Just months ago, newspaper headlines across the country trumpeted the
good news: Poverty, at 12 percent, was at its lowest level in two decades
and median income was at its highest rate ever. A late September headline
in the Minneapolis Star Tribune blared, "Incomes rise, poverty
falls; minorities, poor make strides, census finds." All hail America?
Hardly, for in what seemed to be a 24-hour relapse, that report faded
to black, overpowered by the more nagging issue of income and wealth disparitythe
gap between the top vs. that of the bottom, which critics point out has
Like any spirited public debate, there is no shortage of villains
and anecdotes concerning the income gap in America and the nation's
current system of economic rewards. Some have called the income
disparity the "dark side" of the current record economic expansion.
Not all of the arguments, however, stand up very well to close
analysis. At an October retreat for the Minneapolis Fed board of
directors, a handful of experts zeroed in on the nature of income
disparity in the United States, and poked holes in some of the commonly
perceived sources of that discrepancy. Not pretending to have all
the right answers in a bottle, the speakers said income disparity
defies an easily traceable, uncontaminated source.
Two factors that do appear to exert significant influenceeducation
and urbanizationmight not be surprising, but can get lost
in argumentative din. Moreover, well-intentioned responses intended
to narrow the income disparityhigher minimum wages, limits
on trade and immigration, capping executive salarieswere not
likely to have much of an impact because they did not target the
underlying causes, experts told the directors.
Us against them
Arguments over income are largely framed by perspective. From an absolute
standpoint, the percentage of people below the poverty line has been declining,
and is well below the rates of the 1950s and '60s, considered a golden
economic age by many despite the fact that poverty rates were above 20
percent for a good number of years.
But in a relative sense, the income disparity between top and
bottom income earners has widened significantly over the decades.
Part of the reason for this was a decline in real income for the
bottom one-fifth of workers from 1979 to about 1993. But since that
time, real income for this group has grown modestly. This means
that growing income disparity is more the result of what's going
on at the top than what's not going on at the bottom.
As such, the relative income gap overshadows any absolute improvement
for the lowest-earning workers. Among many factors for this, "there's
always been a strong undercurrent of envy" as it relates to income
disparities in the United States, according to Arthur Kennickell,
a senior economist for the Federal Reserve Board of Governors, and
director of the Fed's triennial Survey of Consumer Finances.
But describing the size of the income gap and identifying its
root causes are two separate and difficult tasks, Kennickell and
other speakers pointed out. For starters, people mistakenly use
different "rich-ness" measureslike income, net worth and wealthas
proxies for one another. "They really are not the same thing," Kennickell
said. "There is this confusion, and you see it often in news reports."
That's not to say there is no relationship among these measures,
but the link is more tenuous than most would believe. For example,
research by the Minneapolis Fed in 1997 found concentration of earnings,
income and wealth to be "significantly different." It noted that
"wealth is by far the most concentrated" and the correlation between
wealth and both earnings and income is "surprisingly low." [See
the Spring 1997 Quarterly Review.]
Nonetheless, different measures of disparity do lend insight into
how the current economic system distributes rewards, Kennickell
said. Such comparisons also provide social commentary, as wealth
and income become stand-ins for more romantic and intangible ideals
like well-being and happiness, he said. What's important in disparity
discussions is that everyone understands the financial nature of
the comparison. Even seemingly straightforward comparisons of income
can be misleading, Kennickell said. For instance, wealthy retirees
often live off past investments and might report little in the way
of income; the tax code can also be used in myriad ways to lessen
their tax obligations and, by extension, income. Government programs
that provide health care, housing assistance and other benefits
for the poor and not-so-poor also distort income comparisons.
The dentist's income gap: open wide
All qualifications aside, the existence of a widening disparity gapwhether
measured by income, net worth, earnings or wealthis clearly borne
out in current research. Kennickell's research on net worth (the sum of
tangible assets, minus liabilities) found that the share held by the top
1 percent grew from about 30 percent in 1989 to 34 percent in 1998.
This doesn't mean the nation is experiencing Robin Hood in reversethat
the rich are stealing from the poor. Rather, the economic pie has
expanded and the gains in net worth, in terms of both the rate of
increase and total dollars, are accruing to the top much faster
than anywhere else.
Financial gains made from 1992 to 1998 as a percentage of total
1998 net worth were fairly even from the 20th income percentile
to the 95th percentile, averaging increases of roughly 20 percent
to 25 percent, according to Kennickell's research. Gains in net
worth of the top 5th percentile during this period, on the other
hand, were closer to 50 percent. Add on the proportional effectthat
50 percent of 1,000 is twentyfold larger than 25 percent of 100and
the accelerating income gap starts to become clearer.
Like other public policy issues, critics are eager to identify
hand-in-the-cookie-jar sources that might help identify culprits
responsible for inequalities. But like many other policy issues,
there are few easy villains that might explain the income disparity.
Indeed, the single largest factoreducationcan hardly
be considered evil.
