Income inequality and the Rule of 72 – part 3

      3 Comments on Income inequality and the Rule of 72 – part 3

“If we don’t do something to fix the glaring inequities in this economy, the pitchforks are going to come for us. No society can sustain this kind of rising inequality.” Entrepreneur and investor Nick Hanauer. [1]

Part One of this series looked at how some basic compounded income growth projections with fairly-low rate differentials could alone result in fast-widening income inequality, and then Part Two reviewed real-world data that appear to get to the same end point as those predictions. There are certainly other causes and complications to rising income inequality, but the point of the first two parts can be summarized as:

  1. Small differential income growth rates averaged over 30 years, with relatively-stable inflation, project out to large and exponentially-widening differences in income, requiring only about a 1.5% growth rate differential between the two bottom sectors, comprising 90% of the population, and only a 3% differential above that to explain the next 9.9% of Americans. In the short term, this usually does not appear to be a big difference, but the effect is huge over time.
  2. The last 30 years of experience in the U.S. support the observation that low inflation and a stable economy can, counter-intuitively, exacerbate the spread in income inequality. In a sense, time itself is the enemy.

This presents both a positive and a negative outlook on the issue. First, no grand conspiracy or radical growth rate differentials are required to explain income inequality. This deflates a lot of hot air on the subject. The downside is that these small differences are very hard to get out of the economic system and business culture.

The effect of the new tax legislation

Employers have begun to cite the Tax Cuts and Jobs Act of 2017 as their incentive to pay out new employee one-time bonuses and to make some pay rate improvements, although mostly just the former, it appears. This is significant because the business tax cuts were made permanent, while the employee tax cuts were made temporary by Congress. Yet, the primary response has been one-time pay bumps with little indication that this will “change the curve” in the long run (or even in the second year).

Walmart always seems too “pick-on-able” here, but they often like to spin without addressing the larger reality of their low-paid workforce. The Des Moines Register notes that their touted $1000 bonuses only apply to 20-year employees, with more employees getting as little as a one-time $250. They also announced a rise in their minimum pay from $10.00 per hour to $11.00 per hour. However, the average rise of hourly wages for full-time employees (“full-time” being a very important Walmart distinction) is only 29 cents, a rise of just 2%. And again, this is a one-time bump, with no indication of a continued trend. [2] Yet these same tax cuts will accrue as much as two billion dollars of additional income to the owners annually. [3]

A lot of the research and writing around income stagnation among the lower tiers is focused on “the Why” of economic forces “holding down” wage growth, usually blaming global competition and illegal immigration as dominant factors. My cynical response as to why employers don’t raise wages faster is simply, “Why should they?” There is no general inflationary pressure and union power has been decimated. There are reduced incentives for families to relocate, and labor shortages have mostly been limited to spotty and short-term inconveniences. Several studies are now suggesting that increasingly-consolidated businesses have generated “monopsony” power (“one buyer”) over wages in many communities.

And even if companies did raise “normal employee” wages a bit more aggressively, my key point in this series is that unless wages are rising at the same rate as top management and high-skill incomes have been rising (the dark-gray line below), the gap will continue to get bigger. This is the heart of the Rule of 72. A small increase to the bottom groups, a bit higher rate of managerial income growth, and a big bump to capital income growth only exacerbates the inequality.

Where does it end?

Given that reality, the next question to ask is whether there is a natural end to this trend. Will it peter out through some market forces? Recall the trends of income growth described in Part Two:

Income gains

The math of the Rule of 72 says there is no reason why the top line can’t double to 600% in the next ten years, or increase four times to 1200% in twenty years. Is there a natural limit on how much of Earth’s wealth can accumulate to the top 0.1%? My first reaction would be to say yes, but the accumulation of wealth at the top in the last ten years has far exceeded most prior conjectures. Death breaks up some family fortunes, but the top three Walmart heirs alone have pushed the value of the Walton estate to well over $100 billion without much of a speed-bump in passing through the generations. [4]

A new paper from the Federal Reserve Bank of San Francisco appears to bear this out. Says the Washington Post analysis of this paper, “Wealth accumulates faster — much faster — than economies can keep up. If this is true, it means that in coming years, wealth inequality could grow even faster than [Thomas] Piketty feared.” [5]

Of course, all this assumes no major economic crash or wars in the next decade. Each of these events in the past have had unique unanticipated economic effects. Insert your best guesses here.

There is also, unfortunately, no real reason, short of major economic shifts, that the bottom two income groupings, making up 90% of the U.S. populace, will start kicking up in income growth, even in extended good times. The new tax legislation’s best proponents have predicted only small marginal increases total economic growth at best, and the most common response we have seen to projected bottom-line increases so far has been stock buybacks and other ownership consolidation moves.

A recent Bloomberg story also suggests that the fear of future recessions causes businesses to hold back raises even in good times, because a bump in base pay turns these raises into higher fixed costs well into the future. Note that higher managerial pay costs seem to be not as suspect. [6]

Or “just the way it is”?

This begs the second question of whether this is “just the way it is.” In other words, should we just accept this as the inevitable evidence of “rich people excelling over poor people”?

Omaha billionaire Warren Buffett has long taken the stance that reasonable taxation and citizen-focused government creates the very secure foundation on which his own wealth both grew and still requires for its future value. Banks and the monetary system need to protect all of the people. The needs of the poorest Americans have to be addressed, and the middle class needs to see a reason to “buy in to the American Dream.” Otherwise, Buffett says, his own wealth could collapse to nothing, and fear will reign. The “pitchforks” will come out, as Nick Hanaeur noted.

