What’s Driving Income Inequality?

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Hal Weitzman: Income inequality is increasing in most big, developed economies. But are those at the very top there mainly because they are getting paid more, or are they increasingly collecting the proceeds of their accumulated wealth? And do we need policy changes to address the phenomenon?

Welcome to The Big Question, the monthly video series from Chicago Booth Review. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Eric Zwick is assistant professor of finance at Chicago Booth. He studies the interaction between public policy and corporate behavior, with a focus on fiscal stimulus, taxation, and housing policy. Gabriel Zucman is an assistant professor of economics at the University of California at Berkeley. He’s the author of The Hidden Wealth of Nations: The Scourge of Tax Havens. And Luigi Zingales is Robert C. McCormack Distinguished Service Professor of Entrepreneurship and Finance and director of the Stigler Center at Chicago Booth. He’s also the cohost of the podcast Capitalisn’t.

Panel, welcome to The Big Question. Eric Zwick, let me start with you. When we say “top incomes,” “top-income inequality,” what do we mean by top income? What do you have to earn to be at the very top in the United States?

Erik Zwick: Yeah so, I think one of the really useful things for this debate is to be very precise about the object we’re trying to study. In the US, I’ll give you the number, from the top of my head, for 2014, which is the top 1 percent of fiscal income, which is the object in my research I’ve been focused on, which is data that you observe in tax returns. The top 1 percent, roughly 1.5 million tax units, so it’s a combination of married and single filers who have collective income of over $400,000 roughly, excluding realized capital gains. Then the top 0.1 percent is gonna be 160,000 units. They’re going to have income over $1.5 million. And then the top 0.01 percent is gonna have income between $10m and $15m, depending on how you cut things up, and that’s gonna be about 16,000 tax units in the US.

Hal Weitzman: So, right at the very top, the 0.01 percent, is 16,000?

Eric Zwick: 16,000 families or individuals. Exactly.

Hal Weitzman: And what evidence do we have about how those groups are becoming more unequal, diverging over time?

Eric Zwick: Yeah, so, within those groups, income inequality— or, so, their share of total income—has been going up over the last 30 years, with roughly equal contributions to the share of income within the top 1 percent going to the one to 0.1, the 0.1 to 0.01, and the 0.01. Although of course, per person, because the .01 is such a small group, they’re getting a lot more income. So there is a sense in which it’s concentrating more at the very top.

Hal Weitzman: OK. Gabriel Zucman, what evidence do you use to show us the same kind of phenomenon, that concentration there at the very top?

Gabriel Zucman: Tax data are the most important source of information because everybody has to file, or almost everybody has to file a tax return, and so you can study the wealthy using tax data.

But for measuring certain things, like distribution of income after government intervention, after government transfers and taxes, you need to look at survey data as well. In recent research with [London School of Economics’] Thomas Piketty and [University of California at Berkeley’s] Emmanuel Saez, we try to combine all the information that’s out there, so tax data, survey data, national account data, macroeconomic statistics, to have a kind of comprehensive picture of how GDP—our national income, the total output, the total income of the country—is distributed. And when you do that, what you see is that there has been a dramatic change in the US since the 1980s. In 1980, the top 1 percent earned about 10 percent of total national income. And today they earn about 20 percent of total national income.

And then when you look at the bottom 50 percent, half of the population, they used to earn about 20 percent of national income and now they earn about 10 percent. It’s the mirror image of what has happened in the top 1 percent. And so the top 1 percent, which is a group that’s about 50 times smaller than the bottom 50, they earn twice as much income as the bottom 50. So their average income is 100 times larger than the average income of the bottom 50.

Just one more piece of information, which I think captures how terrible things have been for the working class and the middle class in the US: you look at the average income of the bottom 50 percent in real terms, so adjusted for inflation, it used to be $16,000 per adult in 1980. And today it’s still $16,000 per adult.

So the average income for half of the adult population is 16. One. Six. $16,000. It’s not a lot of income. And it has completely stagnated over more than a generation. So you have half of the population that’s been shut off from economic growth.

