with this either from 1984 going forward, or starting from 2016.  While the specific figures for the distant future (the numbers go out to 2090) should not be taken too seriously, the trends are of interest.

The figures are calculated from data and projections provided in the 2015 Social Security Trustees Annual Report, with most of the specific data coming from their supplemental single-year tables (and where the share of wages subject to tax used in the Social Security projections are provided in the 2015 Social Security Technical Panel Report).  Note that throughout this blog post I am combining the taxes and trust funds for Old-Age Security (OASI, for old age and survivor benefits) and for Disability Insurance (DI).  While technically separate funds, these trust funds are often combined for analysis, in part because in the past they have traditionally been able to borrow from each other (although Republicans in Congress are now trying to block this flexibility).

The Base Case line (in black) shows the path of the Social Security Trust Fund to GDP ratio based on the most recent intermediate case assumptions of Social Security, as presented in the 2015 Social Security Trustees Annual Report.  The ratio recovered from near zero in the early 1980s to reach a high of 18% of GDP in 2009, following the changes in tax and benefit rates enacted by Congress after the Greenspan Commission report.  But it then started to decline, and is expected to hit zero in 2034 based on the most recent official projections.  After that if would grow increasingly negative if benefits were to continue to be paid out according to the scheduled formulae (and taxes were to continue at the current 12.4% rate), although Social Security does not have the legal authority to continue to pay out full benefits under such circumstances.  The projections therefore show what would happen under the stated assumptions, not what would in fact take place.

But as noted above, an important assumption made by the Greenspan Commission that in fact did not hold true was that adjustments (based on changes in the average wage) of the ceiling on wages subject to Social Security tax, would leave 90% of wages in covered sectors subject to the tax.  This has not happened due to the growth in wage income inequality in the last 35 years.  With the rich (and especially the extreme rich) taking in a higher share of wages, the wages below a ceiling that was adjusted according to average wage growth has led to a lower and lower share of overall wages paying the Social Security tax.  The rich are seeing a higher share of the high wages they enjoy escaping such taxation.

The blue curves in the chart show what the path of the Social Security Trust Fund to GDP ratio would have been (and would be projected going forward, based on the same other assumptions of the base case) had the share of wages subject to Social Security taxes remained at 90% from 1984.  The dark blue curve shows what path the Trust Fund would have taken had Social Security benefits remained the same.  But since benefits are tied to Social Security taxes paid, the true path will be a bit below (shown as the light blue curve). This takes into account the resulting higher benefits (and income taxes that will be paid on these benefits) that will accrue to those paying the higher Social Security taxes.  This was fairly complicated, as one needs to work out the figures year by year for each age cohort, but can be done.  It turns out that the two curves end up being quite close to each other, but one did not know this would be the case until the calculations were done.

Had the wage income distribution not deteriorated after 1983, and with all else as in the base case path of the Social Security Trustees Report (actual for historical, or as projected going forward), the Trust Fund would have grown to a peak of 26% of GDP in 2012, before starting on a downward path.  It would eventually still have turned negative, but only in 2056.  Over the long term, the forecast increase in life expectancies (beyond what the Greenspan Commission had assumed) would have meant that further changes beyond what were enacted following the Greenspan Commission report would eventually have become necessary to keep the Trust Fund solvent.  But it would have occurred more than two decades beyond what is now forecast.

At this point in time, however, we cannot go back in time to 1984 to keep the ceiling sufficient to cover 90% of wages.  What we can do now is raise the ceiling today so that, going forward, 90% of wages would be subject to the tax.  Based on 2014 wage distribution statistics (available from Social Security), one can calculate that the ceiling in 2014 would have had to been raised from the $117,000 in effect that year, to $185,000 to once again cover 90% of wages (about $187,000 in 2016 prices). 

The red curves on the chart above show the impact of starting to do this in 2016.  The Trust Fund to GDP ratio would still fall, but now reach zero only in 2044, a decade later than currently forecast.  Although there would be an extra decade cushion as a result of the reform, there would still be a need for a longer term solution.   

E.  The Impact of Removing the Wage Ceiling Altogether

The financial impact of removing the wage ceiling altogether will be examined below.  But before doing this, it is worthwhile to consider whether, if one were designing a fair and efficient tax structure now, would a wage ceiling be included at all?  The answer is no. First, it is adds a complication, and hence it is not simple.  But more importantly, it is not fair.  A general principle for tax systems is that the rich should pay at a rate at least as high as the poor.  Indeed, if anything they should pay at a higher rate.  Yet Social Security taxes are paid at a flat rate (of 12.4% currently) for wages up to an annual ceiling, and at a zero rate for earnings above that ceiling.

While it is true that this wage ceiling has been a feature of the Social Security system since its start, this does not make this right.  I do not know the history of the debate and political compromises necessary to get the Social Security Act passed through Congress in 1935, but could well believe that such a ceiling may have been necessary to get congressional approval.  Some have argued that it helped to provide the appearance of Social Security being a self-funded (albeit mandatory) social insurance program rather than a government entitlement program.  But for whatever the original reason, there has been a ceiling.

But the Social Security tax is a tax.  It is mandatory, like any other tax.  And it should follow the basic principles of taxation.  For fairness as well as simplicity, there should be no ceiling.  The extremely rich should pay at least at the same rate as the poor.

One could go further and argue that the rates should be progressive, with marginal rates rising for those at higher incomes.  There are of course many options, and I will not go into them here, but just note that Social Security does introduce a degree of progressivity through how retirement benefits are calculated.  The poor receive back in pensions a higher amount in relation to the amounts they have paid in than the rich do.  One could play with the specific parameters to make this more or less progressive, but it is a reasonable approach.  Thus applying a flat rate of tax to all income levels is not inconsistent with progressivity for the system as a whole.

Leaving the Social Security tax rate at the current 12.4% (for employer and employee combined), but applying it to all wages from 2016 going forward and not only wages up to an annual ceiling, would lead to the following path for the Trust Fund to GDP ratio:

Social Security Trust Fund to GDP, with benefit changes, All Wages from 2016, 1970 to 2090, revised

The Trust Fund would now be projected to last until 2090.  Again, the projections for the distant future should not be taken too seriously, but they indicate that on present assumptions, eliminating the ceiling on wages subject to tax would basically resolve Trust Fund concerns for the foreseeable future.  A downward trend would eventually re-assert itself, due to the steadily growing life expectancies now forecast (see the chart in the text above for the projections from the 2015 Social Security Trustees Annual Report). Eventually there will be a need to pay in at a higher rate of tax if taxes on earnings over a given working life are to support a longer and longer expected retirement period, but this does not dominate until late in the forecast period.

As a final exercise, how high would that tax rate need to be, assuming all else (including future life expectancies) are as now forecast?  The chart below shows what the impact would be of raising the tax rate to 13.0% from 2050:

Social Security Trust Fund to GDP, with benefit changes, All Wages from 2016, 1970 to 2090, revised #2

The Social Security Trust Fund to GDP ratio would then be safely positive for at least the rest of the century, assuming the different variables are all as now forecast.  This would be a surprisingly modest increase in the tax rate from the current 12.4%.  If separated into equal employer and employee shares, as is traditionally done, the increase would be from a 6.2% tax paid by each to a 6.5% tax paid by each.  Such a separation is economically questionable, however.  Most economists would say that, under competitive conditions, the worker will pay the full tax.  Whether labor markets can be considered always to be competitive is a big question, but beyond the scope of this blog post.

F.  Summary and Conclusion

To summarize:

1)  The Social Security Trust Fund is projected to be depleted under current tax and benefit rates by the year 2034.  But this is not because retirees are living longer.  Increasing life spans have long been expected, and were factored into the estimates (the last time the rates were changed) of what the tax and benefit rates would need to be for the Trust Fund not to run out.  Nor is it because of aging baby boomers reaching retirement.  This has long been anticipated.

2)  Rather, the Social Security Trust Fund is now forecast to run out by the 2030s because of the sharp increase in wage income inequality since the early 1980s, when the Greenspan Commission did its work.  The Greenspan Commission assumed that the distribution of wage incomes would remain stable, as it had in the previous decades since World War II.  But that turned out not to be the case.

3)  If relative inequality had not grown, then raising the ceiling on wages subject to Social Security tax in line with the increase in average wages (a formula adopted in legislation of 1972, and left unchanged following the Greenspan Commission) would have kept 90% of wages subject to Social Security tax, the ratio it covered in 1982 and again in 1983.

4)  But wage income inequality has grown sharply since the early 1980s.  With the distribution increasingly skewed distribution, favoring the rich, an increasing share of wages is escaping Social Security tax.  By 2013, the tax only covered 82.7% of wages, with the rest above the ceiling and hence paying no tax.

5)  Had the ceiling remained since 1984 at levels sufficient to cover 90% of wages, and with all other variables and parameters as experienced historically or as now forecast going forward, the Social Security Trust Fund would be forecast to last until 2056.  While life expectancies (at age 65) in fact turned out on average to be lower than forecast by the Greenspan Commission until 2010 (which would have led to a higher Trust Fund balance, since less was paid out in retirement than anticipated), life expectancies going forward are now forecast to be higher than what the Greenspan Commission assumed.  This will eventually dominate.

6)  If the wage ceiling were now adjusted in 2016 to a level sufficient to cover once again 90% of wages ($187,000 in 2016), the Trust Fund would turn negative in 2044, rather than 2034 as forecast if nothing is done.

7)  As a matter of equity and following basic taxation principles, there should not be any wage ceiling at all.  The rich should pay Social Security tax at least at the same rate as the poor.  Under the current system, they pay zero on wage incomes above the ceiling.

8)  If the ceiling on wages subject to Social Security tax were eliminated altogether, with all else as in the base case Social Security projections of 2015, the Trust Fund would be expected to last until 2090.

9)  If the ceiling on wages subject to Social Security tax were eliminated altogether and the tax rate were raised from the current 12.4% to a new rate of 13.0% starting in 2050, with all else as in the base case Social Security projections of 2015, the Trust Fund would be expected to last to well beyond the current century.

The Highly Skewed Growth of Incomes Since 1980: Only the Top 0.5% Have Done Better Than Before

Piketty - Saez 1947 to 2014, June 2015, log scale

A)  Introduction

The distribution of the gains from growth have become terribly skewed since around 1980, as the chart above shows and as has been discussed in a number of posts on this blog (see, for example, here, here, here, here, and here).  From 1980 to 2014, the bottom 90% of households have seen their real income fall by 3%, while the top 0.01% have enjoyed growth of 386%.  This was not the case in the post-war years up to 1980:  Over those decades the different income groups saw similar increases in their real per household incomes:  By 87% for average income for the period between 1947 and 1980. But that ended around 1980.

