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Top fractiles income share and the “good old days”

November 21, 2010

I hear some people pining for “the good old days” and how good things used to be.  Many times it seems like those same voices are also quick to fault the “socialist” programs of the Obama administration as the reason we are not enjoying the same prosperity as we did “back in the day”.  If we set aside the phenomenon that the past seems better because we tend to remember the good times and tend to forget the bad, then what were the economic conditions that made the good old days so good?

In his recent book, Aftershock, Robert Reich observes there are three stages of modern American capitalism. From 1870 to 1929 there was an increasing concentration of income and wealth. The period from 1947 to 1975 was characterized by more broadly shared prosperity and the third stage from 1980 to the present is one of increasing wealth concentration. It is arguable that the middle period is what some remember as the good old days.  Reich also points out that currently the top 1% of Americans take home 23% of the total national income.  In 1979, the top 1% was taking home 9.8 percent.

Could it be that “back in the day” prosperity was marked by a more even distribution of wealth? If so, does it make sense to try approximate the conditions that lead to that prosperity?  One step would be to adjust the top marginal tax rate to levels it was during those years and keep taxes relatively low on the middle income earners.  The debate of extending the Bush tax cuts to those earning over $250,000 is laced with passion but those arguing for extending the cuts to the top earners should consider the substance of Reich’s position.

In Aftershock, Reich presented a trend graph of the percent of income earned by the top income group.  Below is a similar chart with income data with the addition of the top marginal tax rate.  Although correlation is not causation, it is interesting to note that as the top tax rate was lowered during the Regan administration there was an undeniable trend of increasing earnings percentage in the top wage earners.

Income share and top marginal tax rate

The era of broad prosperity between 1947 and 1974 coincided with a high top marginal tax rate and a relatively evenly distributed income share.

In the above chart, the red line is the percent of national income taken home by the top 10% of wage earners.  “Back in the day” this value oscillated around 34%.  The blue line is the marginal tax rate of the highest income tax bracket/  During the years of prosperity the maximum tax rate was between 70 and 90 percent.  Today, the discussion is centered on increasing the marginal tax rate from 35 to 38 percent.

Setting the percentages and charts aside the bottom line is what Reich describes as the “basic bargain” which is simply that in order to have a healthy economy the producers of goods and services must also have the financial ability to consume those services.  When the middle class does not have the means to consume then demand is diminished.

This is not a new concept. Henry Ford caused quite a stir when he decided to pay his line workers twice the average salary of the day. He saw this as common sense because the people who would be buying his Model T would not be the small number of wealthy individuals but his real market was the middle class.  By providing a high salary to his workers he was providing them the means to buy his cars.  He recognized that the producers were also the consumers.

I wonder if in today’s vitriolic environment Henry Ford would be labeled a bleeding hear liberal for driving income to the middle class. In fact he was just being a wise businessman.  I also wonder if Henry Ford would see the folly of putting more money in the hands of the wealthy by extending tax cuts at the same time taking money away from the front line consumers by not extending the unemployment benefits.

Data sources used in creating the above chart:
http://emlab.berkeley.edu/users/saez/
http://www.bls.gov/webapps/legacy/cpsatab1.htm
http://www.irs.gov/pub/irs-soi/histab23.xls

Other references:
http://robertreich.org/

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