Hal Weitzman: Let me bring you in, Luigi Zingales. To a certain extent, inequality is inevitable. Why should we care about this trend?

Luigi Zingales: So I will distinguish very much between the first part of Gabriel’s conversation, which is about sharing of the pie, and the second part, which is the absolute level.

So in China, inequality has gone up tremendously in the last 20 or 30 years. But the Chinese are very happy because when, on average, you grow 7 percent per year, and everybody benefits somehow from that growth, even the bottom of the distribution is lifted.

I think that, to me, what is the dramatic fact that they have established beyond reasonable proof, I think is a fact that in its simplicity was around for a long time—I wrote about it in 2012 in my book—is the fact that the median American worker has not seen an increase in real salary for more than a generation. I think that that is the fact that, in essence, puts into question the entire system, because the capitalist system is based on the principle that yes, we tolerate an inequality in exchange for a great increase in the size of the pie. A great increase in the size of the pie that must benefit everybody because otherwise it becomes intrinsically incompatible with a democratic country.

Hal Weitzman: Let’s talk about who these people are and what they’re actually doing, which is some of your research, Eric Zwick. You find that the people at the top are earning their wealth, their income. So tell us about how you found that, and who are they?

Eric Zwick: We were very interested in trying to—you know, you have these top-level statistics from macroeconomic data from everywhere that have labels that are coarse: labor income, capital income—how we measure those things is not always clear. We were able to work with coauthors at the Treasury Department to go from the bottom up and ask: For an individual who’s residing—an earning income that looks like capital income or labor income—at the top of the income distribution, what is the nature of the activity in which they are participating? Are they actively working? And, I think, in this research, what we learned from that is in the top 1 percent, primarily the median person looks to be a working rich person as opposed to a rentier. This is one of the key facts—

Hal Weitzman: Just remind us what a rentier, a ren-tee-ay, I guess—

Eric Zwick: A ren-tee-ay is right, the proper French pronunciation—I’ll leave that to Gabriel.

Hal Weitzman: So what is a rentier?

Eric Zwick: These were the people who at the top of the income distribution in the early part of the 20th century were earning their income primarily through rents, interests, and dividends from passively accumulated capital, so they were benefiting . . .

Hal Weitzman: Many of them heirs to wealth, or—

Eric Zwick: Yeah, and so there was also a dynastic component to the wealth there, that they were earning the rents or the coupons. They were clipping coupons—these are not like coupons that you take to the store, but the coupon payments from fixed-income securities. And that was really dominating top incomes at the beginning of the 20th century. Piketty and Saez’s 2003 paper showed that in the US, that top incomes, while income inequality had grown so much, didn’t look like the rentier society from the early 20th century. It looked like the working rich. Labor income was very important.

In recent years, there’s been some debate about, well, maybe capital income has come back into play. And what we do is we look at: What is the nature of this capital income? A lot of it looks like entrepreneurial income, income earned by doctors, lawyers, skilled consultants, people in high-skilled service professions that structure themselves as businesses because of tax preference. It looks like capital income, but when you look under the hood, it’s kind of a mixed income–entrepreneurial combination of labor income. But they look to be actively involved in generating that income.

Hal Weitzman: OK, so Gabriel Zucman, does that sound right? Or are you more of the view that this is actual, genuine capital income that’s driving this inequality?

Gabriel Zucman: Well, I guess there are two different questions. I think it’s very important to distinguish two things.

One question is what’s the composition of the income of the rich? Is it mostly labor income or mostly capital income? And another question is: What is the source of the wealth of the capital income of the rich? Is it wealth that’s been accumulated out of their own saving or is it wealth that’s inherited? And when we talk about the rentier, we talk about that second question of inherited wealth being important, and people at the top of the wealth distribution having inherited their wealth in contrast to having created their own business.