The data underlying these figures were recently updated to include estimates for 2014, and this may be an opportune time to look at them again and more closely.   Specifically, most analyses (as well as the chart above) focus on the incomes of the top 10%, the top 1%, and so on, even though these are overlapping groups.  The top 10% includes the top 1%, and an open question is the extent to which the gains of the top 10% reflects gains primarily in the top 1% or also gains of those in the 90 to 99% income range.  This will be examined below.  Finally, the post will look at the question of what share of the growth in overall incomes over the full 1980 to 2014 period went to the various groups.  As one would expect, the gains were highly concentrated for the rich.  What one might find surprising is how concentrated it was.

B)  Real Income Growth (or Decline) Between 1980 and 2014 

As seen in the chart above, the rich got far richer in the period since 1980, while not just the poor but even those making up fully 90% of the population, got poorer.

The data in the chart come from Professor Emmanuel Saez of UC Berkeley, who has for some years been providing the figures from which the incomes of the very rich can be calculated, often in collaboration with the now better known Thomas Piketty.  In late June, Saez released data updated through 2014:  See his June 29 post at the Washington Center for Equitable Growth website, with links there to an Excel spreadsheet from which the data used here was downloaded.  The basic data are now also available at the World Top Incomes Database, of Facundo Alvaredo, Tony Atkinson, Thomas Piketty, and Emmanuel Saez.  Note that this data for 2014 reflects initial estimates.  They may change as more detailed figures are released by the IRS (the ultimate source for the data).

The chart covers the 1947 to 2014 period, indexed to 1980 = 100 for each of the groups. A logarithmic scale is used as equal proportional changes will then show as equal distances on the vertical axis.  That is, the distance between index values of 50 and 100, between 100 and 200, and between 200 and 400, will all be equal as all represent a doubling on income.  This makes it easier to see and track relative changes in values across different periods, for example between 1947 and 1980 in comparison to 1980 to 2014.

The data through 2014 confirm the trends discussed before in this blog, with a sharp increase in inequality since 1980 but also with large year to year fluctuations.  The year to year fluctuations are especially large for the very richest.  The incomes reported here come from anonymized tax return data, and hence reflect incomes by tax reporting units (generally households) with incomes as defined for tax purposes.  The income figures include income from realized capital gains, and hence one sees peaks (especially among the very rich) around 2000 (due to the dotcom bubble) and again in the middle of the first decade of the 2000s (coinciding with the housing as well as stock market bubbles of those years). The fluctuations between 2012 and 2014 can also be explained, at least in part, from tax law changes.  The Bush tax cuts were allowed to expire for the very rich in 2013 (they were made permanent for everyone else), which created an incentive for the rich to bring forward their taxable incomes into 2012.  This increased reported income in 2012 (when their tax rates were lower) while reducing it in 2013.  There was then a return to more normal levels in 2014.

Average household incomes rose only by 27% over 1980 to 2014, a sharp slowdown from the 87% growth achieved on average between 1947 and 1980 (with one less year as well in that period, compared to 1980 to 2014).  An earlier post on this blog discussed the immediate factors that led to this sharp deceleration in growth for average incomes (at least for wages).  But I want to focus here on the growth in incomes of the higher income groups, where there was no such slowdown.

Between 1980 and 2014, the top 10% saw their average incomes rise by 82%.  This was far better than the 27% growth in overall average household income in the period, and even more so than the 3% fall in incomes for the bottom 90%.  But it is actually similar to the growth seen for most income groups between 1947 and 1980, when average incomes rose by 87%.  One could reasonably argue that the top 10% did not do especially well over this period, but rather only saw a continuation for them of the previous trend growth.

The ones who undisputedly did especially well post 1980 were the top 1%, top 0.1%, and especially the top 0.01%.  The richer you were, the greater the increase enjoyed in the post-1980 economy.  Note there is no necessity in this:  The households are stratified by their rank in income in each year, but the growth in incomes over the period could be greater for the top 10%, say, than the top 1%.  Indeed, this was the case over the 1947 to 1980 period.  But between 1980 and 2014, the higher your income, the higher your growth in income:  The average income of the top 1% rose by 169% between 1980 and 2014, by 281% for the top 0.1%, and by 386% for the top 0.01%.

It should not be surprising that the extreme rich are pleased with how their incomes have grown since 1980, which many have not unreasonably attributed to the election that year of Ronald Reagan.  But you have not done well if you are in the bottom 90% of the population – your real income has stagnated over this period of more than a third of a century, and indeed even fell slightly.

C)  Real Income Growth of Non-Overlapping Groups

As noted above, there is a potential issue when figures are provided for the top 10%, top 1%, top 0.1%, and top 0.01%.  Even though commonly done, the figures for the top 10% include the incomes of the top 1% (and the top 0.1% and top 0.01%).  That is, these are overlapping groups, and one cannot determine just from figures presented in such a way whether the share of the top 10% increased because of higher incomes for most of those in the group, or because those in the top 1% saw an especially sharp increase.  Similarly for the top 1% and top 0.1%.  Since the very richest enjoyed such a sharp increase in their incomes, one cannot say with certainty from just these figures whether the widening distribution reflected higher incomes for most of those with higher incomes, or just for the extremely rich.

Thus it is of interest to break down the population categories into non-overlapping groups:

Piketty - Saez 1947 to 2014, by exclusive categories, log scale, June 2015The bottom 90% is as in the chart at the top of this post (decline of 3% in their real per household incomes between 1980 and 2014), and growth was 27% for average household incomes over this period.

But then it is of interest to note that those with incomes in the 90 to 99% range of households saw real income growth over this period of just 47%.  While better than the overall average of 27%, it is worse than the average growth achieved of 87% in the third of a century before 1980.  It would be difficult to argue that they have done especially well in the period since 1980.  They did worse than what average growth for everyone was before.

The group in the 99 to 99.5% percentile of income (in red in the graph) saw their incomes over the 1980 to 2014 period as a whole rise by 89%.  This was almost exactly what their growth in incomes would have been had they grown at the same rate as average incomes grew between 1947 and 1980.  Thus they did not do worse post-1980, but also not better than what the average for everyone was before.

The groups that did do better post-1980 were those in the top 0.5% of the distribution. Those whose income put them in the top 99.5 to 99.9% of the population saw income growth of 127% over this period; those in the top 99.9 to 99.99% of the population saw income growth of 219%; while those in the top 0.01% enjoyed income growth of 386%. These groups did extremely well in the post-1980 economy.

Thus the slogans about the top 1% should perhaps be refined.  It is really the top 0.5%.

D)  The Share of Growth Going to the Rich

Finally, one can calculate what share of the growth in the economy over this period accrued to the different income groups.  The measure used here is the one the Professor Saez has used in his work, and has applied to various periods (although not to the 1980 to 2014 period).  It shows what share of the growth in the overall economy was captured, in per household terms, by the group identified:

Bottom 90%

Top 10%

Top 1%

Top 0.5%

Share of income in 1980

65%

35%

10%

7%

Share of 1980-2014 growth

-7%

107%

63%

54%

Share of income in 2014

50%

50%

21%

17%

Difference in Share 1980 – 2014

-15%

15%

11%

10%

The top 10% of households accounted for a little over a third (35%) of overall household incomes in 1980.  But between 1980 and 2014, they captured 107% of the gains in overall growth, raising their share of overall incomes to 50%.  The bottom 90%, in contrast, saw their per household real incomes fall.  They “gained” a negative share of the income growth, of -7% (the mirror image of the top 10%).  Their share of overall incomes fell from almost two-thirds (65%) in 1980 to just one-half (50%) by 2014.  These are huge changes in national income shares over such a period.

Breaking this down further, it is the top 1% and even more the top 0.5% that accounted for the bulk of this worsening in distribution.  The top 1% captured 63% of the gain in overall incomes between 1980 and 2014 (in per household terms), and saw their share of overall income more than double to 21% in 2014 from “just” 10% in 1980.  But the top 0.5% captured 54% of the gains, and saw their share rise from 7% to 17% over this period, or an increase of 10% points.  That is, the increased share of the top 0.5% accounted for, by itself, fully two-thirds of the 15% point increase for the top 10%.  Yet there are only one-twentieth (1/20) as many households in the top 0.5% as the 10%.

The distribution of the gains from growth have become extremely concentrated.  Just the top 0.5% (five-thousandths of the population) captured more than half of income growth generated by the economy over this 34 year period.

E)  Conclusion

The gains from growth have accrued overwhelmingly to the very rich since 1980.  And it is not really the top 10% who have done so well, nor even the top 1%, but rather the top 0.5% .  At the same time, the bottom 90% have seen their real incomes fall.

Something changed around 1980.  Growth before then (in the period since 1947) had been much more evenly distributed, with the rich as well as the bottom 90% doing similarly well, with growth of 1.9% per annum in average household incomes (a cumulative 87%).  To be fair, one cannot say with certainty that the turning point was in 1980 rather than a few years before or a few years after.  Incomes in any given year will depend a good deal on whether the economy is growing strongly or is in recession, and (especially for the rich) whether the stock market and other asset prices are booming or in a bust. The economy was also already struggling in the 1970s.  It is therefore difficult to mark when there has been a change in trend as opposed to fluctuations caused by year to year factors.  But something happened to the economy in either 1980 or in the years surrounding it.

Ronald Reagan was of course elected president in 1980.  He launched a broad set of policies that conservatives like to praise as the “Reagan Revolution”.  There is no doubt that a deterioration in distribution resulted from many of the policies that Reagan won (large tax cuts focussed on the rich, attacks on labor unions, a focus of macro policy on inflation rather than unemployment, deregulation of financial markets and other sectors, changing wage norms which led to giant compensation packages for CEOs and others at the top, and so on).  But to be fair, one should add that other structural changes in the economy in recent decades have also had an impact on distribution, such as changes in technology, from globalization, and following from these, an increasing number of “winner-take-all” markets.

But whether due to policy or structural changes or (almost certainly) a combination of both, it is clear that policy did not counteract the resulting extreme concentration in the benefits of growth accruing to very rich.  And that is a challenge that needs to be addressed.

Concrete Measures to Address Real Income Stagnation of the Poor and Middle Classes

Piketty - Saez 1945 to 2013, June 2015, log scale

I.  Introduction

The distribution of the gains from economic growth has gotten horribly skewed since around 1980, as the graph above shows (using a log scale so that distances on the vertical scale are equal relative changes).  Average real incomes of the bottom 90% of households have fallen by 5% in real terms since 1980, while the real incomes of the top 0.01% have grown by 325%.  This is astounding.  Something has changed for the far worse in recent decades.  The real incomes of these groups grew at roughly similar rates in the post-World War II decades leading up to 1980, but then diverged sharply.