In a world of increasing sophistication, the market is paying
a premium for ever-higher levels of education, according to Kevin
Murphy, an economics professor at the University of Chicago and
1997 winner of the American Economic Association's John Bates Clark
Medal, which goes to the economist under 40 who has made the most
significant contribution to the field.
By now, most are familiar with the college premiumthe fact
that wage earners with a college degree typically earn more than
those with a high school diploma. But Murphy's research shows that
a still-higher premium has appeared for wage earners with a graduate
degree, resulting in a sort of three-tiered income standard
(see Chart 1).
A worker with a college degree still receives a wage premium of
about 50 percent above the wages of those with only a high school
diploma. That premium, however, is only about 10 percentage points
higher than the wage premium collage grads enjoyed almost 30 years
ago (see chart). The income disparity becomes more obvious when
you look at the wage premium for those with graduate degrees, which
took off from about 160 percent in 1981 to almost 215 percent by
However, education levels by themselves do not explain the wage
gapevidenced by the fact that the wage premium for both bachelor's
and graduate degrees saw a decade-long decline from about 1971 to
1981, Murphy told the directors. Another critical factor is demographicsthe
number of people achieving higher education levels. In the 1970s,
the rate of college attendance surged coincidentally with a surge
in the number of college-age people (young baby boomers). So, there
were more of them, and more of them decided to go to college. This
growth of college-educated workers outstripped employers' need for
such individuals, Murphy said, which pushed down the value of these
workers relative to high school-educated workers for about a decade.
"The relative quantity of labor is the key," Murphy said, pointing
out that beginning in the 1980s, enrollment rates were still high
but the subsequent pool of Generation X college-goers was smaller,
bringing back relative scarcity of college-educated workers.
The third leg of this stool is employer demand for educated workers.
Murphy told directors that employment at companies with a high ratio
of college-educated workers has grown significantly and steadily
for the past three decades see Chart 2). So when graduating baby
boomers hit the workplace full force, it took the private market
some time to pick up the slack. This temporarily distorted the wage
premium, which returned only when the stock of educated workers
had been winnowed down in relation to demand.
Montana: a shooting gallery of disparity ducks
Aside from education, however, public debate often floats a variety of
other ducks to shoot at as the primary source of income disparity.
Montana, for instance, has seen its state ranking in average income
steadily drop over the past 50-plus years from 10th in the late
1940s to 48th by 1999the result of a decline in average work
earnings (rather than, say, shifts in either capital income or transfer
payments). Critics variously argue that this earnings dip comes
from the state's job mix, a poor business climate, demographics,
even the amenity trade-off people make for a higher quality of life
in the scenic beauty of Montana.
None of these culprits offers a very fulsome explanation for Montana's
plunge in rank, according to research by Ron Feldman, an assistant
vice president, and Jason Schmidt, a financial analyst, both of
the Minneapolis Fed. "I don't think any [of these sources] are going
to get you very far," Feldman said.
Feldman and Schmidt looked at a number of indicators that might
explain lagging average work earnings in Montana. Ironically, education
offered little insight in Montana's case. The percentage of Montana
residents with a high school diploma surpasses the U.S. average,
and the percentage with college degrees is only very slightly lower.
The high-amenity quality of life in Montana, Feldman said, "for
all I know, could be very important" in explaining the decline,
but such a relationship "is very difficult to capture in any way
There are plenty of other theories for the decline. For example,
many people point to the general decline in manufacturing jobs,
and a shift in the state's job base away from natural resource extraction
(like timber and mining) and toward lower-paying retail jobs. But
Feldman and Schmidt found that Montana average earnings would be
lower even if the state's economy were rebuilt.
First, they gave Montana a hypothetical job mix that exactly mirrored
the U.S.'s industry mix, and then applied the average Montana wages
earned in these various industries. They found that average wages
were still far below the U.S. average. Similarly, they went back
in time and reconstructed the Montana economy to have a job mix
similar to the one it had in 1969, and projected average current
wages. Again, they found that Montana's wages lagged (see Chart
"What jobs people have [in Montana] doesn't explain much of the
difference," Feldman told the directors.
Poor business climate is also a common whipping horse, Feldman
said, which "is very common-sensical. It's something you'd want
to look at." However, available research generally has shown that
Montana ranks in the middle of the pack on business climatewhich
most people informally define as business taxes and environmental
regulation. But many other factors are at play with regard to locational
decisions for businesses, including available labor, energy costs
and proximity to markets, Feldman said. He added that when state
rankings on business climate "start to get serious, states act"
to improve their position.
Even demographics offer little insight to Montana's eroding income
ranking, Feldman said. Compared with other states, Montana has a
higher concentration of men (who typically earn higher average wages),
a higher percentage of workers in their peak earning years (45 to
54 years old) and a lower minority population (who typically earn
lower average wages). All of this points to the fact that average
Montana wages "relative to the United States are lower in similar
kinds of industries," Feldman said (see Chart 4).