So on the first question of whether labor income or capital income is more important at the top, I think in the recent years, when you take a comprehensive view of all national income, it’s capital income that has been growing very fast at the top of the income distribution since 2000. According to our estimates, most of the increase in the top 1 percent income share comes from an increase in pure capital income, not labor income. And in particular, it comes from a rise of corporate profits.

One very striking development in the United States, and in fact all over the world, is the rise of corporate profits and corporate savings. So corporations are very profitable; they make a ton of profit, but they don’t distribute a lot of their profits to their shareholders. They retain a lot of their income. To study that, you can’t only look at tax data, their income tax data, because you don’t see this big fraction of corporate profits that are not distributed. But when you take that into account, the huge amount of profits of companies like Apple, Alphabet, that don’t get distributed to shareholders, when you attribute that income to shareholders, then you see that that contributes a lot to the documented rise in income inequality. So on the first question, I think the evidence is more consistent with the view that it’s capital income that’s driving the rise of overall income inequality in recent years.

On the second question of whether we are returning to a kind of rentier society, there is no evidence for the US. If anything, the evidence is more suggestive of a world where a lot of the wealth right now at the top comes from saving. So people in the 1980s, 1990s who earned very high incomes and then they saved a lot of their income, that’s what explains why they’re very wealthy today. People at the top of the wealth distribution, some of them probably are rentier inheritors, but many of them are life-cycle, self-made savers. But they have a ton of wealth, which generates a lot of capital income, and so you can have a society where most wealth is self made, and yet capital income is what really matters at the top of the distribution. And that, I think, characterizes the US today.

Hal Weitzman: OK, how does that fit in with your work?

Eric Zwick: Well, I think there’s a question—there are two parts to it. And the first thing I’ll say is that I think there’s a lot of room for further research to shed more light on this, and it’s super policy relevant and important. I think the final word has not been written yet. One point is about whether we’re talking about people or about dollars. Gabriel’s statement was primarily a statement about dollars, which was about the share of aggregate dollars that are labor versus capital income.

My statement emphasized more, sort of, if you look at the median person, how would you characterize the activity in which they’re engaging. So there could be a different answer at the person-level versus the dollar-level basis.

The second is that there’s not a completely assumption-free way to take this extra capital income that we don’t observe in tax data and allocate it to people, because we don’t observe their ownership, at least given the data that’s currently collected. So we have to make assumptions, and there’s a range of assumptions that I think can lead you to conclude one way or the other about the relative importance of capital income, the unallocated corporate profits of Apple and Alphabet, which really depends on how much of the share of Alphabet and Apple goes to the top 1 percent versus everyone else.

We have estimates about how much of it is nontaxable, how much of it is in pensions, how much of it is in the nonprofit sector, and so you can have a range of assumptions based on that that can allocate it. And those numbers are actually quite important and change the conclusions.

So I think more data on the underlying ownership is really important to settle this. But I think we’re probably in agreement about this person-level statistic, which feels to me like something that’s consistent with the self-made versus dynastic point. So I think there’s actually more area of agreement than disagreement, even if the punchline sounds different.

Hal Weitzman: And you said it’s super policy relevant. Luigi Zingales, what is the policy implication, if we say that those at the very top are earning their money as opposed to collecting it?

Luigi Zingales: I don’t think that the most interesting question is whether they are collecting out of past savings or whether they’re making the money. Because in many of the businesses, the two things are intermingled. So at the top of his statistics of income distribution, there are doctors, there are dentists, there are car dealers. So do I make money out of the capital I invest as a car dealer? Or do I make money out of my skills as a car dealer? It’s very hard to disentangle.

I think the more interesting question is whether as a society we are rewarding the right people, and whether the market is sufficiently competitive, or not. And I think that what emerges very clearly, especially from Eric’s research, because it goes more in this direction, is that these pockets that are making the most money are in sectors that are not very competitive, are sectors that are not being exposed to international competition, and are sectors that generally benefit tremendously from regulation. Car dealers come to mind because they have state regulation that is to protect them. Doctors come to mind. Dentists come to mind. And honestly, even if I’m in finance, the financial sector comes to mind.