An earlier post on this blog looked at the proximate factors which took substantial growth in GDP per capita (which grew at about the same pace after 1980 as it had before) down to median wages that simply stagnated.  As discussed in that post, this was principally due to a shift in distribution from labor to capital, and a shift within labor from the lower paid to the higher paid.  (Demographic effects, principally the increased participation of women in the labor force, as well as increases in the prices of items such as medical care relative to the prices of other goods, were also both important during this period. However, both have now become neutral, and are not factors leading to the continuing stagnation in recent years of median wages.)

The purpose of this blog post is to look at concrete policy measures that can be taken to address the problem.  The issue is not slow growth:  As noted above, per capita growth in GDP since 1980 has been similar to what it was before.  The problem, rather, is the distribution of the gains from that growth, which has become terribly skewed.

Discussion of this is also timely, as a consensus appears to be forming among political leaders in both major parties that something needs to be done about the stagnant incomes of the poor and middle classes.  Several of the candidates seeking the Republican presidential nomination have said they wish to make this a primary issue of the 2016 campaign.  This is good.  If they are serious, then they would support measures such as those laid out below.  I doubt they will, as they were strenuously opposed in the past to many of them, and indeed championed the changes in policy from the Reagan period onwards which are, at a minimum, associated in time with the deterioration in distribution seen in the chart above.  But one can hope.

This is a long blog post, as it discusses a long list of measures that could be taken to address the predicament of the poor and middle classes.  Many (although not all) of these policies have been reviewed in previous posts on this blog.  Thus the discussion here will in such cases be kept individually brief, with the reader encouraged to follow the links to the earlier blog posts for more substantive discussion of the points being made.  And the reader with limited time may wish to scan through the section headings, and focus on those topics of most interest.

II.  A Policy Program

A.  Labor Market

We start with the labor market, as it is fundamental.

1)  Raise the minimum wage:  The minimum wage is now less in real terms than what it was in 1950, during the presidency of Harry Truman.  This is amazing.  Or perhaps what is amazing is the argument made by some that raising it would price workers out of their jobs.  Real GDP per capita is now 3.75 times what it was then, and labor productivity has grown to 3.5 times what it was then.  But the minimum wage is now less in real terms than what it was then.  The minimum wage in 1950 was not too high to price low paid workers out of the market, and labor productivity is three and a half times higher now.

Obama has called for the minimum wage to rise to $10.10 per hour from its current $7.25 per hour (with this then indexed to the rate of inflation).  This would bring the minimum wage back only to where it was in the 1960s, a half century ago.  There is no evidence that such a rise will hurt low wage workers, and it would still leave a full time worker (at 40 hours a week, and with no vacation time, so 52 weeks per year times 40 hours per week = 2,080 hours per year) at such a minimum wage (2,080 x $10.10 = $21,008 per year) earning well less than what is needed to bring a family of four up to the poverty line ($24,250 per year for a family of four in 2015).  This is the minimum that should be done. Indeed, it should be more.

2)  Ensure predictable work hours:  Many workers, particularly in sectors such as retail and food service (whether fast food or traditional restaurants), are increasingly being required to accept “flexible” work hours, where their employer tells them only a short time ahead what days to come in, at what time to report, and for how many hours.  They might be told a few days before, or only the day before, or sometimes only on the day of possible work, whether they will be needed and should report to work.  This is sometimes called “just-in-time” scheduling (a term taken from just-in-time inventory management) or “on-call” scheduling, and managers are rewarded for what is seen as “optimizing” their use of labor.

But it plays havoc with the life of many workers.  They cannot take a second job in the evening to help make ends meet, if they do not know whether their primary job may sometimes require that they come in on short notice to work an evening shift.  Students cannot enroll in college classes in order to finish a degree if they do not know whether they might be called in during class time.  Parents and especially single mothers can have great difficulty in arranging for child care when their work schedules are unpredictable.  And an unpredictable number of weekly work hours, of perhaps 30 hours one week and 20 hours the next, makes budgeting impossible.

Recent developments in computer and communications technology have made on-call scheduling possible and increasingly common.  Establishments such as Starbucks can receive at some central office real-time information on coffee sales (from the cash registers, via an Internet connection), and together with other factors (weather forecasts; whether a convention is in town) can run sophisticated software algorithms predicting how many workers will be needed, exactly when, and which ones should be called in.

The problems this creates for low income workers has only recently come to be recognized.  An important spark was a story in the New York Times on August 13, 2014, on the impact on a worker at Starbucks.  This led Starbucks the very next day to announce it would change its practices, but a review a month later by another news organization raised questions as to whether anything of significance had really changed.

Starbucks can possibly be shamed into improving it working conditions, as it sells high-end coffee to those with significant disposable income.  And if the problem were solely with Starbucks and a few similar firms, a shaming approach might possibly be effective. However, while Starbucks may have become the symbol, the practice has unfortunately become increasingly widespread.  Furthermore, there is competitive pressure across firms to adopt such practices.  If Starbucks stops the practice, it may face coffee retailers who continue to “optimize” their use of labor through such practices, who can then take away business by charging less.  There is thus pressure on firms to impose the lowest standards they can get away with.

There is no federal law against such labor practices.  There may be state laws which might constrain the practices in some way in certain jurisdictions, but they are not widespread. What is needed is a legislated solution which will apply generally, and should be undertaken at the federal level.  This has been done before.

Abuses of labor had become common during the “gilded age” of the late 1800s / early 1900s (when income distribution was, not coincidentally, as bad as it is now).  Progressive Era and later New Deal reforms addressed some of the more egregious issues.  Work place safety and child labor laws were enacted, a minimum wage was established, and a 40 hour work week was set as the standard, where a worker is required to be paid overtime at the rate of “time and a half” (150% of their regular wage) for any hours worked beyond 40 in a week.

The issue of unpredictable work hours could be addressed similarly.  All workers would have a normal set of hours, defined individually and a function of their particular job.  They would always be paid for this set of normal hours.  But it is recognized that firms may have an unexpected need for additional workers at certain times (for example to substitute for a worker who is sick).  Workers could take on such additional shifts beyond their regular hours if they so chose, but as a financial inducement for the firm not to rely on such job calls, the firm would be required to pay 150% of normal wages for such time (as for overtime work).

This would lead firms to assess better when they need workers and when not, and build this into the standard work schedules.  Firms have little incentive to do this now, since the cost of unpredictable schedules is shifted onto the workers.  Note also that with this system there will not be an incentive to further split up jobs, as all workers will be assigned an individualized normal schedule.  The firms will gain no flexibility by splitting a 30 hour a week job into one of 20 hours and one of 10 hours.  They will still need to determine when workers are expected to be needed, in order to assign hours accordingly.  And to the extent they do not do this carefully, they will be penalized as they will then need to pay 150% of the wage when a worker needs to be brought in to cover those extra hours.

Predictability in hours is extremely important to low wage workers.  Indeed, it is quite possibly more important than raising the minimum wage.  It will shift some of the costs of unpredictability back onto the firm, where it had been until modern computer and communications technology (and lax labor laws that did not foresee this) allowed the firms to shift onto workers the cost of unpredictability.  Firms did this to raise profits, and business profits did indeed then rise while wage earnings stagnated.  This is precisely the issue that needs to be corrected.

3)  Manage policies to return the economy rapidly back to full employment when there are economic downturns:  While it would be ideal always to keep the economy at or close to full employment, economic downturns happen, most recently in 2008 in the last year of the Bush administration.  But when they do, the priority should be to return the economy to full employment as rapidly as possible.  Everyone can of course agree on this. Differences arise, however, on how to do it.

Monetary policy should be used to the extent possible, but there is a limit to how much it can do since interest rates cannot go below zero.  And they have been at essentially zero since late 2008, following the Lehman Brothers collapse.  The Fed can also try to reduce long term rates (such as through quantitative easing), and while its policy here has had some beneficial effect, it is also limited.

Monetary policy in a downturn such as that just experienced must therefore be supported also by expansionary fiscal policy.  Additional government spending is the most effective way to expand demand, as it does this directly.  Tax cuts can also help, but are less effective since a significant share of the reduction in taxes may be partly saved by households (and likely will be largely saved by higher income households).  There will thus be less stimulative effect per dollar from tax cuts than from direct spending.

Unfortunately, government spending was cut each year from 2010 up to 2014. This was the first time in at least 40 years that government has cut spending in a downturn.  Hence the economic recovery has been the slowest of any over that period, and only picked up in 2014, when government spending was finally allowed to increase.

Republicans have argued that to return the economy to full employment, one should instead reduce regulations.  But this makes no sense.  Regulations in the middle of a downturn are not far different from what they were before the downturn began, so how can they be blamed for the unemployment, and how would reducing them lead to less unemployment?  And if some regulations are wrong, one should change them, whether the economy has high unemployment or low unemployment.  Regulations do not serve as a macro policy to reduce unemployment, but rather serve a micro purpose to ensure the economy functions efficiently.

A slack labor market will have a direct effect on income inequality.  When there is available labor that is unemployed, a laborer will have little leverage to negotiate for higher wages. And unemployment has been higher, on average, in the three decades following 1980 than in the three decades before 1980.  A simple regression analysis suggests that if the average rate of unemployment after 1980 had simply matched what it had been before 1980, then the real incomes of the bottom 20% of households would not only have grown at a rate similar to how fast they had grown before, but also at a rate similar to that of the top 20% in the period after 1980.  That is, there would have been continued growth in the real incomes of the bottom 20% after 1980, instead of stagnation, and no increase in inequality relative to the top 20%.  Keeping the economy at close to full employment is critical to the poor and middle classes.

B.  Fiscal Policy

Fiscal policy is therefore an important instrument to keep the economy at full employment, or to return it to full employment from a downturn.  What specifically should be done?

1)  End the Congressional budgetary “pay-as-you-go” rules when in or recovering from a recession:  The Budget Enforcement Act of 1990 required that, as a budgetary rule, any increase in mandatory government spending or reductions in taxes must be “paid for” over the next five years as well as the next ten years by offsetting spending cuts or tax increases, so as to be budget neutral over these periods.  While the rules have been modified over the years, were not in place for a period during the Bush II administration, and were not always abided by (such as for the large tax cuts at the start of the Bush administration), they have acted in recent years to limit the government spending that was needed to recover from the downturn.