The only significant relationship Feldman and Schmidt could find
that might explain this phenomenon had to do with geography. "It's
the absence of large cities" or proximity to large cities, Feldman
said. Per capita income is higher for big-city workers compared
with small-city and rural workers, and rises with the increasing
size of a city, something Feldman called the "urban wage premium"
(see Chart 5).
Holding all other things constant, wage earners in cities of more
than 500,000 earn 30 percent more than those in rural areas, which
dominate the Montana landscape. The few larger cities in Montana
(Great Falls, Billings) barely make it above the 20th percentile
in population among U.S. cities, he pointed out.
Theorizing about the underlying factors of this urban wage premium,
Feldman said, "It's got to be productivity that's driving this."
Urban areas offer businesses higher density, which lowers the cost
of finding labor and moving goods and ideas, and allows a higher
degree of specialization in both end products and labor training.
Urban areas also are better at "capturing aggregate knowledge spillovers,"
Feldman said, a fancy way of saying urban areas are better able
to maximize the skills of workers, which ratchets up the rewards
to both individual workers and the larger society.
"It's not that I don't think these [other] things aren't important,
but urbanization seems to have a bigger role" in the wages people
earn. Feldman also noted that average rural wages in Montana are
higher than the U.S. average, "so people [in Montana] are doing
well by this measure."
Unfortunately for policymakers, Feldman said, the urban wage premium
"doesn't develop overnight but over time," which means quick-fix
policy prescriptions are unlikely to have much of an effect.
Minimum wage: poorly engineered solution to wrong problem
In a similar vein, Preston Miller, vice president and monetary adviser
for the Minneapolis Fed, told directors that increasing the minimum wage
was the wrong lever for correcting the income disparity gap.
Miller said he assumed the intent behind the minimum wagenamely,
the transfer of wealth from the fortunate to the unfortunatewas
a social insurance objective largely agreed upon as a good thing.
As such, he said, "I view the issue as an engineering problem" in
finding the best way to achieve that objective.
For starters, Miller pointed out that minimum wage laws are poorly
targeted, that as many as four of five workers receiving minimum
wage are not the intended targetnamely, a head of household.
As such, minimum wage laws appear to have little broad effect on
putting more money in pockets of low-earning households. Rather,
they appear to artificially raise the wages of supplementary and
teenage earners. Second, Miller said, few workers are earning only
minimum wages, particularly given the current labor shortage.
Designers of redistributive programs need to understand the reward
structure of today's economy, Miller said, which is based on three
factors: luck, effort and human capital. Each of these factors is
influenced by the others (it's lucky to be born smart; intelligence
is part of human capital, but is maximized through effort).
Based on this tripartite, the social safety net should redistribute
based on a person's luck, rather than his or her effort or human
capital, Miller said. "Paying for lack of effort," he added, encourages
and rewards "even less effort."
He also said Congress' "shrug and a wink" attitude toward the
minimum wage was disingenuous, often sitting on legislation until
its implementation was moot for wage earners. He said he would prefer
to see Congress pursue policy that would ratchet up the skills of
low-wage earners. "We've got to help them help themselves."
In doing so, government programs should introduce as little distortion
as possible into the market, Miller said. "It is costly to interfere
in markets when there is no clear evidence of market failure."
Most redistributive programs can be categorized into two basic
groups, Miller said: "Before market closing" refers to those programs
that interfere with market activities to achieve some social objective,
including things like price supports or controls and job protection.
"After market closing" programs wait until after the market has
conducted its business, so to speak, and then smooth out the day's
winners and losers. The earned income credit, rental assistance
and school meal subsidies are good examples of such programs, Miller
said. In general, he added, Europe depends more on the "before market
closing" design, while the United States favors the "after market
Each has had both positive and negative effects, Miller said.
Europe has been successful in preserving workers' jobs, but at a
cost of labor mobility and entrepreneurship. In the United States,
employment volatility is more common, but so too is innovation,
higher productivity and economic reward. Volatility, Miller said,
"is the stick to go along with the carrot."
Ultimately, the Minneapolis Fed's interest regarding income disparities
goes beyond merely trying to understand its underlying causes. The
Community Reinvestment Act was passed almost 25 years ago (and subsequently
enforced by the Federal Reserve System) to ensure low-income people
and businesses in low-income areas have proper access to credit,
which can provide the leverage needed for income growth.
Robert Townsend, an economics professor at the University of Chicago,
told directors that despite the law, there is "very little data
on what's going on in individual communities." As a result, there
is a tendency "to think that banks are the only game in town" for
individual or business credit. Overlooked are informal networks
and other nontraditional credit sources that are common in many
Townsend conducted groundbreaking
research two years ago on the access and use of different credit
sources in two minority neighborhoods in Chicago. Based on this
work, Townsend has been brought in to advise a similar study of
the Hmong community in the Twin Cities by the Minneapolis Fed. "We
need to better understand how these informal relationships work."