So I think that that’s an important problem we need to consider. And it’s very important from a policy point of view because the traditional view of income distribution is that you fix it with more taxes or more redistribution.

Now, what Gabriel’s research shows very clearly is that this is a teeny-tiny thing. That reality is not that in the ’60s the redistributions were much more massive. Absolutely not. It’s that in the ’60s, the market outcome was a more equal-market outcome. And somehow this has been deteriorating. I think that the question is very much the traditional, I would call [Harvard’s] Larry Summers type of policy, where you are taxing and spending. And it questions a market design. We need to bring more competition. We need to actually be more careful about the anticompetitive effect of regulation. We need to attack monopolies in a more massive way. And I think this is a new kind of policy that some people here and there are advocating. But it’s not a mainstream policy in Washington in any form or shape, neither for the Democrats nor for the Republicans.

Hal Weitzman: And is it your contention, then, that more competition would solve or address the inequality issue, or is it sort of irrelevant?

Luigi Zingales: No, no, absolutely. It will massively improve the situation, for two reasons. Number one is the people are earning these rents because there is no free entry. There is no competition. So it will decrease the rent, but also remember: all these measures of income are deflated by prices. Part of the reason why the real wage has not increased is there is a question of the numerator and there is the question of the denominator. And the denominator is the price level. So in a more competitive sector, many things would be cheaper.

In my research, I look at the mobile-service sector. There you see that if the United States had the same prices as Germany— we’re not talking about an underdeveloped country, and I can assure you when you go to Germany, phones work perfectly fine—so if you had the same price as Germany, consumers overall will benefit $50 billion a year. $50 billion a year. Only for this thing, the real wage would be 2.5 percent higher as a result.

Now, you think two and a half is little, but his statistics say that in 24 years, the bottom 50 percent of the distribution got only 1 percent increase, so we are almost tripling the increase just by fixing one sector. Imagine if you are fixing a lot of sectors, what is the outcome?

Hal Weitzman: Gabriel, what’s your view on that? Is competition in itself enough to address the issue?

Gabriel Zucman: I think tripling just 1 percent growth rate is not enough (laughs). You know it’s not—

Luigi Zingaes: I agree with you.

Gabriel Zucman: That’s not going to fix the problems of the US. So in my view, I don’t think there’s clear evidence that when you have more competition and a better competitive economy, you have more equality. I think more competition’s probably good for efficiency reasons, but when it comes to the distribution of income and wealth, I think you can have a lot of inequality even with perfectly competitive markets. And so I don’t think that this is going to fix the inequality problem. I think if you want to have a more equal distribution of economic resources, you have to look at policies, in particular tax policy I think plays a very important role. But also, you know—

Hal Weitzman: You were talking about a more, what was characterized as a Larry Summers–type, the more Keynesian–type tax-and-spend policy—

Gabriel Zucman: Well not exactly in that sense. I’m not talking about the size of government revenue and government spending, but more about how taxes are collected. That I think has a big effect on the distribution of pretax income. If you have a very progressive tax system, with very high top-marginal-income-tax rates, just like the US used to have for half of the 20th century, with top marginal rates as high as 90 percent, then it reduces the inequality of pretax income because it reduces the incentives for people to try to capture rents because there’s no point in trying to earn $100 million or $10 million in income in the financial sector or in other sectors if, at the margin, 90 cents out of any extra dollar is going to go to the IRS. And so I think if you want to reduce the kind of rent-seeking economy in which we very much live, tax policy and sharply progressive income taxation plays a very important role.

Hal Weitzman: But the trade-off there might be it’s less competitive or less efficient, presumably.

Eric Zwick: There’s also a massive weight or burden that you place on enforcing the tax code. I feel like the historical record suggests that when you introduce very sharp taxation of income, you also invited a lot of evasion or avoidance or consumption through firms, retained earnings as a way of avoiding those top-income tax rates. So there’s some sense where the pretax income inequality as measured through tax data looks like it’s been improved, but it’s really just because it’s been shoved underground or in different pockets, off-shore for instance. So I think there’s a lot of burden to enforce. So maybe when you say sharp taxation, you must say also a much more powerful IRS to enforce the rules, and also a political class that is somehow immune to the catering that was always in place after these sharp taxes were introduced.