Over the course of a full business cycle, covering the full period over when the economy is at or close to full employment and when it is not, a limit on the size of the government deficit is warranted.  But by setting such a limit to apply identically and continuously both in a downturn and when the economy is booming, one limits the government expenditures that may be needed for a rapid recovery.  The rule should be suspended during any period when the economy is in a recession or recovering from one, to be replaced by a rule that applies over the course of the business cycle as a whole and which focusses on the government debt to GDP ratio rather than simply the government deficit.

2)  Stop cuts to important safety net programs such as food stamps and unemployment insurance, especially in a downturn:   Safety net programs such as food stamps (now called SNAP) and unemployment insurance are critically important to the poor and middle classes, and especially so in a downturn. They provide limited support to households who lost their jobs or other sources of income in the recession, due to no fault of their own.  (The 2008 downturn was a consequence of the reckless management of banks and other financial institutions in the US, and the policy decision of the Bush administration officials not to make use of their regulatory powers to limit it.  This led to very high bank leverage, a build-up of the housing bubble, and then collapse when the housing bubble burst.)

As unemployment rose and incomes fell, especially of the poor and near poor, many more households became eligible for food stamps and, having lost jobs, for unemployment insurance.  Expenditures on these and other safety net programs expanded, as they are designed to do in a downturn.  But Congressional Republicans then forced through cuts in the key safety net programs (e.g. unemployment insurance, and food stamps) by limiting eligibility, and have sought much more extensive cuts.

If one wishes to help the poor and near poor, one does not cut programs which help them directly, and especially not when they most need them.  These programs are also extremely efficient.  The food stamp program (SNAP) spends only 5% of its budget on administrative costs.  Few charities are anywhere close to as efficient, but at least some prominent Republicans think otherwise.  Former Congresswoman Michele Bachmann, at one point the leading contender for the Republican presidential nomination in 2012, asserted that 70% of food stamp funding went to “bureaucrats”.  This was absurdly wrong.

Safety net programs in the US, while efficient for the money spent, are however highly limited in how much they do spend.  US income inequality or poverty rates are actually not worse than those seen in other high income OECD economies in terms of wages and other income paid to workers. That is, the US capitalist market economy does not itself produce more unequal outcomes than those of other high income OECD economies.  The US is near the average in this across all the OECD countries.  But once one takes into account government taxes and transfers, the US turns out to be the very worst, both in terms of inequality (as measured by the Gini coefficient) and in terms of poverty (by the share of the population considered poor).  The problem is not that the US tax and transfer programs are not especially progressive:  They are in fact more progressive than in most countries.  The problem is that they are simply too small to matter.

3)  Implement a public infrastructure investment program:  American public infrastructure is an embarrassment.  Compared to other high income countries, US roads, bridges, mass transit, and other public structures, are clearly inadequate in scale, are in terrible condition due to inadequate maintenance, and constitute what is in effect a growing debt that will need to be repaid in the future when they finally have to be rebuilt (normally at much greater cost than if they had been maintained properly).

Public investment has been cut back especially sharply in recent years, whether measured as a share of GDP or simply in real per capita terms, as a consequence of Congressional cuts in the budget.  But while the cuts have been especially sharp since 2010, the problem is long-standing.  Amazingly, US non-defense public investment in structures in 2013 was less, in real per capita terms, than what it was in 1960, even though real per capita GDP almost tripled over this period.

It should therefore be no surprise that roads and bridges are in poor condition (with some bridges that have even collapsed), mass transit systems are in poor repair, and all are grossly inadequate to what we need.  This impacts especially the middle classes, who have to sit in traffic jams daily just to get to work.  Toll roads or tolled lanes built by private concessionaires have become fashionable in recent years to build roads that government is no longer willing to pay for, but they can be expensive.  The tolled lanes opened recently in Northern Virginia in the I95/I495 corridor have tolls that, for the entire length, could conceivably reach $40 or more per trip (and double that per day).  Rich people can afford this, but most of those with middle class incomes cannot.

Adequate public infrastructure is needed to raise productivity and for the economy to grow.  And the recent severe downturn should have been a time for a special effort to expand such investment, putting to work unemployed construction and other workers, in firms that had capacity to produce more than they could sell due to low demand in the downturn.  Furthermore, the government could have borrowed long term funds during this period at historically low rates, and even at times at negative real rates.  It was insanity not to utilize the unemployed labor and underutilized firms, financed by funds at low or even negative real cost, to build and repair infrastructure that the economy and especially the poor and middle classes desperately need.

But this was not done.  It instead will need to be done over the coming years (and at much higher cost, due to the lack of maintenance), when the economy is hopefully at full employment, interest rates have returned to normal levels, and anything extra spent on public infrastructure will need to come out of less being available for other goods and services, including for private investment.

4)  Increase public support to higher education:  At one time, students could pay for the total costs of attending a state university, including room and board, through work at just the minimum wage during summers and part time during the academic terms.  This is no longer the case.  In part this is due to the fall in the minimum wage in real terms from where it had been in the 1960s.  But it was also a consequence of the rising cost of university education (a result of Baumol’s cost disease) coupled with sharp cutbacks in the share of these costs covered by state support to their colleges and universities, shifting more of the cost onto students and their families.

This reduction in state support to their colleges and universities needs to be reversed, or soon state schools will in effect no longer exist.  They will have become essentially private schools catering to those who can afford them.  And while federal programs exist to help students (most importantly the Pell Grant program, which provides grants of up to $5,775 per year, in academic year 2015/16), they are limited and family income based.  The maximum Pell Grant goes only to the poorest households.

There are different ways to assist students from poor and middle class households to continue their schooling beyond high school.  President Obama, in this year’s State of the Union address, proposed for example that federal support be provided so that community colleges would stop charging tuition for students in good standing.  One would in essence be extending the availability of public schooling from 12 years now to 14 years.  The budget cost would be relatively modest at just $6 billion per year.  Others have suggested, constructively, that using such funds to expand the Pell Grant program would achieve the same aim, while assisting also those low income and middle class students who would do better by enrolling in a four-year college.

The response of the Republicans in Congress has, however, been in the opposite direction.  While rejecting Obama’s proposal for community colleges, the recent proposal from the House Budget Committee would instead freeze the maximum Pell Grant at $5,775 for at least the next ten years, thus leading to its erosion in real terms as prices rise (much as the minimum wage has eroded over time due to inflation).

C.  Tax Policy

Tax policy has a direct impact on income distribution.  But while most still accept the principle that taxes should be progressive (the principle that the rich should pay taxes at a higher rate than the poor), the tax system the US in fact has is regressive in many of its aspects.

1)  Stop the preferential tax treatment of income from wealth:  The wealthy pay a lower rate of taxes on their income from wealth than most of the population pays on their income from labor.  In terms of policy options to address inequality, little would be more straightforward than to end the practice of taxing income from wealth at lower rates than income from work.  Tax rates on all income groups could then be reduced, with the same total tax revenues collected.

The long-term capital gains tax rate on most assets is only 15% for most earners (there is an additional 3.8% for those households earning more than $250,000 bringing the rate to 18.8%, with this rising by a further 5% points to 23.8% for those earning $464,850 or more in 2015).  These rates on income from wealth are well below what is paid by most on income from labor (wages).  While the regular income tax rates (on wages) vary formally from 10% in the lowest bracket to 39.6% in the highest, one should add to these the social insurance taxes due.  These are often referred to loosely as Social Security taxes, but they include both Social Security at a 12.4% rate (up to a ceiling in 2015 of $118,500), and Medicare taxes at a 2.9% rate (with no ceiling).  Note also that while formally the employee pays half of this and the employer pays half, analysts agree that all of the tax really comes out of wages.

Once one includes social insurance taxes on wages, the effective tax rates on income from labor goes from 25.3% for the lowest bracket to 40.3% on those earning between $74,900 and $118,500, after which it drops down to 27.9% as the Social Security ceiling has been hit, and then starts to rise again.  The long-term capital gains rate is always below this even for the very richest, and normally far below.

To add further complication, preferential rates of 25% apply to long-term capital gains on certain commercial building assets (“Unrecaptured Section 1250” gains), and 28% apply to collectibles (such as fine art or gold coins) and certain small business stock. These are still well below what most pay in taxes on income from work.

This system not only worsens income inequality, but also creates complications and introduces distortions.  Many of those with high income are able to shift the categorization of their incomes from what for others would be wage income, to income which is treated as long-term capital gains.  Properly structured stock options, for example, allow CEOs and other senior managers to shift income from what would otherwise be taxed at ordinary income tax rates to the low rates for capital gains.  “Carried interest” does the same for fund managers.  With many fund managers earning over $100 million in a year, and indeed some earning over $1 billion, this preferential tax treatment of such extremely high earnings is perverse.

The reform would be simple.  All forms of income, whether from labor or from wealth, would be taxed at the same progressive rates that rise with total household income.  The one issue, which can be easily addressed, is that income from long-term capital gains should be adjusted for inflation, to put the gains all in terms of current year prices.  But this can easily be done by scaling up the cost basis based on the change in the general price level between when the asset was bought and when it was sold.  The IRS could supply a simple table for this.

2)  Reduce marginal effective tax rates on the poor:  Conservatives have long argued for cuts in marginal tax rates for the rich, arguing this would lead to faster growth (“supply-side economics”).  While there is no evidence that lower tax rates in recent decades have in fact led to faster growth, this was the stated rationale for the big tax cuts under Reagan and then Bush II.

Liberals have noted that if one were really concerned about high marginal tax rates, you would look at the high marginal effective tax rates being paid at the other end of the income scale – by the poor and those of moderate income.  Studies have found that these can range as high as 80 or even 100%.  The marginal effective tax rates take into account the impact of means-tested programs being phased out as one’s income rises.  When extra income is earned, you will pay not only a portion of this in taxes, but you will also lose a portion of benefits that are being provided (such as food stamps) in programs that phase out as income grows.  If the extra paid in taxes plus the amount lost in benefits matches additional earnings, the marginal effective tax rate will be 100%.

Conservatives have started to pay attention to this.  An opinion column in the Wall Street Journal last September by Senators Marco Rubio and Mike Lee (both Tea Party favorites) decried the 80 to 100% marginal effective tax rates that low income workers might face, arguing this can act as a strong disincentive to work.

In reality, the rates being faced by the poor are normally less, although still substantial. The issue is complex since the effective tax paid will depend not only on income, but on such factors as:  1)  Family composition (whether married and number and age of children); 2) Where one lives (what state and often what city or county); 3)  Particular benefit program qualification criteria (which will vary by program, and will often depend on many factors other than income); and 4) Whether the individual always enrolls in programs they are qualified for, as one may not be aware of certain benefit programs, or find the benefits to be too small to be worthwhile (because of difficulties and complications in enrolling, with these quite possibly deliberate difficulties in some jurisdictions).

