Progressives Are Wrong: Income Inequality in the U.S. Is Not Increasing!

Progressives never tire of promoting the Iron Law of Wages. First promulgated by Thomas Malthus and David Ricardo in the early 19th century, the Iron Law is touted by the political Left (whether they know it or not) as the primary reason dirigiste management of the economy is more desirable than free-market capitalism. As evidence for the reality of the Iron Law, American progressives cite the apparent growing income inequality observed over the past few decades. Yet, this growing inequality is more apparent than real.

The Iron Law of Wages

So, just what is the Iron Law of Wages? It is an idea developed in tandem between Malthus and Ricardo. Some economists such as the Keynesian John Kenneth Galbraith give Ricardo greater credit for its development due to his more developed ideas about wages and other factors of production. The phrase “Iron Law of Wages” was never uttered by Malthus or Ricardo, but was first used somewhat later in the mid-nineteenth century by the German socialist Ferdinand Lassalle.

Ricardo developed what he called his “corn model” to predict changes in the output produced by the various factors of production. In addition, it also predicted changes in those factors themselves: wages, profits, interest, and rents (Reference [E1], chapter 4). In his model, workers were just another factor of production. Their employers had no interest in paying more than subsistence wages. If the employers paid more, workers would just have more children, producing an increasing supply of new workers. The increased supply would then drive the price of labor, wages, downward. The tragedy of the Iron Law of Wages was that in the long run workers would receive only enough wages to sustain their lives, no more.

According to the Iron Law, the owners of the means for producing wealth are driven by market forces to give the minimum wage possible to their employees. This maximizes the returns of the owners while minimizing the income of the common folk, driving an increasing inequality in wealth between the masses of ordinary people and the very rich. Yet, when we look around at the economically developed world today, the masses quite evidently do not live on subsistence wages (even though it might feel that way to many!). Something has gone very wrong with the Iron Law of Wages.

In 2013, a French socialist economist named Thomas Piketty updated the Iron Law of Wages for modern times. His main thesis is that as capitalism has historically developed, the returns on investments, especially stocks and other capital investments, have increased faster than the growth of the GDP in most nations. For that reason, the income of the owners of capital, i.e. the owners of stocks, bonds, and other capital investments, must necessarily grow faster than that of the lower economic classes. This increasingly inequitable distribution of wealth and income would then trigger social and economic instability.

A primary part of his argument is that economic inequality is not an accident but a central feature of capitalism. If the rate of economic growth is low, then he argues wealth accumulates more rapidly through investments than from labor. In such a situation those who hold stocks and other forms of capital ownership such as real estate will garner out-sized shares of the national income. Holders of capital will naturally invest their new income to maximize their gains.

In Piketty’s opinion, the process can be reversed only if the wealth, not merely the income, of the very wealthy is taxed away by government. His own proposal is a global wealth tax of up to 2%, together with a progressive income tax with a top marginal rate of 80%. Then, government can redistribute the wealth through a multitude of mechanisms, such as a universal basic income welfare program.

The Gini Index: the Measure of Income Inequality

Before we can discuss whether or not the Iron Law of Wages (especially in Piketty’s modern rendition) describes reality, we must have a measure for how unequal income distribution is in a given country. That measure is the Gini index. It is defined with the use of a curve called the Lorenz curve, as illustrated below. For any point on the curve, the x-coordinate on the horizontal x-axis represents the x% of households with the lowest incomes. The y-coordinate of the point is the cumulative income of the lowest-earning x% of the population as a percentage of GDP.

The fully constructed Lorenz curve then separates regions A and B in the figure. Let A be the area of region A and B be the area of region B. If there is absolutely no inequality, then the x percent of the households with the lowest incomes have x percent of the income, and the Lorenz curve becomes the Line of Equality in the figure. As a country’s GDP is distributed increasingly equally, the Lorenz curve approaches the Line of Equality ever closer, until finally at complete equality A=0 and B is the entire area under the Line of Equality. When there is complete inequality only one household has 100% of the income and all the rest have 0%. In that case, the Lorenz curve is on the x-axis until it reaches 100% of the population, where it jumps vertically to hit 100% of the income. Then A is the entire area under the Line of Equality and B=0. The Gini index G can then be defined as

As defined, the GINI index varies from zero to one, but it is almost universally multiplied by 100 to scale it to vary from zero to 100. The smaller the GINI index, the closer the Lorenz curve approaches the Line of Equality and the more equally the GDP is distributed among the population.

