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What accounts for the rise in income inequality since the 1970s? 

Opposing this prevailing view, however, is Princeton economist and New York Times columnist Paul Krugman, winner of the 2008 Nobel Prize in economics. According to Krugman and a group of like-minded scholars, structural explanations of inequality are inadequate.  They argue instead that changes in economic policies and social norms have played a major role in the widening of the income distribution.

“Since the 1970s,” according to Krugman, “norms and institutions in the United States have changed in ways that either encouraged or permitted sharply higher inequality.  Where, however, did the change in norms and institutions come from? The answer appears to be politics.”

But here’s the puzzle: the return to peacetime and prosperity did not result in a shift back toward the status quo ante.  Instead, the new, more egalitarian income structure persisted for decades.  Why? “This persistence,” Krugman argues, “makes a strong case that anonymous market forces are less decisive than Economics 101 teaches.”   In support of this claim, he cites economists Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California at Berkeley, authors of widely discussed studies of changes in the income distribution.  

Beginning around 1980, though, the Treaty of Detroit gave way to the free-market “Washington Consensus.”12  Tax rates on high earners fell sharply, the real value of the minimum wage declined, and private-sector unionism collapsed.   As a result, most workers’ incomes failed to share in overall productivity gains while the highest earners had a field day.

But the trends in wealth inequality and income inequality have been quite different.  According to economists Emmanuel Saez of Berkeley and Wojciech Kopczuk of Columbia University, wealth inequality (at least as measured by the share of total wealth held by the wealthiest 1 percent of Americans) has trended up slightly since the 1970s, but wealth remains considerably less concentrated than it was during the 1950s and ’60s—and dramatically less so than back in the 1920s.

To get a more detailed look at income trends, we often look at the share of total income accounted for by particular segments of the income distribution: for example, the bottom quintile, the top 10 percent, the top 1 percent, etc. Or we compare ratios of incomes: for example, 90/10 (income in the 90th percentile of the distribution compared to income in the 10th percentile), 95/50, or 50/10.  In addition, we might want to look at other ratios—black income to white income, say, or female income to male income—or at Gini coefficients for particular groups within society (e.g., income inequality among blacks or among women).  For something as complex as changes in the pattern of millions of incomes over time, no single measure is capable of revealing the whole picture. And over a given period of time, some indicators of inequality may be rising while others are holding steady or falling.

Indeed, according to a paper by Peter Gottschalk of Boston College and Robert Moffitt of Brown University, some one-third of the measured increase in earnings inequality between the periods 1970–78 and 1979–87 is due to an increase in the volatility of earnings.

First, overall income inequality as measured by the Gini coefficient is up since the 1970s: from 0.395 in 1974 to 0.470 in 2006. Over that same period, the 95/50 household income ratio (household income at the 95th percentile compared to median household income) rose from 2.73 to 3.61—an increase of nearly a third.   Looking at wages as opposed to household income tells a similar story.

All of these statistics, though, are based on income tax data; and income reported for tax purposes, especially by high-income taxpayers, is extremely susceptible to changes in the tax code.

The nation’s corporate elite has profited in similarly spectacular fashion. According to a long-term historical study of top corporate executives in large publicly traded firms conducted by Carola Frydman of the MIT Sloan School of Management and Raven Saks of the U.S. Federal Reserve, median compensation (in 2000 dollars) averaged $930,000 during the 1970s, but jumped all the way to $4.08 million in 2000–2005.  Between 1970 and 2005, the ratio of median executive compensation to average earnings per full-time-equivalent worker rose from under 30 to 110.

There is now enormous scholarly as well as popular literature on the possible causes of increased income and wage inequality.   Without attempting any kind of comprehensive synthesis of that literature here, I will briefly describe the most plausible structural explanations currently on offer—that is, explanations that link changes in the income distribution to broad changes in the economy and the workforce.  The leading explanation that emerges from the literature is one of “skill-biased technical change” (SBTC).

The top marginal income tax rate shot up from 25 percent to 63 percent under Herbert Hoover in 1932, climbed as high as 94 percent during World War II, and stayed at 91 percent during most of the 1950s and early ’60s.35 In theory, the effects of progressive rates on the decision to become an entrepreneur can cut both ways.

Here, stripped of nostalgia, is the actual story of the connection between income trends and changes in political economy and social norms.  Economic policies were altered to give wider scope to entrepreneurship and competition, in accordance with advances in economics.  Social norms shifted away from an emphasis on loyalty to the group and toward a greater emphasis on personal fulfillment (including through elective membership in groups of our own choosing).   The upshot of these changes was to add to the increase in income inequality over the past generation through the following channels:

• Increasing the supply of less-skilled workers (through increased immigration) Decreasing the relative demand for less skilled workers (through increased imports of labor-intensive products)

• Decreasing the ability of less-skilled workers to command above-market wages through minimum wage laws

• Decreasing wage compression through collective bargaining

• Increasing competition among employers for the most-skilled workers (because of a stronger connection between firm productivity and firm performance, and reduced barriers to moving from firm to firm)

• Amplifying underlying income trends through assortative mating and the growing prevalence of two-earner households.  There is no morality tale here. Economic institutions improved, and social norms improved, but as a result incomes diverged.