Friday, 20 January 2012

Percentages and inequality: where is the middle class?

In the last post I brought to attention the inequality issue and have presented a different approach on the 1% debate. Today’s post will be a follow up on inequality, the alleged disappearance of the middle class and the forgotten ideas of innovation and progress that drive the economy forward.


Apparently, there is no more middle class in America. What has once been the proud distinction of the nation is now split up between the rich and the super rich on one side (I can’t track the percentages of who’s who anymore) and everyone else, or the poor on the other side. However this data, just as the data on the top 1%, can be misleading.

The middle class hasn't disappeared. One needs to be careful with the data on income measurements. There is a huge possibility of bias as the levels of income are taken from reported income tax data. This means that making inter-country comparisons can be futile as countries (1) don’t have the same statistical standards, and (2) some countries experience a high level of tax evasion from the richest individuals which will bias the Gini coefficient downwards. Looking at the figure presented, the Gini in India, for example, is lower than in the US simply due to a higher level of tax evasion from the rich – the reality is a big income difference between the rich and the poor in India, much higher than in the US or anywhere in Western Europe. The same goes for the bias in China, the Philippines, Thailand, Malaysia, Cambodia and so on. It is much easier for the rich in those countries to misreport their earnings and channel them to offshore accounts in order to avoid paying taxes. This is why the cross-country Gini coefficient data tend to be misleading: they are collected from only one possible source: officially declared income, not the actual income, which tends to be higher than reported. 

However, one can make the same claim the other way around; perhaps the US is also experiencing a high amount of tax evasion from the rich which is biasing the Gini downwards, so that the US inequality is actually even bigger. This seems unlikely for several reasons.

First of all is (again) the data bias argument where the US income data is based on the IRS reported taxable income. Michael Tanner from Cato finds the following: 
"...reports of skyrocketing incomes among the top 1 percent of earners may be distorted by changes in the tax code that have resulted in more wealth being reported as taxable income. These tax changes caused businesses to switch from filing under the corporate tax system to filing as individuals, and executives to switch from accepting stock options taxed as capital gains to nonqualified stock options taxed as salaries. Simultaneously, the reductions in income-tax rates in 1986 caused much previously unreported income to show up on tax returns."
"At the same time, incomes among lower- and middle-income workers have been shifting from cash wages to non-cash benefits such as health insurance and pensions. These non-cash benefits frequently do not show up as taxable income even though they have value to the worker. In fact, a recent study by Mark Warshawsky of the Social Security Advisory Board suggests that nearly all of the recent increase in earnings inequality "can be explained by the rapid increase in the cost of health insurance employee benefits, and that therefore [there] has not been as significant increase, if any, in inequality of compensation." (M. Tanner, "The Income-Inequality Myth", Cato Institute)

Rewarding education, talent and innovation 

Second, there has been an increasing return on education during the last 30-year period, particularly during the last 10 years. People realized that obtaining a higher education degree would make them move to the upper class of income much quicker than it took their parents. Especially today. Young people go to college, invest in themselves thinking they will be able to make a good return on that investment by earning a higher income when they graduate and land a high paying job. This is why there has been a significant increase in demand for (and supply of) finance and business programs. People realized this is where the high returns are. The competition to get there is great; the competition to get a job in the industry is even greater. 

This is, btw, driving the high salaries of such careers – high demand for investment banking jobs and a limited supply. If you succeed and get a job in the finance industry, you are assured to have a high yield on your college investment. On average, young people do this job for 5 to 10 years due to the stress it brings with it, and afterwards invest their acquired wealth and get even higher incomes. In business, the situation is similar. The competition is high, demand is high, the supply is limited, and the returns are big. Eventually when one does end up becoming a CEO, or a member of the Board, he will see a lot of additional income in the form of stock options and all sorts of performance-related bonuses.



This is where the middle class has gone to. And who is to blame them on doing so?

People are not equal in their intelligence, skills or ability. Every person is a unique individual and should be respected for his or her uniqueness. Every individual should be given an equal chance to succeed. Based on their capabilities to rise above the competition, that individual will achieve prosperity. This is the point of capitalism; the more capable and intelligent you are and the more determined you are, the more likely is it for you to succeed.

People make their money on talent - whether it's singing, acting, sports, innovating, selling, banking - and they are free to do what they want with their money. If the price for their services is high it is because you are willing to pay for it. Just as much you are willing to pay for a game or a concert or a movie, you are willing to pay for the best service from a lawyer, an investment banker or a broker. It has always been this way.

For example, insurance companies are willing to accept the share of risk of adverse events, no matter how likely or unlikely they may be. They make a bet that you’ll never have an illness or an accident, and if they are right they make a profit. The financial services industry enables its customers to increase their purchasing power and buy goods now, instead of having to save for them for a long period of time. The profits these companies earn arise from voluntary trade, the driving force of capitalism, unlike anything earned by political allocation of resources (through bailouts or stimulus projects).

