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.