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The Great Compression
Paul Krugman recently blogged:
The middle-class society I grew up in didn’t evolve gradually or automatically. It was created, in a remarkably short period of time, by FDR and the New Deal. As the chart shows, income inequality declined drastically from the late 1930s to the mid 1940s, with the rich losing ground while working Americans saw unprecedented gains.
As you can see, the share of the top ten percent (not counting capital gains) falls steeply at about 1937 and flattens out by about 1942-43, with a slight uptick just afterwards. But I am puzzled by Krugman's description of the process. A few points:
1. 1937-38 were disastrous years for the American economy and also for the middle class, mostly because of bad contractionary monetary policy. This can be considered a second Great Depression and it aborted a recovery in process. Robert Higgs has shown convincingly that World War II was an economic disaster, look at the figures at consumption don't be fooled by aggregate gdp which is inflated by production for the war.
2. Therefore I am not sure when the "unprecedented gains" came during this period. Yes 1940 was a year of recovery (and part of 1939) but is the claim that the middle class was created in that year? Surely not but then I am confused.
3. Krugman cites "strong unions, a high minimum wage, and a progressive tax system" as driving the Great Compression -- did these factors change so notably in 1937-44?
4. In real terms, relative to the time, the new federal minimum wage of 1938 was not especially high, even compared to the minimum wage today. And the data are for pre-tax incomes, which means that progressive taxation is unlikely the major part of the story about the distribution of pre-tax income (noting the Yglesias caveat that the rate of tax will influence pre-tax incomes through labor supply).
5. Here are some data on U.S. unionization. The history does broadly track Krugman's time frame, as long as one does not obsess over 1937-43 as being special. Note that optimistic estimates of the union wage premium today run about 15 percent, so it is hard to see unionization as the dominant factor in the change in the distribution of income.
6. The wartime economy, and the scarcity of labor, bid up wages for black workers, women, and many remaining non-drafted male laborers (due to forced saving, however, consumption was low).
7. My explanation of the break in the chart emphasizes a combination of events: top incomes were crushed by the depression of 1937-8, the war economy put a further lid on top of high incomes (for reasons of law and norms; surely the phrase "wartime wage and price controls" deserves to be uttered at least once), and the war economy bid up wages for many people near the bottom and middle of the distribution. The wealthy classes financed a disproportionate chunk of World War II, it seems.
8. Krugman mentions none of the factors listed in #7. Admittedly I may be wrong, but are not those factors obvious candidates for an explanation?
9. It is a vitally interesting question why postwar America stayed at this new percentile distribution of income (more or less), even after recovery from the war. It may be possible to defend a version of Krugman's broader hypothesis -- policy matters for income distribution -- in this setting, but the story then puts greater stress on both the equalizing effects of catastrophes and also on path-dependence. That story might also suggest that strongly negative real shocks would be needed once again to make income distribution much more egalitarian.
10. How about this for an alternative story: "Crush the incomes at the top and then make the fat cats pay much higher wages to protect the world and become a superpower. Impose wage and price controls as well. See how long it takes before these distributional effects -- which don't exactly match the distribution of economic talent-- reverse themselves in the aggregate." I'm not sure that's right but at least it seems to match more of the history.
I am sensitive to the claim that many people misinterpret the words of Paul Krugman, so please do read his whole post. If he addresses these matters in more detail in his forthcoming book, I will let you know.
Posted by Tyler Cowen on September 23, 2007 at 06:44 AM in History | Permalink
Comments
I note that the incomes used in the graph excluded capital gains. In the presence of high marginal tax rates, larger incomes tend to be diverted into financial instruments. For example, take a look at the population of partnerships (Statistics of Income, IRS) and consider the rapid growth in the 70's and 80's. A lot of this growth was due to real estate partnerships used as tax shelters.
The increase in non-capital gains incomes would seem to track the marginal tax rate cuts rather well.
(PS: I used to work on this particular study as the lead survey statistician.)
Posted by: Paul McMahon at Sep 23, 2007 8:04:23 AM
I do not trust anyone who writes at length about the distribution of income over time (i.e. income inequality) without even mentioning income levels. At the very least it is a joint optimization problem, even if we disagree on the weights.