The Congressional Budget Office, in a careful study issued in November 2012, concluded that the marginal effective tax rate for citizens with incomes of up to 450% of the federal poverty line averaged about 30% in 2012.  And under law as then in effect, this would rise to 32% in 2013 and 35% in 2014.  There was a good deal of variation within the average, with a marginal effective tax rate of as much as 95% (for example, for single mothers with one child with an income in the range of about $18,000 to $20,000, which was just above the poverty line for such a household).  But rates of 40% or more were not uncommon.

Such rates, even when not at the 80 to 100% extremes cited by Senators Rubio and Lee, are high.  Even at just 30% (the average) they are double what those who are far better off pay in long-term capital taxes.  While the conservative senators argue that such high marginal rates discourage work effort (there is in fact little evidence that this is the case – when you are poor, you are desperate for whatever you can get), such high marginal rates are in any case unfair.  If one wants to help those of low and moderate income, these effective tax rates should be reduced.

There are three ways, and only three ways, to reduce the marginal effective tax rates on the poor.  One is to get rid of the benefit programs for the poor altogether.  If they receive no food stamps to begin with, one has nothing to lose when incomes rise.  But this then penalizes the poor directly.

One could also phase out the programs more slowly, and pay for this by reducing the benefits to the poorest.  This is then a transfer from the poorest to the somewhat better off than the poorest.  Senators Rubio and Lee proposed this route (without explicitly calling it that) by reducing benefits such as food stamps and providing instead larger child tax credits for all households (including the rich).  This would be a transfer from the poorest to those of higher income (including the rich), and especially to those with large families.  The poorest would be penalized.

Finally, the third and only remaining option is to phase out the benefit programs more slowly.  This reduces the marginal effective tax rate that poor households will face if they are able to obtain jobs paying more than what they earned before.  It will not penalize the poorest, but it does of course require that budgets for the programs then rise.  But this will be support made available directly to the poor, and in particular to the working poor (as they are the ones facing the high marginal effective tax rates from additional earnings). If one is concerned about poverty and inequality, this is precisely the support that should be provided.

3)  Tax inherited wealth the same as any other wealth:  Wealth that is inherited enjoys significant tax benefits.  The only exception is wealth that is so large that it becomes subject to the estate tax (greater than $10.86 million for a married couple in 2015).  But few pay this due to that high ceiling, as well as since one can establish trusts and use other legal mechanisms to avoid the tax.  Indeed, in 2013 (the most recent year with available data), estate taxes were due on less than 0.2% of estates; the other 99.8% had no such taxes due.  This is down from over 6% of estates in the mid-1970s, due to repeated changes in tax law which narrowed and reduced further and further what would be due.

Any wealth that is passed along within the effective $10.86 million ceiling will never be subject to tax on capital gains made up to the point it was passed along.  That is, the cost basis is “stepped-up” to the value upon the date of death.  If one had purchased $100,000 of General Electric stock 40 years ago, the stepped-up value now would be roughly $3 million, and no taxes would ever be due on that $2.9 million of gain.

This is not fair.  Taxes on such wealth should be treated like taxes on any other wealth, and as argued in item #1 of this section above, all sources of income should be taxed the same (recognizing, importantly, that capital gains should be adjusted for inflation).

Some have argued that this cannot be done for inherited wealth since those inheriting the wealth may not know what the original cost basis was.  But this is not a valid excuse.  First of all, the two most important categories of wealth that are passed along through estates are homes and other real estate, and stocks and bonds and other such traded financial assets.  There are government land records on all real estate transactions, so it is easy (and indeed a matter of public record that anyone can look up) to find the purchase price of a home or other real estate.  And purchases of stocks, bonds, and other trade financial assets are done via a brokerage, which will have such records.

Second, if there are any other assets with special value (such as valuable coins or works of art) that will be passed along through an estate, the owner of those assets can include a record of their cost basis as part of the will or trust document that grants the asset to those inheriting the estate.

4)  Equal tax benefits for deductions should be provided for all income levels:  Under the current tax system, if a rich person in a 40% marginal income tax bracket makes a $100 contribution to some charity, then the government provides a gift to that rich person of $40 through the tax system, so that the net cost will only be $60.  If a middle class person in a 20% marginal tax bracket makes a $100 gift to the exact same charity, then the government will pay them back $20, for a net cost of $80.  And if a poor person in the 10% bracket makes a $100 gift to that same charity, the net cost to him will be $90.

This is enormously unfair.  There is no reason why deductions should be made more valuable to a rich person than to a poor person.  And there is an easy way to remedy it. Instead to treating deductions as subtractions from taxable income, one could take some percentage of deductions (say 20%) as a subtraction from taxes that would otherwise be due.  The $100 gift to the charity would then cost the rich person, the middle class person, and the poor person, the same $80 for each.

5)  Set tax rates progressively, and at the rates needed to ensure a prudent fiscal balance over the course of the business cycle:  I have argued above that all forms of income should be taxed similarly.  Whether you earn income from working or from wealth, two households with the same total income should pay taxes at the same rates.  This is not only for fairness.  It would also simplify the system dramatically.  And this is not only for the obvious reason that calculations are easier with one set of rates, but also because the current diverse rates interact between themselves in complex ways, which make computing taxes due a headache when there are different rates for different types of income.  Perhaps most importantly, it would eliminate the incentive to shift income from one category to another (e.g. from wage income to stock options) where lower taxes are due.  That creates distortions and wastes resources that should be used for productive activities.

There remains the question of what the new rates should be.  I do not have the data or the detailed tax models which would allow one to work that out, but a few points can be made.  One is that the new tax rates would be lower (at any given level of income) than what regular income tax rates (on wage income) are now.  This is because the tax rates on income from wealth (such as for capital gains, or inherited wealth) would be unified with the now higher tax rates on income from labor, so the new overall tax rates on regular income can be lower than before to yield the same level of tax revenues.  General income tax rates would come down.

Second, one should of course preserve the principle of progressivity in the tax code.  Rich people should pay taxes at a higher rate than poor people.  As Warren Buffitt argued eloquently in a New York Times column in 2011 (“Stop Coddling the Super-Rich”), there is no economic justification for the rich to pay taxes at lower rates than those with less income.  And it is grossly unfair as well.  Their secretaries should not pay at higher rates than the rich (fully legally) pay.

Third, one needs to recognize that the purpose of taxes is to raise revenues, and rates should thus be set at the levels required to cover government expenditures over time.  As argued above, the budgetary accounts should not be forced to balance each and every year, since fiscal policy is extremely important to move the economy back to full employment in an economic downturn (and fiscal policy is basically all that is available when interest rates are at the zero lower bound, as they have been since late 2008 in the US).

But over the full course of the business cycle, tax rates should be set so that the tax revenues collected suffice to keep the government debt to GDP ratio at a stable and reasonable level. This implies deficits when unemployment is high, and surpluses when the economy is close to full employment.  The economy was at full employment in 2006-07 (unsustainably so due to the housing bubble building up in those years) with the unemployment rate below 5% and as low as 4.4%.  Unfortunately, due to the Bush II tax cuts, the government’s fiscal deficit in those years was still significant.

Applying these principles, the tax rates needed for this would need to be worked out.  This can be done, but I do not myself have access to the data that would be required.  In the end, I suspect that regular income tax rates could be reduced substantially from what they are now, with this still sufficient to provide for adequate government expenditures over the course of the business cycle.  But the rich would pay more while those of low to moderate income would pay less, and whether this would then be possible politically is of course a different issue.

D.  Health Insurance

Access to health insurance is important.  A careful statistical analysis published in 2009 found that the likelihood of dying is higher for the uninsured than for the insured, and the lack of universal health insurance (as was then the case in the US) was leading to an estimated 45,000 more Americans dying each year than would be the case if they had health insurance.  This is greater than the number of Americans killed in action over the entire period of the Vietnam War.

The ObamaCare reforms have been a big step forward to making it possible for all Americans to obtain access to health care, but it remains under threat.  If Republicans are serious about helping the poor and middle classes, they should support the following.

1)  First, stop trying to block health care access for all:  ObamaCare, while not perfect (it reflects political compromises, and is based on the system of individual mandates first proposed by the conservative Heritage Foundation in 1989), is nonetheless working.  An estimated 16.4 million Americans now have health insurance coverage, which they did not have before ObamaCare became available.  And a Gallup poll found that there was a higher satisfaction rate among those obtaining health insurance policies through the ObamaCare exchanges, than among those with traditional health insurance policies (mostly via employers).

Despite this, Republicans continue to campaign aggressively to terminate ObamaCare, and have supported lawsuits in the courts to try to end this health care access.  A case now before the Supreme Court, with findings to be announced this month (June 2015), may declare that the federal government payments made through certain of the ObamaCare exchanges (those not run by the states) to those of low to moderate income, cannot be continued.  If the Supreme Court finds in favor of those opposed to such payments, these low and moderate income households will no longer be able to obtain affordable health insurance.

If the Republican presidential candidates are in fact in favor of helping the poor and middle classes, they should call for an end to the continued efforts by their Republican colleagues to terminate ObamaCare.  There are ways it could be improved (e.g. by taking more aggressive actions to bring down the cost of medical care to all in the US), but it is working as intended, and indeed better than even its advocates expected.

2)  Extend Medicaid in all states in the US:  The ObamaCare reforms built on the system of existing health insurance coverage.  Medicare would remain the same for those over age 65; employees in firms would normally pay for health insurance coverage through employer based plans; Medicaid would expand from covering (generally) those up to the poverty line to include also those with income up to 133% of the poverty line; and all those remaining without health insurance would be allowed to purchase coverage from private health insurers competing on internet-based health insurance exchanges, where those with incomes of up to 400% of the poverty line would receive federal subsidies to make such health insurance affordable.

The Medicaid expansion to cover all those with incomes of up to 133% of the poverty line was thus one of the building blocks in the ObamaCare reforms to enable all Americans to obtain access to affordable health care.  Because of its historical origins in health care programs for the poor that had traditionally been implemented in the states, Medicaid is implemented at the state level even though it is funded jointly with the federal government. For the Medicaid expansion to 133% of the poverty line, the federal government through the legislation setting up ObamaCare committed to funding 100% of the incremental costs in the first three years (2014 to 2016) with this then phased down to 90% in 2020 and thereafter.

