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Economic Insights

While the topic has generated enormous controversy, what’s needed is a clear, dispassionate approach to identifying the causes—and potential solutions.

President Barack Obama in this election season has raised the nation’s consciousness of income inequality. Such concerns, however, are hardly new. Scholars, commentators, and working people have been talking about the widening gap between higher-income and lower-income earners for years now. The president has looked for a cause in greed and injustice. No doubt these perennial evils have contributed, but dispassionate research points elsewhere—to globalization and advancing technology—to explain the growing income gap. Relief, then, will come less from ridding society of sin and misdeed and more from finding ways to cope with the inexorable trends that have caused the income gap. Improved education and worker training provide answers.   

The Evidence
The evidence of a widening income gap is powerful. During the last 20-some years, the incomes of the richest tenth of the country have grown five times faster than the incomes of the bottom fifth. The nominal earnings of the top 5% of the income distribution have grown a robust 9% a year, while the earnings of the bottom 5% have actually suffered an average annual decline of 2.5%. The richest 25% of the country now, on average, have annual incomes 15 times those among the bottom 25%, up from 10 times in the mid-1970s. Meanwhile, the Internal Revenue Service (IRS) has noted that the top 1.0% of the country earns 22% of the nation’s income, actually exceeding the previous high of 20% in 2000. Meanwhile, the bottom 50% of the income distribution earns a mere 12.8% of the total, down from its previous low of 13% set in 2000.1

Some analysis takes exception to these measurements. This work points out, quite rightly, that because these data are drawn from tax statistics, they miss much and, consequently, overstate the gap. Fringe benefits for workers constitute some of what they miss. Because pensions and employer-provided health insurance are paid outside taxable income, they do not count in these IRS figures. Especially since such fringe benefits constitute a larger part of the total compensation of lower-income than higher-income employees, their inclusion would tend to narrow the compensation gap. Government transfers, such as the earned-income tax credit, child care benefits, and the like have a similar effect. These, too, do not appear in the tax data. Since all accrue to those at the lower end of the income distribution and not at all to those at the upper end, an accounting for them would tend to narrow the recorded income gap as well. They affect the trend, too, as such benefits have grown in significance over time.  

Also casting doubt on these summary measures is a novel U.S. Treasury study. The Treasury, in order to gauge how families move between groups in the income distribution, actually followed the incomes of specific households over decades. While it identified the growing gap between high pay and low on average, it also discovered that most families move from one bracket to the other. Over the 10-year stretch, 1996 and 2006, the incomes of those who started in the lowest quartile of the income distribution rose a comparatively fast 6.7% a year on average, as they advanced through the income distribution, far faster than the 1.5% gains showed by those who started in the highest quartile of the distribution. Those advancing were, of course, replaced in that bottom quartile by those just starting their careers or those who suffered some unfortunate setback. The Treasury concluded from this analysis that the widening income gap might well capture the fact that experience was becoming more highly rewarded next to starting salaries than previously.    

Causes
If there is ample room for dispute on the specifics, there is still enough evidence of a growing income gap to raise questions about the causes. Of course, it suits certain political objectives to find the cause in the evil of others, almost always one’s political foes. But without condoning or ignoring sin, research, as indicated earlier, finds the fundamental causes in globalization and the advance of technology. They are interlinked.   

The impact of globalization has received more media attention. Because it is so much cheaper to produce some products in China, India, and other emerging economies, managements have sent the factories, mills, etc., overseas, throwing thousands out of their former positions into lower-paying jobs or simply onto unemployment rolls. And because the competition from emerging economies is most intense among the simpler products—toys, textiles low-level call centers, and the like—this burden has fallen most heavily on the less skilled and lower-paid in society. Even when the factories, workshops, and offices have remained in place domestically, the threat of a move abroad has constrained wage demands and so has slowed earnings growth at the lower end of the income distribution. Meanwhile, the greater profitability gained by the transfer to lower-wage workers overseas and the restraint exercised on wages domestically has accrued to the salaries and bonuses of management, boosting the income growth at the top of the income distribution.

Technology has reinforced this effect. Indeed, to the extent that firms have responded to foreign competition by upgrading for greater productivity, the globalization has accelerated the pace at which firms apply such technologies. Whatever the motivation for the technological upgrades, however, the effect is much the same. Because the technology—robotics, systems, and the like—tends to substitute for more routine, repetitive functions, it tends to throw more lower-wage than higher-wage people out of work, with similar effects on income when production moves overseas. Also in a similar way to foreign competition, the threat of a technological solution has also restrained the wage demands of those still employed, especially in lower-income occupations. And also as with globalization, the systems, robotics, etc., enhance the productivity and reach of management, fostering more rapid compensation growth at the top of the wage distribution.

