What is Causing Wealth Gap

Study shows a stunning gap between U.S. rich and poor: The gap between the top one percent of income earners and the bottom 90 percent is greater than at any time since 1928

Income and the Top 1%

As I said in an earlier post, the middle class hasn't gotten poorer or stagnated. The story about a disappearing middle class, the ultra wealthy few, and an increasing mass of poor is a powerful narrative, but doesn't line up well with careful analysis. The real story is about the top 1% getting much much richer, not about others getting poorer.

Wealth begets wealth

If am born with one dollar more than you, and we earn the same rate of return, I'm going to end up with more than you. And the wealth gap would widen at an increasing rate. That's just the math behind compound interest.

And the gap gets bigger when the difference between the groups is related to income rather than starting assets. If, instead of being born with $1 more than you, I earn $1 more than you each hour, the wealth disparity will be exacerbated.

In some way, specialization is fueling the income gap. Not the gap between the top 1% and the bottom 90%, but perhaps the gap between the top 10% and bottom 40%. The more specialization and education we have in the country, the larger the education gap, which generally leads to a larger wage disparity.

What I'm saying is that even without cronyism, we'd still have a wealth gap, if you assume assuming people are different and some will earn more than others. If that is true, then we'll have a wealth gap and because of compound interest, the gap will widen at an increasing rate.

I don't think this explains all of the gap in the US - the economy is full of privilege granting, government favoritism, and unaccounted externalities. But even if it wasn't, we'd still have a wealth gap and it'd be increasing.

Taxes and the Top 1%

So why did the gap shrink between the 50s and 80s? The best explanation I've read so far is simple: progressive tax schemes and wealth distribution. This begs the question, "but we have the most progressive tax scheme ever, right now, and the gap is increasing, what gives?"

First, I'm not sure we have the most progressive tax scheme ever. For example, the capital gains tax is far less than the income tax, the Bush tax cuts disproportionately benefited the wealthy, and state/local governments have incentives not to overtax the wealthy - since the wealthy have the greatest ability to relocate and pay taxes elsewhere (see Tom Golisano for example).

However, the top 1% are paying a larger share of the tax burden than ever before, more than the bottom 95% combined in 2007. This fact doesn't show anything by itself though. The top 1% are earning more than ever before, and they're getting the bulk of new wealth too.

Despite all this, it seems the tax system hasn't kept up with the tremendous growth of the to 1% of earners.

U.S., the richest 1% of Americans in 2006 garnered the highest share of the nation's adjusted gross income for two decades, and possibly the highest since 1929, according to Internal Revenue Service data.

Meanwhile, the average tax rate of the wealthiest 1% fell to its lowest level in at least 18 years. The group's share of the tax burden has risen, though not as quickly as its share of income.

Source and more reading. The top 1% is paying more than they ever have before, but they're also making more than ever before - both inflation adjusted and relative to others. The real question is NOT "why hasn't the tax system kept up" but instead "why has the top 1% enjoyed such tremendous growth?"

Theories
Many people have suggested the technological revolution increased gains in the top 1%. This theory doesn't line up very well with what we know:

Most theories of the rising education premium attribute it to skill-biased technological change generated by the high-tech computer industrial revolution. But the high-tech boom's effects on overall productivity became large only in the second half of the 1990s, well after the biggest increases in inequality. The timing doesn't fit either.

Tyler Cowen has another theory:

My intuition is that there has been an increase in the ability of very smart and very wealthy people to buy up undervalued assets and turn them into greater value . . . American entrepreneurs were building up capabilities which exploded in value once the economy stabilized in the early 1980s.

Perhaps this explains much of the growth until the 90s, but then what? The depressed asset prices of the 70s were soaring in the 80s, surely these "very smart and very wealthy" people didn't leave so much on the table during the 80s that this trend could continue through 2007 (which is the latest data I've looked at). Does the educational and technological improvements explain the gains from 1990s through 2007? If so, why did the gains all accrue to the top 1% rather than all those who leveraged increased technology and education?

Increasing Trade
Currently, I think the best theory suggests it is simply the result of globalization. As we know, trade always leaves both trading partners better off. And in all but a few contorted situations, trade leaves both countries as a whole better off. However, trade provides increasing returns to those producing goods at a comparative advantage, and decreases returns to those producing goods at a comparative disadvantage. Again, except in really unusual fringe cases, economic models (Heckscher-Ohlin, Specific Factors, and New Trade Theory) predict the gains to those with the comparative advantage exceed those producing at a comparative disadvantage.

I suspect this explains a lot of the top 1% gains. The U.S. seems to have a comparative advantage in capital intensive goods & services. I'm including human capital in the "capital" category. Those who command these inputs are generally wealthy. International trade benefits these individuals disproportionately. The U.S. seems to have a comparative disadvantage in labor intense goods and services. Labor is owned by each individual, and so individuals without capital or human capital would be harmed by international trade.

If true, I don't think this means we should stop trading. It simply means we need to continue building human capital. Arguably, it would also suggest we should continue our transfer systems, and perhaps ensure trade is pareto optimal for everyone.