Despite this generous federal funding, the Supreme Court decided in 2012, in its decision that also found ObamaCare in general to be constitutional, that Congress could not force the states to expand Medicaid to the higher income limits.  Thus the expansion became optional for the states, and as of April 2015, 21 states have decided not to.  The 21 states are mostly in the south or the mountain west, with Republican legislatures and/or Republican governors or mostly both.

Blocking this Medicaid expansion in these states is being done even though an expansion would cost little or nothing.  There is literally no state cost in the first three years as the federal government would cover 100% of the extra costs.  And while the federal share would fall then to a still high 90% for 2020 and thereafter, allowing more of the poor to be covered by Medicaid will reduce state costs.  The poor in this gap in coverage are forced to resort to expensive emergency room care, for which they cannot pay, when their health gets so bad that it cannot be ignored.  These costs are then partially compensated by the state.

A careful analysis for Virginia, undertaken for the state by Price Waterhouse Coopers, concluded that if Virginia opted in to the Medicaid expansion, the state would save $601 million in state budget costs over the period 2014 to 2022.  And this did not even include the indirect benefits to the budget from higher tax revenues, as a consequence of the additional jobs that would be created (nurses and other care providers, etc.) and the higher incomes of hospitals from less uncompensated care.

Denying affordable health care to the poor with incomes of between 100% and 133% of the poverty line is callous.  These are the working poor, and there really is no excuse.

3)  Ensure employers pay a proportionate share for health insurance for their part-time workers:  Employers have traditionally not allowed part time employees to obtain (through their wage compensation package) health insurance cover in employer-based plans.  There was a practical reason for this, as health insurance plans only provided cover in full.  It has been difficult to provide partial plans, so part time workers have traditionally gotten nothing.

This has now changed with the introduction of the ObamaCare health insurance market exchanges.  Those without health insurance coverage through their employers can now purchase a health insurance plan directly.  One could therefore now require that all employers make a proportionate contribution to the cost of the health insurance plans for their part time workers.  That is, for someone working half time (20 hours a week normally) the employer would contribute half of what that employer pays for the health insurance plans for their full time workers.

There would then be no incentive (and competitive advantage) for an employer to split a full time job with health insurance benefits into two half time jobs with no health insurance benefits for either worker.  Under the current system of normally no health insurance benefits for part time workers, employer are in essence shifting the cost of health insurance fully onto the worker and onto the federal government (and hence general taxpayer) if the worker earns so little that they are eligible for federal government subsidies to purchase health insurance on the exchanges.

The proportional employer contribution would be paid to the “account” of the worker in the same way (and at the same time) as Social Security and Medicare taxes are paid for the worker.  The funds from this account would then be used to cover part of the costs of the worker purchasing health insurance on the ObamaCare exchanges.  And if the worker was working in two (and sometimes three or more) part time jobs in order to make ends meet, the total paid in from all of the worker’s employers might well suffice to cover the cost of the health insurance plan in full.

4)  Allow competition from low cost public health insurance:  As part of the political compromises necessary to get ObamaCare passed in the face of steadfast Republican opposition, only private health insurers are allowed to participate in the ObamaCare health insurance exchanges.  Yet Medicare, which provides health insurance to all Americans age 65 and older, is far more efficient than private health insurance providers.  Giving Americans the option (not a requirement) to purchase Medicare administered health insurance on the ObamaCare exchanges would introduce much needed competition. There are often only a few insurers competing in the exchanges, which are all state-based (3 or fewer insurers in 15 of the 51 states plus Washington, DC, with only one insurer offering policies in West Virginia).

But even with multiple insurers competing on the state exchanges, the private insurers in general have high costs.  Private health insurers nationwide (and for all the policies they offer) have administrative costs plus profits equal to 14.0% of the health insurance benefits they pay out.  This is huge.  The same figure for Medicare is only 2.1%.  Medicare costs only one-seventh as much to administer as private health insurance.  And note these lower costs are not coming out of low payments to doctors and hospitals since the 14.0% and 2.1% are being measured relative to claims paid.

It would be straightforward to allow Medicare to compete on the health insurance exchanges.  One would require that Medicare charge rates sufficient (for the resulting client base, which will of course be younger than and generally healthier than Medicare’s senior citizens) to recover its full costs for such coverage.  But Medicare could use its existing administrative structure, including computer systems and contracts with doctors, hospitals, and other medical care providers at the rates that have already been negotiated.

Purchasing a Medicare administered health insurance policy on the exchanges would be fully optional.  No one participating in the exchanges would be required to buy it.  But with its lower costs, the competition Medicare would introduce into the exchanges could be highly effective in bringing down costs.

E.  Pensions

Probably the greatest failure of any social experiment of recent decades has been the switch of employer pension plans from the traditional defined benefit plans that were common up to the early 1980s, to defined contribution schemes (such as 401(k) plans) that have grown to dominance since the 1980s.  In doing this, employers not only shifted the investment, actuarial, and other risks on to the individual workers, but also typically reduced their matching funding shares significantly.

The end result is that workers are now typically woefully unprepared for retirement.  The funds accumulated in their 401(k) and IRA accounts for households (with head of household aged 55 to 64) with a 401(k) account, only amounted to $111,000 in 2013 (for the median household).  Such an accumulation, for households who will soon be in retirement, would suffice to provide only less than $400 a month by the traditional formulas, or $4,800 per year.

This is woefully inadequate, and these households will need to rely on what they can get from Social Security.  But Social Security payments are also not much.  For 2012 (the most recent year with such data), the median Social Security pension payment per beneficiary (age 65 or more) was just $16,799 per year, or per family unit (with head aged 65 or more) just $19,222 per year.  Furthermore, if nothing is done, the Social Security Trust Fund will run down to a zero balance in 2033 based on the most recent projections.

Fully funding Social Security is eminently solvable, as will be discussed below.  The annual cost (including for disability insurance) will rise from roughly 5% of GDP currently to 6% of GDP in 2030, as the baby boomers retire, or an increase of just 1% of GDP.  But what many do not realize is that on current projections, Social Security expenditures are then expected to remain stable (under current benefit rules) at that 6% of GDP for the foreseeable future, in projections that go out 75 years.  One can find 1% of GDP to save Social Security.  But the politicians in Washington will need to agree to do so.

There are several measures that need to be taken to ensure income security for the poor and middle classes in their old age:

1)  Raise, and certainly do not reduce, Social Security payments to those of low and modest income:  Social Security payments, while a crucial safety net, are low.  As noted above, the median payments in 2012 for those aged 65 and older were just $16,799 per beneficiary and $19,222 per recipient family (for the old age component). Such payments are minimal.  Yet these are just medians, meaning half of all recipients received less than even those figures.

Despite being so low, these Social Security payments are critical to many Americans. For the entire population of those aged 65 and older, Social Security accounted for half or more of their total regular income for two-thirds of the population (65% to be precise); Social Security accounted for 90% or more of their income for over a third of the population (36%); and Social Security accounted for 100% of their income for a quarter of the population (24%).  This is incredible, and shows the failure of the current pension systems in the US to provide a reasonable income in retirement for American workers.

The situation is, not surprisingly, worse for those of low to moderate income.  For the bottom 40% of the population by income, where 40% is by far not a small or insignificant share, Social Security accounted for half or more of their regular total income for 95% of them.  Social Security accounted for 90% or more of their income for three-quarters (74%) of them, and for 100% of their income for over half of them (53%).

Social Security benefits are by no means large.  Yet a large share of Americans depend on them.  They should not be cut, but rather should be raised, at least for those of low to moderate income who are critically dependent on them in their old age.

2)  Broaden the base for Social Security taxes to ensure the system remains fully funded:  As noted above, the Social Security Trust Fund will be depleted in 2033 (based on current projections, and including the disability component – while technically separate, the trust funds for old age and for disability insurance are normally treated together).  While some argue, with some justification, that the Trust Fund is fundamentally just an accounting tool, which can be “topped-up” with regular federal government transfers if necessary, there are also good reasons to stay with the Trust Fund rules.  They help keep the Social Security system out of routine Washington politics, and the temptation by conservatives to cut Social Security benefits in order to reduce the size of government.

Under the current Trust Fund rules, participation in the Social Security system is mandatory; taxes are paid on wage earnings (up to a ceiling of $118,500 in 2015); at a rate of 12.4% for Social Security pension and disability coverage for the employer and employee combined (excluding the 2.9% with no wage ceiling for Medicare); and upon retirement, these contributors will receive regular monthly payments from Social Security until they die, based on a formula which is linked to how much was paid into the Social Security Trust Fund during their working career (for the 35 years of highest inflation adjusted earnings).  The formula is complex, and “tilted” in the sense that those earning less will receive back somewhat more than they paid in, while those earning in the upper end of the taxable range will receive back somewhat less.  There is therefore some progressivity, but the degree of progressivity is limited.  Finally, the taxes paid into the fund will earn interest at the rate of the long-term Treasury bond yield of the time, so the taxes paid in to the fund grow over time with interest.

Based on these Trust Fund rules and on current projections of growth in worker earnings (and its distribution) and of what pay-outs will be as workers retire, the Trust Fund is expected to be depleted in 2033.  The basic cause is not that Social Security administration is inefficient and wasting funds.  It is, in fact, incredibly efficient, with a cost of administration of just 0.5% of benefits paid out (on the old age component).  Note this is not on assets, but on benefits paid.  As will be discussed further below, the typical expenses on savings in 401(k) and similar accounts will be 2 to 3% of assets each and every year.

The principal cause of the Trust Fund being depleted, rather, is that life expectancies have lengthened, and hence the period over which Social Security old-age payments are made have grown.  Crudely (and ignoring interest for this simple example), if life expectancy at age of retirement has grown by 50%, so that the number of years during which one will draw Social Security payments has grown by 50%, then the amount needed to be paid in to the Trust Fund to cover this lengthened life will need to grow by 50%.

Longer life expectancies are good.  The Social Security Trust Fund will run out of assets in 2033 not because the funds are being wasted (as noted above, administrative costs are incredibly low), but because people are living longer.  But this will need to be paid for.

But it is also critically important to recognize who is living longer.  As incomes have stagnated for those other than the rich since Reagan took office (see the chart at the top of this post), life expectancies for the poor and middle classes have in fact not increased substantially.  Rather, the overall life expectancy is rising principally because those at higher income levels are enjoying much longer life expectancies (in part precisely because their incomes have been growing so fast).

Specifically, life expectancy for a man at age 65 in the bottom half of earnings rose from 79.8 years in 1977 to 81.1 years in 2006, an increase of just 1.3 years.  But life expectancy at age 65 for a man in the top half of earnings rose from 80.5 years in 1977 (only 0.7 years longer than men in the lower half of the earnings distribution in that year) to 86.5 years in 2006, an increase of 6.0 years.  People are living longer, but it is mostly only those of higher income who are enjoying this.  Life expectancies have not changed much for those of low to moderate income.