Posted by: Jack at Sep 23, 2007 8:58:27 AM
I agree with Jack. Suppose all wealth was confiscated and destroyed, and all forms of employment is outlawed. Look at how equitable this society is, everyone has the same income ($0).
Posted by: Justin R at Sep 23, 2007 9:37:51 AM
The exclusion of capital gains is certainly a large question mark in my mind. Why ignore a tax that is disproportionately paid by those toward the top of the distribution?
Also, it seems that Krugman is suffering from narrative bias. Simply because his explanation is plausible, does not mean that it is necessarily correct. Essentially, I agree with Tyler. Why doesn't Krugman mention any of the factors listed in #7?
Posted by: Everyday Economist at Sep 23, 2007 9:41:20 AM
Paul's point is the main thing of relevance here, but lets generalize it a bit further. The private company car and the expense account are part of this story too, as are, in fact, all of the tax-burden driven transitions from direct expenditures to "benefits", "expenses" etc. Remember that top (federal only) tax brackets were 87%-90% of income for most of this time. People at the top simply were not and could not have been working for income under such circumstances. They were getting compensation in other ways.
Posted by: michael vassar at Sep 23, 2007 10:44:03 AM
"Admittedly I may be wrong, but are not those factors obvious candidates for an explanation?"
For Krugman? No, they are not. His mind was made up long ago, now he's just writing political pieces. This, of course, does not mean that he is wrong. It merely suggests that his arguments come off as less convincing.
Posted by: Erik at Sep 23, 2007 10:44:50 AM
I didn't see a link to the study shown in the graph, but a few questions need to be asked. Is that pre-tax or post-tax income? Does it count income from government transfers? In-kind government transfers? Cash income only or benefits? Not including capital gains is only the first of many ways a graph of this sort can be juggled. While policy might or might not effect inter-personal compensation levels, there is absolutely no doubt that tax policy greatly effects how rich individuals structure their compensation.
Posted by: Dave at Sep 23, 2007 10:52:18 AM
I'd be more impressed with his analysis if he ran the data back to before the Civil War, or even to before the American Revolution a la David Fischer ("The Great Wave"). What are the odds that he'd see a similar curve before, during, and after every huge national crisis? Though the post-Civil-War Gilded Age was somewhat of an anomaly.
I am greatly impressed with Fischer's book, BTW - you can look at his graphs and even find the Siege of Athens (from Plato's time) on it!
Posted by: Pat Mathews at Sep 23, 2007 11:23:26 AM
What has everyone got against vertical gridlines these days? Without them, you have to count data points from 1917 to figure out that the Great Compression-- all of it!-- occurred in 1941-43. Wartime inflation seems the likeliest cause; its persistence after the war may have something to do with the continued poor performance of bonds all the way up to 1981. Leaving capital gains out of a measure of income for the top 10% will tend to exaggerate the importance of the bond market.
Posted by: Paul Zrimsek at Sep 23, 2007 11:34:09 AM
A graph of the top 1% and 4% corresponding to Krugman's graph of top 10% is at
http://www.visualizingeconomics.com/2006/04/03/
breakdown-of-income-share-top-5-1917-2002/
and with top marginal tax rates superimpose is at
http://www.visualizingeconomics.com/2007/03/24/
us-income-of-top-01-percent-vs-marginal-tax-rate/
Putting the 2 together it looks line the top 1% of income share, but not the next 4%, was strongly effected by the tax rates for all periods except the depression and WWII.
Since this data was obtained from income tax data, it is of from income reported to IRS. The sharp increase in the 1% share when the 1987 tax reform, which eliminated tax shelters, went into effect looks like the income was under reported in the post war period. I would guess, but do not know, that shelters were not in the tax code in the depression and WWII period.
Posted by: joan at Sep 23, 2007 11:51:35 AM
3. Krugman cites "strong unions, a high minimum wage, and a progressive tax system" as driving the Great Compression -- did these factors change so notably in 1937-44?Unions were at their peak after the imposition of NIRA (passed 1933). It is reasonable to imagine that it could have taken a few years to have its full effect. Union membership peaked at about 34%. The NRA also introduced a minimum wage, new income taxes and other taxes, strict price controls, public works programs and some very heavy handed regulation.