Luigi Zingales: But I would like to dispute Gabriel’s position that more competition will not reduce inequality. I think that, I’m not saying it’s sufficient. I think that, for example, some policies to help create a safety net for people at the bottom of distribution are necessary and need to be integrated.

But I challenge you to indicate any extraordinarily wealthy person that did not accumulate that money somehow through some form of monopoly. I don’t know if you know, but Carlos Slim used to be the richest man on Earth and dropped by $40 billion to position No. 4. Now don’t feel so bad because he has $50 billion left.

So why did he drop? Because they introduced more competition in his market, which is the mobile market in Mexico. I think that there is a clear redistribution from consumers to producers because the wealth is more concentrated and the ownership of shares is more concentrated. That goes and accumulates in this small fraction of the population. I think that to reduce that, more competition is necessary, but probably not sufficient.

Hal Weitzman: And you’ve also, in your work and in your work on the podcast, you talk a lot about superstar companies and concentration. How does that issue of the small number of firms that have a lot of market power, how does that relate to the inequality that we talked about in the beginning?

Luigi Zingales: So I think this is what Eric was hinting to, is the fact that once we have companies or individuals that are disproportionately wealthy, they tend to have a disproportional amount of political influence in the system, and they modify and change regulation and legislation to their own advantages. And there is research showing that it’s not true that when you have more inequality, you tend to have more redistribution, like we would expect from first economic principles. You have actually the opposite.

And why? because a very unequal top is very able to capture the conversation and change the policy in a particular direction. So I think that is very dangerous. And we witness it every day now in the United States. And the fact that a company like Foxconn got $4 billion from the State of Wisconsin to relocate there I think is an outrage. It’s an outrage because the Joe Schmucks in Wisconsin don’t like this benefit. Not only that. They pay taxes in order to subsidize the big companies. And I think this is an outrage.

Hal Weitzman: What about that point, Gabriel Zucman, about the politics of it, because we just had some tax legislation passed in the United States, which lowered rates, and there was not a popular uprising against it. It lowered rates on corporations and on wealthy individuals, or on many individuals. Does America have the stomach for that kind of policy?

Gabriel Zucman: Well when you look at polls, you see that the tax bill is actually very unpopular. It’s not like it has a lot of support among the American public, and it’s true, it’s very striking to see that inequality has increased so much and tax policy has become less progressive. And the tax system at the same time is reinforcing—

Hal Weitzman: That may be connected to this politics that we’re talking about.

Gabriel Zucman: It is. I think the key reason why we care about income and wealth inequality, is that wealth in particular is power, is political power, and so when wealth is too concentrated, power is too concentrated, starts being made mostly at the benefit of the very wealthy. So the key question for the country is: How do you extract yourself from this plutocratic trap?

Hal Weitzman: Eric Zwick, what’s your policy proposal for tackling this issue?

Erik Zwick: Right, so I am very sympathetic to Luigi’s concern that a lot of the sectors where we see top, active earners are sectors where barriers to entry have been erected. Some of these barriers to entry are regulatory and some of them are really just about opportunity. And I see inequality of opportunity to even become a doctor that’s across society that’s based on the cost of education, access to sufficient education, that I feel like is an important public good that we’ve underinvested in historically over decades.

Luig Zingales: No, but the number of doctors in the United States is fixed by law.

Eric Zwick: I totally agree—

Luigi Zingales: More than by anything else. This is the No. 1 example of barrier to entry.

Eric Zwick: At the same time, their distribution does not reflect the population distribution for many other characteristics, which suggests that there’s inequality of opportunity as well as barriers to entry.

Luigi Zingales: I’m not disputing—

Eric Zwick: No no, I agree that there’s a lot of regulatory stuff, especially in health care, where the market is not setting the price. And so the private marginal product, which is what we’re observing with income data, is not the social marginal product or the social product.

