Disallowing extreme income inequality

This will be a very short post on the way the US used to not allow extreme income inequality during the Golden Age of Capitalism.

The idea was quite simple: Going into WWII, income tax rates on the highest bracket  reached levels around 90% which meant that wage earners had little incentives to increase their annual income above the highest bracket. At the same time, that bracket was set at 100 times the lowest bracket:

The latter was at least 1.5 times personal income per capita although it reached even close to being 3 times larger. The very high level of the top income tax rate remained roughly constant for two decades (40’s and 50’s).

That meant that the highest income allowed was somewhere between 150 and 280 times that of average personal income depending on the specific year. As a result, extreme inequality was reduced through tax incentives. This is in contrast to today when CEO pay hovers around 300 times that of the typical worker:

It is quite evident that fiscal (and more specifically tax) policy can be used as a tool for a society to place specific limits on the level of extreme inequality allowed within it.

Economic Reproduction Frontier

Since my last post was mainly focused on the issue of inequality I would like to continue on this road and introduce a concept which I will call «Economic Reproduction Frontier» (ERF).

The main idea is rather simple: Take the threshold of the major brackets of income distribution as a share of average per capita income and examine their course across time. I will be using data from the World Inequality Database on a per adult (equal split) unit for this exercise.

One can think of average per capita income as a crude pointer for both the consumption basket (or frontier) in a given country at a given time as well as the cost of human capital development for an individual. An income say 20% of average per capita income will correspond to a significantly different (and highly constrained) consumption basket and place large obstacles on the opportunities and capabilities of an individual increasing and expanding his human capital. Since most economic output is mass consumed and production is highly connected to human capital, the income available to a large proportion of the population will ultimately act as a constraint on economic growth. Especially if individual income as a percentage of average per capita income falls on a permanent basis.

To do this I calculate the share of threshold income for various income brackets in the US during the period 1966 – 2014 (due to data availability). Below are two graphs, one for P20/P30 percentiles and one for P40/P50. Linear trendlines along with the exact equation and R² for each percentile are also presented.

It is striking how all threshold shares are on a permanent downward trajectory, as well as the very strong R² for all lines (over 0.93 in all cases with stronger results in the P40 and P50 cases). The relative stability of the threshold shares up until the turning point of 1980 is also evident. The regression coefficient points to a fall of roughly 50bp annually for the P40 and P50 brackets which means that each bracket losses almost 5% share of per capita GDP every decade.

P20 and P30 brackets start below 50% and fall to 20% and 30% by 2014. What is striking is that the P40 brackets falls to roughly 40% by 2014 starting from 63% (the P50 bracket falls to 56% of average income starting from 77%). This suggests that at least 40% of the population  cannot maintain a middle-class consumption basket and human capital without going into debt since it is severely income constrained. Even P60 and P70 brackets show a clear drop in the given period (from 90% to 73% for P60 and from 106% to 94% for P70) suggesting an extremely strong middle class hollowing out in recent decades, at least for the p30p70 bracket. Only the top-10% threshold share shows an increase in the given period from 170% to 184% while even the P80 threshold share lost 2.5%:

Although I am sure this simple exercise will have methodological issues it still suggests a strong loss of income resources for a major part of the general population with serious consequences on long-term growth. If 40% of the population are not able to finance their human capital development through their income nor afford a basic middle-class consumption basket without going into debt, this suggests that long-term growth will be affected in one way or another.

Modern capitalist economies are based on large scale production of mass consumption goods and on using a highly educated workforce in a large part of the production process and sectors.  Linear extrapolation suggests that the P50 bracket will fall to 50% of per capita income by 2026 (while P40 will be 35% and P30 24%) making the above process highly constrained. We might be nearing an inflection point for economic growth due to growing inequality.