Between 1941 and 1945 more than 1/3 of the top 100 American corporations were seized either in whole or in part.
I absolutely believe that these things had a huge impact on the economy including compressing wages, dragging all incomes down, suppressing growth, scaring away investment and driving businesses into bankruptcy.
Its a wonder that we ever climbed out of the great depression at all, and with fits and starts (thank you Jimmy Carter) finally have managed to recreate much of that intense growth that we had pre-FDR.
Posted by: liberty at Sep 23, 2007 12:20:31 PM
Paul Zrimsek is correct. The narrative implies that the compression starts with the New Deal, but just analyzing the graph provided shows that the almost all the decline to the bottom occurs at that point when the US economy was converted to war production.
War does not increase economic wealth- it destroys it in the most efficient way possible short of boating capital out to the middle of the ocean and sinking it. This is the cause of the Great Compression that Krugman seems to be remembering so fondly.
Posted by: Yancey Ward at Sep 23, 2007 12:23:12 PM
I'd like to see how the top 1% and 5% and bottom 1% and 5% fared over the years. It might show something very different. I suspect that the rise of the top 10% is due mainly to the dramatic rise in income of formerly upper middle-class people, due to changes in society that reward talented and intelligent people (as opposed to the "middle class era," where rich people made their money by inheriting it). In other words, it's due to the rise in income of a substantial portion of the bottom group of the top 10%.
Posted by: The Emperor at Sep 23, 2007 12:29:56 PM
Commenters interested in this topic should simply read the series of papers by Cal's Emmanuel Saez and various coauthors that this data seems to be derived from. They deal with the capital gains and benefits issues quite nicely. Of course, Boston U's Robert Margo (and Goldin's?) "The Great Compression" from 1992 is also good, though they didn't have the top-end IRS tax data. Neither of these papers are particularly technical, so are accessible to non-economists.
I'd suspect the changes since 1975 are US specific, since many other developed nations have not seen divergence over this period - including some which have grown faster than the US!
Posted by: kevincure at Sep 23, 2007 1:06:56 PM
Neither Paul Krugman nor Tyler Cowen, nor for that matter any of the commenters so far, realy have it. The Great Depression had very little to do with this. It was almost entirely a matter of World War II and its very strong labor market, plus the pushing of the top marginal tax rate to 94% after the war started (it was 75% in 1939). Actually looking closely at the figure that Tyler presents shows it. The sudden drop in the Gini does not start until 1940 (OK, a year before the US got into the war, but not going back to 1937, much less 38 or 39).
Anyone wanting to see an authoritative source on this matter should look at the old, but not disproven, book by Morgan Reynolds and Eugene Smolensky from 1977, _Public Expenditures, Taxes, and the Distribution of Income: The United States, 1950, 1961, 1970_ Academic Press (yes, they do talk about what happened before 1950, despite the title).
To Pat Mathews:
Although there is data on income distribution going back into the 19th century (big surprise, the 1890s appear to be the peak of inequality), it gets progressively less reliable as one goes further back in time, already pretty shakey once we are back as far as the 1920s.
Posted by: Barkley Rosser at Sep 23, 2007 1:46:46 PM
Yancey Ward wrote, War does not increase economic wealth- it destroys it in the most efficient way possible short of boating capital out to the middle of the ocean and sinking it.
Completely true, as a generic claim.
Not clear to me that it's true in the case of the US in WWII. (Meaning: compare total US domestic capital stock before and after the war.)
Posted by: liberal at Sep 23, 2007 1:58:25 PM
Imposing punitively high income tax rates like we had during "the great compression" and thereafter will do wonders for the tax avoidance industry wherever you are in the world.
Same goes for wage and price controls, people still find a way to get paid, such as employer paid health insurance that is wrongly not recorded as income. This occurred during "the great compression" as well and stayed.
Just because income isn't getting recorded by the IRS as individual income doesn't mean that there isn't income, and I'm not talking about tax evasion here, noting that tax avoidance is legal and tax evasion is illegal. Warren Buffett seems to have mastered the art of tax avoidance and has paid very little (in relative terms) in taxes over the decades even as his net worth soared. Nevertheless it seems pretty apparent that it is due to Buffett's mostly untaxed labor that his holding company conglomerate has soared in value.