To be clear here, one reason for the differential income growth that has ballooned into extreme income inequality is that people in the bottom tier of the economy are trapped, either by choice or circumstance, into behaviors that defeat family economic growth. Excessive debt, a lack of preparedness to improve career choices, and emphasis on current consumption rather than savings easily combine to kill the opportunity to get ahead for millions of Americans. I frankly can’t see that reality changing.

At the same time, the higher you get up the economic food chain, the more opportunities you have to take advantage of investments and tax preferences that, despite (or because of) higher risk, generate higher returns and income growth. Income growth itself, once you are beyond the press of day-to-day survival, feeds even more income.

To bring back a point in the introduction of Part One, it is important to recognize that the top tier of wealth is growing exponentially by “orders of magnitude” (i.e., powers of ten) as compared with wealth in the past. Today’s upper one-thousandth of the American populace aren’t five or ten times richer than in the past, compared to the middle. They are at least one thousand times, and even coming up on one million times richer than the family with $100,000 of net worth stuck in their home equity or retirement plan.

The first place to address the still-growing gap would normally be the tax code, but unfortunately, the most recent revision in December of 2017 is definitely going the wrong way. But even if the bottom tiers of wages began growing another percent or two faster because of tax law changes or economic growth, the Rule of 72 demonstrates, as shown in Part One, that the differential gap in income growth will continue to grow even bigger as long as the upper tiers have even a slightly-higher growth rate. And over time, because of compounding, the curve for them points ever upward.

30-year growth

Growth of $30K in salary over 30 years

The unconscionable, mostly overlooked part of the changes to the tax code, however, are the increasing number of ways that differentiate between how wage income versus investment income is taxed. New preferences were created, for instance, to lower tax rates on income from real estate (gee, I wonder why?) and the long-standing tax preference for “carried interest” from private equity investments remains, despite being almost universally panned by tax experts and economists as anachronistic and unjustified.

In addition, a very complicated set of new preferences will encourage high-wage people to convert their income to lower-tax “pass-through” income in ways that are not available to conventional wage-earners. Tax lawyers will be in high demand for constructing these businesses.

Focusing on “income security” instead of growth

My general despair over addressing income inequality through the tax code leaves perhaps just one primary option open. The government could focus on income security rather than growth, which has been the most successful European model for addressing this issue, and the evidence backs that up. If high-quality, basic healthcare truly were available to every person in the United States, if the education system had a strong focus on educating and re-training for the careers of the future, if people have better housing options, and if the transportation infrastructure was constantly getting better and safer, then the worst downsides of income inequality could be lessened.

As a start, all but the most doctrinaire economists recommend getting the national minimum wage back up to where it had been in the past, adjusted for inflation. This would not only help the bottom tier of workers, but would likely nudge up all bottom-half income levels.

Eighteen U.S. states have made some adjustments (mostly modest) to their minimum wage levels starting at some point during 2018. [7] There is enough variation and adjacent-state comparisons here that we finally may see a broader and continuing trend upward in minimum wages if income growth happens at the bottom tier without new price inflation. I find it useful to note that McDonald’s Big Mac prices in Germany in dollar terms are very comparable to U.S. prices despite a significantly-higher minimum wage. It can be done.

But implementing more significant change affecting income inequality would likely require a major change to the representative government through the ballot box and courts. Or perhaps pitchforks…


Notes:

  1. Sherman, Erik. “7 Billionaires Worried about Income Inequality.” Fortune, 28 Nov. 2015.
  2. Johnson, Patt. “Citing the GOP Tax Overhaul, Walmart Raises Wages, Offers Bonuses to Its Iowa Employees.” Des Moines Register, 22 Jan. 2018.
  3. Walmart currently pays an aggregate tax rate of around 30%. Every percent drop in taxes is worth about one-quarter of a billion dollars.
  4. “The World’s Billionaires.” Forbes Magazine.
  5. Ingraham, Christopher. “Massive New Data Set Suggests Economic Inequality Is about to Get Even Worse.” The Washington Post, 4 Jan. 2018.
  6. Greenfield, Rebecca. “Bonus or No, Don’t Get Your Hopes Up for a Raise.” Bloomberg.com, 3 Jan. 2018.
  7. Michaels, Matthew. “Minimum Wage Will Rise in 18 States in 2018 – but No One Can Agree on the Impact It Will Have.” Business Insider, 21 Dec. 2017.

 

3 thoughts on “Income inequality and the Rule of 72 – part 3

  1. Pingback: Income inequality and the Rule of 72 – part 2 – When God Plays Dice

  2. Bill Morain

    Rick, You have made this SO CLEAR.
    There is no chink in your armor. It is the reality, and it is so frustrating.
    The paradox is that the “American values” that are part of our hereditary hardware (upward mobility, resourcefulness, self-determination, economic freedom, equal opportunity) mask the brutal reality. Every eight or twelve years or so, we wake up, but the old Jacksonian campaign pitches throw us back. And the first takes us a step forward and the latter TWO steps back.
    You and I will never see the denouement, and I suspect it will be the pitchforks. But unfortunately, in November 2016 the pitchforks were on the wrong side.
    My only consolation is in understanding the stark reality, and that is what you have clarified so beautifully.

    Reply
    1. RKL Post author

      The frustrating thing to me here is that the absolute explosion of wealth created in recent years, even as it accumulates at the top end, demonstrates that there is “enough and to spare” wealth in the economy to address the worst downsides of income equality. Instead we want to build very expensive and ineffective walls. We are turning the working class groups against each other instead to disguise the movement of the wealth away from them.

      Reply

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