NFL players make more money than any banker on Wall Street. But they don’t get the negative publicity because they entertain us, and we’re willing to pay the price for it. The salaries in the NFL, or the English Premier League are so high due to the willingness of the public to pay the price to watch state of the art sports. Just as the companies are willing to pay celebrities to advertise their products. They are paying for the popularity, i.e. an intrinsic value of an individual.

Companies like Apple weren’t riding on corporate greed and the misery of others. No, they was innovating and creating value for its customers. And through innovation they have made our life better. Apple products are on average more expensive than other similar IT products and are mostly assembled in China, but this doesn’t stop anyone from buying them. Because they offer quality and intelligent design – they are much user friendly than anything so far on the market. They have created their own demand and are fulfilling it and making a huge profit. 

Profits are thus a reward for innovation and creating value for those willing to pay for it. 
Why should we be mad at someone with higher and better skills if he or she can turn those skills and knowledge into creating value and hence profit. 

There is no such thing as an egalitarian society, there never was, and there never will be. For all those claiming that a socialist distribution of income is bringing inequality down, they are right to some extent – the socialist state makes only one redistributive transfer – from everyone to those in power. The result is lower inequality but much more poverty.

9 comments:

  1. I agree that no one should be punished for being successful, but it's a fact that in the US, the system isn't a meritocracy anymore. It became very hard for kids from lower "classes" to make it to the top...

    this is probably what the people are referring to when talking about the disappearing middle class...

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  2. Charlie, do you have any evidence for this? It seems to me that I pass by thriving businesses in my town everyday which have hispanic names. Most of these people came here with nothing, and had a language and cultural barrier, yet they do quite well through hard work and risk taking.

    In fact we are in a recession, but even in an economic downturn everything is better than it was when I was growing up. There is more opportunity not less.

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    1. I was mostly thinking about the last decade or so...I read this article the other day from NY Times, and they offer some research evidence on how 42% of Americans raised in the bottom fifth stayed there..Here's the paper on that.
      Maybe that's just the media perception, but it's still an issue in my opinion. There was also this great article from the Economist a couple of years ago (when this whole debate didn't even begin to worry people) but I can't seem to find it...

      Now, I don't know how old you are, but it's natural there is progress. The economy grew a lot since I was growing up (80-ies) and today things are much better than in the 90-ies, for example, cause we had a long time of prosperity. But along the way something lost its course

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    2. Found it! (the article from the Economist) it's a good piece, they were talking about this issue a long time before it became fashionable among liberals to talk about it.

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  3. If that's the case, then the problem is obviously cronyism.
    Again the argument stands that those who point out to high inequality and taxes for the rich are missing the point - that won’t make the system more fair, nor will it make it more equal. It’s nothing but a political trick for the voters.
    What is essentially needed is more meritocracy, not less, in order to decrease inequality. I'm always in favour of giving everyone an equal opportunity, so that those who are the best arise above. There is nothing more fair than that.

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  4. Its true that the middle class is really wealthy compared to the middle class in south america but the important thing is what direction are we moving in. If 50% percent of the workforce is getting increases in their wages that average only 2% per year but prices are increasing by 3% than the middle class or at least the lower middle class is shirnking.

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  5. I would not dispute the stats in the chart above. But the question that I have is what is the distribution across the board.

    By that I mean this. What if a small percentage of every 100 college grads makes the majority of the money.

    One hundred college grads together may earn five million dollars a year but to get a better picture of things you must break it down further. If just twenty grads earn an average of one hundred twentyfive thousand dollars a year that would mean twenty grads would earn as much money as the other eighty grads combined. The average of the other eighty grads would be only thirtyone thousand dollars a year.

    I would also like to say I have nothing against improving yourself through formal education for some things its neccessary to learn through formal education.

    Where I really disagree is with all this credentialing based on these different degrees high school bachelors masters doctorate we have created a class structure based on these different degrees.

    Learning can take place in many different ways and forms besides just through formal education. How many folks are their out their that have a vast amount of knowledge about a wide aray of topics but they will not get a credit for what they have learned because they do not have any formal education transcripts to prove they have acquired the knowledge that they have.

    I have had a computer for almost three years when I bought it I did not know how to type I was a terrible speller. I have come a long way in less than three years. I can type and spell pretty good on my computer today. I taught myself to type on the computer I learned how to use the computer by myself I did not take any lessons or anything like that.



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    1. you make a few good points, but what I was in particular aiming at was how people with unique skills get paid more, and people willing to invest into gaining more skills also get higher incomes. There was a lot of restructuring on the labour market in the past 50 years where a lot of new jobs were created based on the existence of new technologies. It were these new industries and markets that led to a rapid accumulation of wealth and rising living standards for many Americans.

      In terms of the stagnating incomes of the middle class, I would think about it from another perspective - how many new innovations became affordable to almost everyone. So despite an on average stagnating income, a lot of products are available to a great majority of the populations (personal computers, cell phones, and internet availability are just one of those for example).

      I certainly agree that inequality is a big issue, but what I'm most concerned with is the lack of social mobility. This is what made America great in the past, and it would be a shame if it ceases to exist as it did before.

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    ReplyDelete