There’s a lot of entry in the legal profession, where the number of lawyers is not fixed per se, but there’s inability for a lot people to enter that profession because they’re unable to afford to get the kind of education required. I’m not saying that everyone should go out and be lawyers. I’m saying there are a lot of extremely rich lawyers, who work really hard and do jobs that I wouldn’t wanna do as well.

So I feel like investing in education and opportunity is an important piece. I totally agree that redistribution is one way to address inequality very directly, but you can also address through redistribution of opportunity or distribution of opportunity, making sure we’re investing in equal opportunity.

Luigi Zingales: Yeah, I think that this is where we should really invest massively, and where very little progress has been done on either side of the political aisle.

Hal Weitzman: If the current state of inequality is unacceptable or damaging, what is an acceptable level of inequality because some inequality in a market system is inevitable? How would we know when we make— apart from the trend going down—how do we know when we’ve reached a good inequality, if that makes sense, Luigi?

Luigi Zingales: I think it’s very hard to have a formula for this. I think it’s a combination of a number of factors. But the first one is, clearly, we want everybody to benefit somehow off the growth. I think that if that’s not diffused, that is unsustainable. But the other is also the sense of fairness in which you achieve these results. I think that people are not particularly complaining of the inequality in sport. In sport, there is gigantic inequality. The superstar pay, in my view, is an outrageous amount of money. But nobody complains. Why? Because they see the talent, and the market is relatively an equal-opportunity market. Not exactly, but you have equal opportunity.

And so I think the sense of fairness is very important. And I think that what has been broken in America in the last 10 or 15 years is the sense of fairness. And I think that the combination of we don’t have growth and there is no sense of fairness, I’m sorry to say, but six years ago I said populism is inevitable. And when I said it, people looked at me like I was a Communist, and unfortunately, I was right (laughs).

Hal Weitzman: Gabriel Zucman, what would that fairness look like?

Gabriel Zucman: At a minimum, you want tax policy to go against the wind, not to increase inequality but to reduce inequality. Right now it’s striking to see that both the 2017 tax reform, the average tax rate paid by the top 0.1 percent is going to possibly return back to the level it was in the 1920s, when the government was one-third the size it is today. So in the 1920s, the top 0.1 percent paid 20 percent of its income in taxes, that increased to 50 percent in the post–World War II decades, and now it’s returning to 20 percent, which is against any notion of fairness and justice that you can have.

So what I want to say is globalization has benefited certain groups of the population a lot— big multinational corporations, top earners— and these groups of taxpayers should be paying more, not less. What has happened is that the very people who have benefited a lot from globalization have seen their taxes collapse, while at the same time those who did not benefit from globalization and sometimes were hurt by globalization—retirees, the working class, small businesses—have seen their taxes go up.

So a basic fairness requirement would be to fix that. To have tax justice, those who gain from globalization should pay more, and those who have suffered from it, who have not gained from it, should pay less.

Hal Weitzman: Finally, Eric Zwick, briefly, you were suggesting that it was more about how you get people into the system and the quality of opportunity. What would be a fairness in that sense?

Eric Zwick: Yeah, so I guess rather than proscribing a specific share that goes to the top 1 percent, it strikes me, we can look at—this almost a revealed-preference interpretation: if the political candidates are talking about populist ideas and redistribution, and are really getting a lot support and there’s a lot of anger around inequality, then we have too much probably.

And if instead they’re talking about what we were talking about in the late 1990s, the election was all about protecting social security and the social programs and getting us onto sustainable debt or something like that, where inequality wasn’t a big political issue, then we probably are OK.

Hal Weitzman: OK, so we’ll watch out for that at the next election. That’s a horrific thought in some way, another election. But in the meantime, time for this discussion is up. My thanks to our panel, Eric Zwick, Gabriel Zucman, and Luigi Zingales.

For more research, analysis, and commentary, visit us online at review.chicagobooth.edu and join us again next time for another The Big Question.

Goodbye.

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