It would therefore be perverse to penalize those of lower income to make up for the Trust Fund shortfall, when it is the lengthening of the life spans of those of higher income which is leading to the depletion of the Trust Fund.  Yet proposals to raise the retirement age, or to increase Social Security taxes on all, would charge the poor as much as the rich to make up for the Trust Fund deficit.

Rather than penalize the poor, Social Security taxes should be raised on those who are better off to pay for their increasing lifetime benefits.  And this is of course also precisely what one should want to do if one is concerned about inequality.

The obvious solution is to broaden the tax base for the Social Security tax to include incomes now excluded – which are also incomes that accrue to the rich.  First, note that the shortfall to be made up when the Social Security Trust Fund is expected to be depleted (if nothing is done) in the 2030s would require a 20% increase in revenues.  That is, following a transition between now and about 2030 as the baby boomer generation retires, the long term projection is that Social Security tax and other revenues will level off at about 5% of GDP, while Social Security obligations will level off at about 6% of GDP. That is, we will need revenues to increase by about 20% to make up the shortfall, to get to 6% of GDP from 5%.  (A more precise estimate, but from my blog post of a few years ago, is an increase of 19.4%).

Broadening the Social Security tax base would easily provide such an amount of funding. For wages alone, there is the current ceiling of $118,500 (in 2015) on wages subject to Social Security tax.  At this ceiling, only 83% of all wages paid are subject to this tax.  This is down from 89% in 1980 as an increasing share of wages are being paid to the very well off (those with wages above the ceiling).  If one were to tax 100% of wages rather than only the current 83%, one would in fact obtain the funds needed, as that alone would provide an increase of over 20% (100/83 = 1.205).

But broadening the base should not stop at simply ensuring the taxes paying for Social Security are paid by all wage earners equally, rich and poor.  There is no economic rationale why only wage income should be taxed for this purpose, and not also income from wealth.  And income from wealth is primarily earned by the wealthy.

Using figures from the National Income and Product (GDP) accounts, total private income (including not just wages, but also income from interest, dividends, rents, and so on, but excluding government transfers) in 2014 was 65% more than just wages alone.  (Note that while these income concepts from the GDP accounts are not the same as the income concepts defined in the income tax code, they suffice for the illustrative purposes here.)  A uniform tax rate of 7.5% rather than 12.4% (12.4/7.5 = 1.65), but on all forms of income and not just wage income, would thus suffice to generate the Social Security tax revenues to fund fully the Trust Fund for the foreseeable future.

But one important proviso should be noted.  Such tax rates (of either 12.4% on all wage income, or 7.5% on all forms of private income) would generate the revenues required to fully fund the system based on current benefit payment projections.  However, with benefit payments tied to one’s history of tax payments, one would also need to change the benefit payment formulae to reflect the broader tax base.  Otherwise the benefits due would also change to reflect the higher amounts paid in.

Finally, as noted above, current Social Security benefit payments are low and really need to be increased.  While I do not have the data and models that would be required to work out fully some specific proposal, the figures here can give us a sense of what is possible. For example, a possible balance might be to broaden the tax base to include all forms of income, but then to reduce the tax rate on this not all the way from 12.4% to 7.5%, but rather to the halfway point of 10%.  But this 10% rate would then suffice to permit a one-third increase in overall benefits (10/7.5 = 1.333), which one should want also to concentrate on those of low to moderate income.  The overall tax rate would be cut, but in broadening the tax base to all forms of income one could support a significant increase in benefits.  Overall taxes paid would be higher (everything has to add up, of course), and while low and moderate income earners would mostly see a reduction in the taxes they owe, richer individuals would pay more.

3)  Require that 401(k) plan administration fees are paid for by the entity choosing the provider:  Turning from Social Security to private pension plans, where defined contribution plans (401(k) plans and similar) are now the norm, the key issue is to keep fees low.  Unfortunately they are extremely high, and take away a large share of the investment returns on the funds saved.

One cause of this is that the fees being received by the financial advisors are often hidden in various ways, and charged in different ways by different entities.  There is no standard, and average levels are not made publicly available to provide a basis for comparison. The fees charged will also vary sharply depending on the type of investment product being used (i.e. direct equities, mutual funds of different types, insurance products including annuities, various complex products, and more).  Finally, while individual fees might sometimes appear to be low, they are imposed at several layers in the investment process, and in total come to very high levels.  Not surprisingly, according to one survey 93% of the respondents dramatically underestimated what their cumulative 401(k) fees will come to.

Estimates for what the average fees in fact now are vary.  At the base will be the fees charged by a plan administrator, chosen by the firm of the employee and responsible for the record keeping, for allocating the investments as chosen by the plan participant, and so on. These fees will vary depending on the size of the firm and the deal negotiated on behalf of the employee, but one set of estimates are that these fees average 0.5% of plan assets annually in large firms (plan sizes of $100 million or more), 0.9% in medium size firms (plan assets of $10 million to $100 million) and 1.4% in small firms (plan assets of less than $10 million).

On top of these base administrative fees one will then have to pay the fees charged by the investment vehicles themselves.  Mutual funds are perhaps most common, and the expense fees on these (normally subtracted from the investment returns, so the amount being paid will not be obvious) average about 1.1%.  But they can range widely, from less than 0.1% for standard index funds, to over 2%.  On top of this, one has the cost of buying and selling the investments (whether mutual funds or equities or the other products), which some estimate may average 1.0%.  But these too can vary widely.

Finally, one may have individual fees on top of these all, which depend on the services being requested (whether investment advice, or entry and exit fees, or loan advances against balances in the worker’s pension accounts, and more).  These will vary widely, but one estimate is that the median might be an annual cost of about 0.7% of assets.

The total amount lost in fees each year can therefore easily be in the range of 2 to 3% of assets, and 2.5% is a commonly taken average.  Note also that these fees (or at least most of them) will be taken by the financial managers regardless of whether the investments perform well in any given year.

Over time, these fees will take for the financial administrators a large share of the investment returns that were intended for worker retirement.  A simple spreadsheet calculation, for example, will show that over a 40 year time horizon, where (for simplicity) equal amounts are set aside each year for retirement, with an assumed 5% real rate of return but financial fees of 2.5% a year, the financial cost will have taken away by the 40th year 45% of what would otherwise be the balance saved.  (It will not equal 50% because of the way compounding works.)  This is 90 times the total fees that would be charged by Social Security for the old-age support it provides, which as noted above is only 0.5% of benefits paid out.  Note that I am not arguing that the private fees should be the same as what the cost is for Social Security to administer the accounts.  Social Security is an extremely efficient system.  The specific share taken by financial fees will also depend, of course, on what is assumed for the rate of return and other parameters. But anything like 90 times as much is a lot.

Furthermore, many of the fees being charged on the private pension accounts will continue into the retirement years, so the final amount paid out in benefits will be even less.  Assuming there will be 20 years of retirement following the 40 years of work, with returns and fees continuing as before, the annual amount that could be paid out to the worker in retirement will be only 44% of what would be paid out if the fees were at the 0.5% (of benefits only) of Social Security, a reduction of 56%!

Fees are therefore hugely important, but the worker can manage (through the decisions they make) only some of them.  In particular, the basic plan administration fees for managing the accounts are made at the firm level.  When firms had defined benefit pension plans, these costs were included in what the firm covered.  They kept track of, or contracted out to some specialist, the individual payment obligations and other bookkeeping.  But when firms switched to defined contribution schemes, most commonly 401(k)s, the firms chose to incorporate the costs of the plan administration into charges against the individual account balances, thus shifting these on to the workers.  But the workers had no choice between plan administrators:  They were chosen by the firm.  And with the firm not bearing the cost, the firm might not worry so much about what the cost was.  Rather, they might choose a plan administrator based on how good they were at making sales pitches, or whether they did other work for the firm where they might extend a discount, or based on who provided the fanciest annual conferences for their clients (the decision maker in the firm) at some resort in Hawaii.

Some firms of course make a sincere effort to choose the best balance between plan administrator cost and performance, but others do not.  But to resolve this, a simple reform would be to require that firms pay the cost of plan administration directly from the firm’s accounts, and not out of the pension savings of the workers.  This would return to what had normally been done with the traditional defined contribution pension plans, where firms had an incentive to ensure plan administration costs were kept low.

4)  Require low cost investment options be included in 401(k) and similar schemes:  One can also keep financial fees down by investing in low cost investment options, such as simple and standard index funds.  The Vanguard S&P 500 Index Fund, and now even the Vanguard Total Stock Market Index Fund, each charge an annual expense fee of just 0.05%.  This is far below the 1 to 2% charged by most managed mutual funds.

Such low cost options are included in many 401(k) plans, but unfortunately not all.  Such options should be required in all.

5)  Provide an option of investing in “Social Security Supplemental Accounts”:  One very low cost investment option would be to invest a portion of one’s 401(k), IRA, and similar balances, into a supplemental account managed by Social Security, which would then be paid out along with one’s regular Social Security checks.  Accounts would earn a return equal to the long-term US Treasury bond rate, the same as existing Social Security balances do now.  The option would take advantage of the extremely high efficiency of the Social Security Administration.

With the far lower cost of Social Security relative to what private financial institutions in the US charge, the net return on such investments would be attractive.  Given historical long term bond interest rates and the differences in fees, the returns would be comparable to what might be earned in pure equity investments, but far less volatile.  And the returns would be far better than what on average has been earned in actual 401(k) and IRA accounts, given how they have historically been managed.

The Social Security Supplemental Account would be purely voluntary.  No one would be forced to put a share of their 401(k) or IRA assets into them.  But this would be an attractive option for at least a share of the plan assets, earning a comparable return (after fees) but with far less risk.  It would be especially attractive to middle class families who may have significant but not huge assets in their retirement accounts, who are seeking to ensure a safe retirement.

F.  Conclusion

The returns to economic growth have become horribly skewed since Reagan took office, but there is much that could be done to address it.  This blog post has discussed a number of actions that could be taken, and if the Republican (and Democratic) candidates are truly concerned about the direction of income inequality, there is no shortage of measures to consider.  And this is not an all or nothing set of actions:  While complementary and mutually reinforcing, taking some actions is better than none, and more is better than some.  Nor are they in general administratively difficult to do.  Most are straightforward.

But action is clearly needed.