There are a number of institutions that provide estimates for various countries. One very important source that gives estimates of the Gini index for many countries is the World Bank. The U.S. Census Bureau provides us estimates for the United States.

Why We Should Not Believe What Progressives Say About Income Inequality

History has given us a big hint about why the Iron Law of Wages has no connection with reality. Ever since the start of the industrial revolution, average real incomes in developed economies have exploded. One detail that Malthus and Ricardo seem not to have appreciated is human labor, especially skilled labor, is not just a factor of production. It is also in itself a scarce economic good. As such, its price (wages and salaries) is determined not just by the selfish interests of the employer, but by the Law of Supply and Demand. Especially during times of fast growth when labor is urgently needed, companies must compete with each other for the services of scarce labor.

Over the past two and half centuries, vigorously growing economies have increased the demand for skilled labor. In addition, rapidly evolving technology has increased economic efficiencies, as well as giving us new medical treatments, educational possibilities, and communication access to the rest of the world. The quality of housing, food, and clothing has greatly increased. The common human being today lives far better than medieval kings.

Of course, this repeal of the Iron Law of Wages lasts only so long as economic activity does not diminish. If government economic regulation and taxes reduce the ability and incentive of companies to produce (as they have over the past several decades prior to Trump), growth is reduced and labor is not needed as much. Wages for ordinary folk can then easily fall.

However, wage growth for the bottom quartile of wage earners has been much better than for the top quartiles during the Trump era. In addition, the second quartile has generally had better wage growth than the top two quartiles. This is displayed by the Wage Growth Tracker of the Federal Reserve Bank of Atlanta, shown below.

The latest data for the 12 month moving average of wage growth in February 2021 shows the first (lowest) quartile of wage growth at 4.2%, 3.5% for the second quartile, 3.4% for the third quartile, and 3.2% for the fourth (highest) quartile. As the monthly inflation rates during 2020 to the present ranged between 0.2% and 2.5%, the wage growth was real and largest for those on the bottom end of income.

Phil Gramm and John Early bring up yet another factor in the controversy in a Wall Street Journal essay entitled Incredible Shrinking Income Inequality. Just how unequal the income distribution actually is depends very much on what you mean by the word “income.” Since our concern is for how much wealth people can claim with their income, we should not take only the sum of their wages, capital gains, and rents as their income. Call this sum “earned income.” In calculating the U.S. Gini index, the U.S. Census Bureau fails to count two-thirds of all government transfer payments as income to recipients. According to Gramm and Early, these transfer payments include Medicare, Medicaid, food stamps, and around 100 other government transfer payments. These transfer payments would increase the income of people on the lower end of the income distribution. In addition, the Census Bureau fails to count taxes paid as a loss of income for individuals. Certainly, taxes reduce the assets they have to meet their own needs. Including taxes in the calculation would reduce the income of everyone who pays taxes. Yet because of the highly progressive U.S. tax structure, the rich would have their incomes reduced far more than the poor. The top 20% of American earners paid approximately 87% of federal taxes in 2018.

A more reasonable definition of income then would be the following:

Income = Earned Income + government transfer payments – all taxes.

When these adjustments are made and the U.S. Gini index is calculated between the years 1967 and 2017, we get the plot below.

The top two curves are produced by Census Bureau data not adjusted for transfer payments and taxes. They differ because of changes in Census Bureau data-collection methods. Those top curves are what have generated the wide-spread belief in growing income inequality. Remember, the larger the Gini index, the greater income inequality becomes. After adjusting income for transfer payments and taxes, the Gini index shows income inequality has actually fallen on average for the past three-and-a-half decades. It is lower now than it was 50 years ago. Gramm and Early write,

While the disparity in earned income has become more pronounced in the past 50 years, the actual inflation-adjusted income received by the bottom quintile, counting the value of all transfer payments received net of taxes paid, has risen by 300%. The top quintile has seen its after-tax income rise by only 213%. As government transfer payments to low-income households exploded, their labor-force participation collapsed and the percentage of income in the bottom quintile coming from government payments rose above 90%.

The next time a progressive tells you income inequality is rising in the United States, you can tell him he does not know what he is talking about.

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