Scholarly work has tried to disentangle these effects. Most of it attaches the greater impact from technology than globalization, tying some 70% of the lost jobs and wage shortfall to it. But because these influences are intertwined, any such effort to distinguish the impact of one from the other is tenuous at best. But in the public’s mind, it hardly matters. People can see that jobs have been lost, particularly in the simpler functions that have long securely employed millions. They can sense that the rich are getting richer and the poor, if not getting poorer absolutely, are losing their share of national prosperity. They want a solution. Since neither globalization nor technology is stoppable, at least not without causing a good deal more pain to an even larger part of the population, the answer lies in helping people find ways to cope with the trends.

Answers
In both cases, job security and income growth depend on an upgrading of worker skills. The object is to serve a more innovative economy, to enable it and each worker to cope with technology, and to produce higher-value product that can support the higher wages earned in this country and expand them over time. The president and many others in Washington have stressed education in math, science, and technology. These certainly have a role in the needed process, but the reality of the situation is more complex and so actually offers more opportunity for individuals, firms, and government to improve the situation.

The most effective response is evident in the nature of innovation. There is, of course, a crucial need for scientists, engineers, and those with advanced technical skills. They make the underlying technological advances. But in order for the engineers’ inventions to have an economic effect, society needs a second aspect to innovation, less discussed but equally important: the sometimes seemingly chaotic efforts of millions of often low-technology skilled people to combine new technologies with old in order to serve particular economic needs or productive efficiencies, often in ways never considered by the scientists and engineers who developed the original technologies.

The educational establishment must produce these people as well as scientists, engineers, and mathematicians. They demand very different educational support. While technical skills require intensive study and instruction, these other contributions require people who think more extensively, an ability cultivated through very different academic disciplines and training than are technical skills. Rather than Washington’s single-minded and simplistic focus on math, science, engineering, and technology, the educational establishment can only meet these needs by also providing courses and support for these other, necessarily broad-based skills and abilities. It is noteworthy in this respect that Apple’s Steve Jobs had far less technical skill than most of his employees, but contributed mightily to his firm’s and the economy’s success by sensing market needs and opportunities and applying technologies accordingly.

Nor is this more complex need restricted only to higher education. In worker training, too, there is a need for a similar sort of broad-based general upgrade. To some extent, workers themselves have already responded to the challenge. They can see what scholarly statistical analyses have verified: that better-trained workers have better job security, as good as 20–30 years ago, in fact, and enjoy better income prospects. Accordingly, workers have upgraded their skills so that the average employee today has 13 years of formal education and training, up from 10 years on average two decades ago. To counter the growing income disparity, this trend must become even more widespread. And, as with higher education, it needs to embrace more than just technical skills. High-value, technically advanced production also needs workers who can adjust to changing circumstances as well as communicate with each other, with management, and, because so much high-value production contains an element of customization, with customers as well.

Even if the nation’s efforts at education and training rise successfully to meet this need, a portion of the population inevitably will fall short. For various reasons—lack of cognitive skills, lost opportunities, or just bad luck—they will miss the upgrade. For them, the economy will always have a need for low-skilled occupations, less than previously, of course, because of foreign competition and technology, and less remunerative, but a need nonetheless. It may be that this group will need public assistance to supplement low wages or substitute where such work is unavailable. Because it will take a broadly rich economy to provide such support, the innovation, as well as upgraded education and training, becomes still more important to create the wealth needed to provide such assistance. 

*I would like to thank Lord Abbett Regional Manager Casey Miller for suggesting this line of analysis.
1All data from Milton Ezrati, Thirty Tomorrows (St. Martin’s Press/Thomas Dunne Books, 2014).

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ABOUT THE AUTHOR

Critical Releases in the Week Ahead

Milton Ezrati examines the key economic and financial releases scheduled for the coming week.

Key Mover:

Retail Sales for March*
Mon., April 14, at 8:30 a.m. ET

The February report showed a bounce from weather-depressed figures in earlier months and so was slightly more robust than the fundamentals would suggest.  March should exaggerate that short-term effect. 
*Source: Department of Commerce.

Others to Watch:

Industrial Production Index for March*
Wed., April 16, at 9:15 a.m. ET
Previous: +0.6% • Prospect: +0.3%

The unsustainable strength registered for February was a bounce from the weather-troubled January decline.  March should see some more such bounce, but more moderate than in February. 
*Source: Federal Reserve.

Leading Indicators for March*
Fri., April 18, at 10:00 a.m. ET
Previous: +0.5% • Prospect: +0.3%

Though many subcomponents show weakness, continued gains will occur on the much improved ISM report, increased hours, and a steepening in the yield curve.
*Source: The Conference Board.

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