 

Why Wages Have Stagnated While GDP Has Grown: The Proximate Factors

Real GDP per Capita & Median Weekly Earnings, 1980-2013

A.  Introduction

A healthy debate appears to be developing in the run up to the 2016 elections, with politicians of all parties raising the issue of stagnant wages.  Republicans have charged that this is a recent development, and the fault of Obama, but that is certainly not the case.  As the diagram above shows, real median wages have been stagnant since at least 1980, despite real GDP per capita which is 78% higher now than then.  Real median wages are only 5% higher (and in fact unchanged from 1979).  In a normally developing economy, one would expect real GDP per capita and real wages to move together, growing at similar rates and certainly not diverging.  But that has not been the case in the US since at least the early 1980s.

Why has such a large wedge opened up between worker earnings and GDP per capita?  This blog post will look at the immediate factors that lead from one curve to the other.  This will all be data and arithmetic, but will allow one to decompose the separation into several key underlying factors.  A future blog post will look at policies that would address those factors.

B.  Moving from Growth in GDP per Capita to Stagnant Real Wages

The progression from GDP per capita to real wages, with intermediate steps shown, looks as follows:

Going from GDP per Capita to Median Wage, 1947 to 2013:14

The chart here goes back further, to 1947, to show the divergence in recent decades in a longer term perspective.  The data come from the Bureau of Economic Analysis (BEA) or the Bureau of Labor Statistics (BLS).  As one sees, the curves moved together until around the mid-1970s, after which they began to diverge.

1)  Real GDP per Capita

Starting at the top, real GDP per capita (the curve in blue) measures the progression, in real terms, of GDP per person in the US.  GDP captures the value of all goods and services produced in the economy.  Its price index, the GDP deflator, is a price index for all those goods and services.  Although there have been temporary dips with periodic recessions, real GDP per capita has in fact grown at a remarkably stable long term rate of about 1.9% per annum going back all the way to 1870.  The growth rate was in fact a bit higher, at 2.0%, from 1947 to 2014, as the 1947 starting point was somewhat below the long term trend.  With this growth, real GDP per person was 3.75 times higher in 2014 than what it was in 1947.

2)  Real GDP per FTE Worker

But wages are paid to individual workers, and the share of workers in the population can change over time.  The share has in fact grown significantly over the post-war period, and in particular since about the mid-1960s, principally due to women entering the labor force.  There will also be demographic effects leading to changes in the shares of the very young and of retirees.

With a growing share of the population in the labor force, real GDP per full time equivalent (FTE) worker (the measure of the labor force used by the BEA) will grow by less than it will per person in the population.  The path of real GDP per FTE worker (the curve in green in the chart above), will rise more slowly than the path for real GDP per capita.  The curves start to diverge in the mid-1960s, when large numbers of women began to enter the labor force.

It should also be noted that the divergence in the two paths will not necessarily continue forever.  Indeed, the paths have in fact grown broadly in parallel from around 1997 until 2008 (when GDP per capita dipped in the downturn that began in the last year of the Bush administration).  The number of women entering the labor force reached a peak as a share of the labor force around 1997, and a decade later the first of the baby boomers started to retire.

Thus while such demographic factors and labor force participation decisions led to a significant divergence in the two paths (between GDP per capita and GDP per FTE worker) from the mid-1960s to the late-1990s, the impact since then has been broadly neutral, and might in fact go the other way going forward.

3)  Average Real Wages using the GDP Deflator

Next, workers are paid wages, not units of GDP.  Wages and salaries made up roughly half of GDP in 1947, with most of the rest accounted for by profits to capital.  And it stayed in the narrow range of 49 to 51% of GDP continuously until 1974.  The share then fell to 48%, where it held until 1981, and then began to deteriorate much more sharply, to just 42% as of 2013 (the most recent year with this data).

If the share of wages in GDP had remained constant, then the growth of wages per FTE worker would have exactly matched the growth of GDP per FTE worker.  But with a declining share of wages in GDP (with a growing share of profits as the mirror image), the curve (shown in brown in the chart above) of wages per FTE worker will rise by less than the curve of real GDP per FTE worker.

4)  Average Real Wages using the Consumer Price Index

The curves so far have been measured in real terms based on the GDP deflator.  The GDP deflator is a price index that takes into account all goods and services produced in the economy, and the weights in the price index will be in accordance with the shares of each of the goods or services in the overall economy.  But to an individual, what matters is the prices of goods and services that he or she buys.  This is measured by the consumer price index (cpi), where the weights used are in accordance with the expenditures shares of households on each of the items.  These weights can be significantly different than the weights of the items in GDP, as GDP includes more than simply what households consume.

The curve in orange in the chart above is then the average real wage but with the cpi rather than the GDP deflator used to account for inflation.  From 1978 onwards, the average real wage based on the cpi grew by significantly less than the average real wage measured in terms of the GDP deflator.  That is, inflation as measured by the items that make up the cpi grew at a faster rate, from 1978 onwards, than inflation as measured by the items (and their weights) that go into the GDP deflator.  Up until 1978, the cpi and the GDP deflator grew at remarkably similar rates, so the two curves (brown and orange in the chart) follow each other closely up to that year.

What happened after 1978?  The prices of several items whose weight in the cpi is greater than their weight in the GDP deflator began to rise more rapidly than other prices.  Especially important was the rise in medical costs in recent decades, but also important was the rise in housing costs as well as energy (with energy increases already from 1974).

Thus wages expressed in terms of what households buy (the cpi) rose by less, from 1978 onwards, than when expressed in terms of what the economy produces overall (the GDP deflator).

5)  Median Real Wages using the Consumer Price Index

The final step is to note that average wages can be misleading when the distribution of wages becomes more skewed.  If the wages of a few relatively well off wage earners (lawyers, say) rise sharply, the average wage can go up even though the median wage (the wage at which 50% of the workers are earning more and 50% are earning less) has been flat.  And that median wage is what is shown as the red curve in the chart.

[Technical Note:  The median wage series used here is the median weekly earnings of full time workers, adjusted for inflation using the cpi.  The series unfortunately only starts in 1979, but is the only series on the median, as opposed to average, wage I could find that the BLS publishes which goes back even as far as that.  The source comes from the Current Population Survey, which is the same survey of households used to estimate the nation’s unemployment rate, among other statistics.]

Since 1980 (and indeed since 1979, when the series starts), the median real wage has been flat.  This is not a new phenomenon, that only began recently.  But it is a problem nonetheless, and more so because it has persisted over decades.

C.  The Astounding Deterioration in the Distribution of Income Since 1980

Aside from demographic effects (including the impact of women entering the labor force), and the differential impact of certain price increases (medical costs, as well as others), the reason median real wages have been flat since around 1980 despite an increase of real GDP per capita of close to 80% over this period, is distributional.  The share of wages in GDP has been reduced while the share of profits has increased, and the distribution within wages has favored the better off compared to the less well off (leading to a rise in the average wage even though the median wage has been flat).

That is, the US has a distribution problem.  Wages have lost relative to profits (and profits largely accrue to the rich and wealthy), and the wages of lower paid workers have fallen even while the wages of higher paid workers have risen.

There are therefore two reasons for the distribution of income at the household level to have deteriorated since 1980.  And one sees this in the data:

Piketty - Saez 1945 to 2012, Feb 2015

This is an update of a chart presented in an earlier post, with data now available through 2012, and with the period from 1945 to 1980 included on the same chart as well.  The data comes from the World Top Incomes Database, which is maintained by Thomas Piketty, Emmanuel Saez, and others.  The data is drawn from individual income tax return filings, and thus the distribution is formally by tax reporting unit (which will normally be households).  The incomes reported are total taxable incomes, whether from wages or from capital.

Over the 33 years from 1947 to 1980, average reported taxable incomes rose in real terms (using the cpi price index to adjust for inflation) by 87%.  The incomes of the bottom 90%, the top 10%, and the top 0.01%, rose by almost exactly the same amount, while the incomes of the top 1% and top 0.1% also rose substantially (by 57% and 63% respectively).  It is amazing how close together all these figures are.

This changed dramatically from 1980.  As the chart above shows, the curves then started to diverge sharply.  Furthermore, the average reported income rose only by 24% over 1980 to 2012, even though real GDP per capita rose by 73% over this period.  The 24% average increase can be compared to the 28% increase over the same years in the average real wage (based on the cpi).  While from two totally different sources of data (income tax returns vs. the national income accounts of the BEA) and measuring somewhat different concepts, these are surprisingly close.

But while average real incomes per household rose by 24%, the bottom 90% saw their real incomes fall by 6%.  Instead, the rich gained tremendously:  by 80% for the top 10%, by 178% for the top 1%, by 312% for the top 0.1%, and by an astounding 431% for the top 0.01%.

The US really does have a distribution problem, and this deterioration in distribution largely explains why real median wages have stagnated since 1980, while real GDP per capita grew at a similar rate to what it had before.

D.  Summary

To summarize, in the post-war period from 1947 to about the mid-1970s, measures of real income per person grew substantially and at similar rates.  Since then, real GDP per capita continued to grow at about the same pace as it had before, but others fell back.  The median real wage has been stagnant.

One can attribute this to four effects, each of which has been broadly similar in terms of the magnitude of the impact:

a)  Real GDP per worker has grown by less than real GDP per capita, as the share of those working the population (primarily women) has grown, with this becoming important from around the mid-1960s.  However, there has been no further impact from this since around 1997 (i.e. the curves then moved in parallel).  It may be close to neutral going forward, but was an important factor in explaining the divergence in the period from the mid-1960s to the late-1990s.

b)  The average real wage (in terms of the GDP deflator) has grown by less than real GDP per worker, as the share of GDP going to wages has gone down while the share going to profits (the mirror image) has gone up, especially since about 1982.

c)  The average real wage measured in terms of the cpi has grown by less than the average real wage measured in terms of the GDP deflator, because of the rising relative price since 1978 of items important in the household consumption basket, including in particular medical costs, but also housing and energy.

d)  The median real wage has grown by less than the average real wage (and indeed has not grown at all since the data series began in 1979), because of increasing dispersion in wage earnings between the relatively highly paid and the rest.

The implication of all this is that if one wants to attack the problem of stagnant wages, one needs to address the sharp deterioration in distribution that has been observed since 1980, and secondly address issues like medical costs.  Medical costs have in fact stabilized under Obama, as was discussed in a recent post on this blog.  But while several of the measures passed as part of the Affordable Care Act (aka ObamaCare) have served to hold down costs, it is too early to say that the previous relentless upward pressure of medical costs has ended.  More needs to be done.

Future blog posts will discuss what policy measures could be taken to address the problem of stagnant real wages and the deterioration in the distribution of income, as well as what can be done to address medical costs.