NBER Paper: What Causes Large Wealth Inequality?

Econintersect:  Four researchers have a working paper at NBER (National Bureau of Economic Research) which discusses the historical perspective of wealth distribution in the U.S. and compares that to the rest of the developed world.  The title of the paper (still a working paper) is “The Top 1% in International and Historical Perspective“.  The authors find correlations of wealth distribution with tax policy and the relative returns to capital vs. labor (capital income vs. earned income).

Click on graph for larger image with legend.

The authors are Facundo Alvaredo (Oxford), Anthony B. Atkinson (Oxford), Thomas Piketty (Paris School of Economics) and Emmanuel Saez (University of California, Berkeley).

Here is the paper abstract (emphasis is the original):

The top 1 percent income share has more than doubled in the United States over the last thirty years, drawing much public attention in recent years. While other English speaking countries have also experienced sharp increases in the top 1 percent income share, many high-income countries such as Japan, France, or Germany have seen much less increase in top income shares. Hence, the explanation cannot rely solely on forces common to advanced countries, such as the impact of new technologies and globalization on the supply and demand for skills. Moreover, the explanations have to accommodate the falls in top income shares earlier in the twentieth century experienced in virtually all high-income countries.

We highlight four main factors. The first is the impact of tax policy, which has varied over time and differs across countries. Top tax rates have moved in the opposite direction from top income shares.  The effects of top rate cuts can operate in conjunction with other mechanisms. The second factor is indeed a richer view of the labor market, where we contrast the standard supply-side model with one where pay is determined by bargaining and the reactions to top rate cuts may lead simply to a redistribution of surplus. Indeed, top rate cuts may lead managerial energies to be diverted to increasing their remuneration at the expense of enterprise growth and employment. The third factor is capital income. Overall, private wealth (relative to income) has followed a U-shaped path over time, particularly in Europe, where inherited wealth is, in Europe if not in the United States, making a return. The fourth, little investigated, element is the correlation between earned income and capital income, which has substantially increased in recent decades in the United States.

The critical correlations are illustrated in the following graphs (as well as the graph at the beginning of the article).

Click on any graph for larger images.

Discussion by Econintersect

The correlations between higher top marginal tax rates and less wealth inequality is quite clear.  But correlation does not prove causation.

One control on the causation hypothesis comes from the variation wealth distributions over time for countries with different tax policies.  That can serve to reduce the likelihood that some other global economic function was involved since all countries are operating in one global economy.

The other question regarding causation is the timeline for the factors being measured.

The top tax brackets for the US and the UK moved above 60% in the early 1930s (1932 and 1931, respectively).  The top 1% income shares in the US peaked in 1928 and dropped sharply until 1931, before the top bracket moved from 26% in 1931 to 63% in 1932.  That might imply that there was no causation effect from the top tax rate, except that the US experienced a calamitous stock market crash and fell into the Great Depression during those years.  That could well have been the dominant factor.

As the top tax bracket in the US was raised further during the 1930s into the early 1940s the income share for the top 1% remained at the relatively elevated 15-19% level until the top bracket hit 88% in 1942.  At that point there was a sharp drop in in the income share to the top 1% (down to 13% from 16% in 1941) and the top 1%  stayed between 9% and 13% share until 1986.

The top tax bracket was lowered from 70% to 50% in 1982.  For the first time since the early 1930s share of income to the top 1% rose four years in a row (1983-1986).  Here the possibility of cause and effect is present.

In the years 1986 to 2010 the variation of the top tax bracket between 28% and 39.6% does not seem to be correlated with any particular change in top 1% income distribution.  In general, all those tax rates seem to be associated with a rising concentration of income for the top 1%, interrupted by three recessions (1990-91, 2000  and 2007-09) and the stock market crash of 1987.

So, timeline conclusions can be drawn:

• Continuing to raise the top tax bracket through the 1930s was associated with income share maintained by the top 1% at the level that resulted after the crash 1929-32.  The question here is how much the continuing dislocation of the Great Depression was responsible for the failure of the top 1% to rise back into the 20%+ share of income and how much was a consequence of the higher tax brackets.

• Income share of the top 1% dropped into a new lower band (9% to 13%) once the top tax brakets reached and exceeded the high 80% level and then remained above 80% for the next 20 years.  Of course, the severe economic dislocation of WW II is also a factor that probably served to hold down the top incomes relative to the middle and lower income groups.

• With the top bracket set at 70% for most of the years from the mid 1960s to the early 1980s, income share for the top 1% remained in the 9-11% range, showing the lowest volatility of any time period for the history displayed.

• When the top bracket was lowered to 50% in 1982, the income share for the top 1% increased to 12% in 1983 and just kept  on moving higher (with the dislocations mentioned previously).  It had been 35 years since the top 1% had received 12% of the personal income.

The question of cause and effect is complicated by the overlay of war, stock market crashes and recessions.  But the tendencies discussed in the timeline above are most strongly reinforced by the comparison of income distributions in countries where top tax rates have remained more stable over the last 40-50 years between 40% and 60% (France, Germany, etc.) than in the US and the UK where the top brackets have been  cut into the 28% to 40% range.  And the US, which has cut more that the UK, has a bigger inequality situation.

Econintersect has heard it argued that income distribution is one of the roles of personal income taxation.  Whether or not it is an intended role, the latest paper from Alvaredo et al strongly suggests it is a consequence.

John Lounsbury

Reference:

• The Top 1% in International and Historical Perspective (Facundo Alvaredo, Anthony B. Atkinson, Thomas Piketty and Emmanuel Saez, NBER Working Paper 19075, May 2013)