Looking at the graph it becomes apparent that there was a huge surge in income inequality after the 1986 tax act. This tax act eliminated an awful lot of tax shelters, and also reduced the need for them by severely lowering the income tax rate. Did employers suddenly start paying their top employees more money at that time? I seriously doubt it. The more likely explanation is that during that two year jump in the graph what happened is that "the rich" simply restructured the vehicles their income was taxed under, and suddenly it wound up being recorded as individual income whereas before it was still income but not officially recorded as such. If such an obvious tax shift is being recorded without an asterisk, it seems logical to think that maybe the whole chart is an omitted asterisk.
Perhaps a more properly conceived chart, taking into account the unseen income as well as the seen income, would show a much more gradual rise in inequality from say 1942 to present, with an upward slope the whole way similar to the decade from the mid 70's to the mid 80's.
Paul Krugman may wish to think that incomes were more equal during that long middle period, but it is more likely a statistical illusion (there are three kinds of lies: lies, damned lies, and statistics), at least in huge part.
Posted by: happyjuggler0 at Sep 23, 2007 1:58:49 PM
See how long it takes before these distributional effects -- which don't exactly match the distribution of economic talent-- reverse themselves in the aggregate.
Yawn.
10--20% of GDP currently goes to holders of land, in exchange for no productive contribution to the economy whatsoever.
Wonder why so few bother to complain about that redistribution of income.
Oh, wait...
Posted by: liberal at Sep 23, 2007 2:00:45 PM
happyjuggler0 wrote, This tax act eliminated an awful lot of tax shelters, and also reduced the need for them by severely lowering the income tax rate.
So I take it you're on record in favor of removing the current favorable treatment of capital gains?
If such an obvious tax shift is being recorded without an asterisk, it seems logical to think that maybe the whole chart is an omitted asterisk.
The entire chart needs an asterisk, because citing marginal rates is a pretty meaningless exercise without information about the definition of taxable income and without the bracket structure.
Posted by: liberal at Sep 23, 2007 2:06:17 PM
The short version of my last post is this:
Look at the trend line from circa 1988 to present. Roughly pseaking the tax rules regarding tax shelters and the need for them were quite similar during the past two decades, and as such may very well reflect a masked trend that started about the same time that the "great compression" started.
Posted by: happyjuggler0 at Sep 23, 2007 2:09:16 PM
liberal,
I am most definitely not in favor of raising anyone's taxes, but I can be convinced to radically lower everyone's taxes and radically lower government spending. My post was merely meant to be an alternative explanation to Krugman's "we need more big government" agenda.
Posted by: happyjuggler0 at Sep 23, 2007 2:13:04 PM
masked trend that started about the same time that the "great compression" started.
should read
masked trend that started about the same time that the "great compression" ended.
Posted by: happyjuggler0 at Sep 23, 2007 2:16:55 PM
Don't forget the immigration restrictions that were passed in 1924 and took effect in the later 1920s and then were repealed in 1965, with the new law taking effect in 1968. It took awhile for immigration momentum to build up, but it was becoming significant by the later 1970s.
This is by no means the whole story, but economists shouldn't ignore this piece of the puzzle.
Posted by: Steve Sailer at Sep 23, 2007 2:35:09 PM
Immigration: you can say that again!
The above chart, compared to a chart showing the percent of Americans who were born in a foreign country, both have the same shape.
When the labor/capital ratio is high, there's more inequality. Immigration increases the supply of labor without increasing capital.
Posted by: Half Sigma at Sep 23, 2007 2:39:08 PM
A very comprehensive comment by Happyjuggler0.
Liberal,
The US suffered less than Germany or Japan since its war production machinery was not obliterated. However, there was a long transition of refitting the capital stock to the production of consumer goods after the war. This was interrupted by the Korean conflict. This refitting involved remaking and scrapping/replacement of the war production capital base. However, the US sufferred mightily during the war as can be seen by any analysis of consumption during and immediately after WWII. This loss in consumption is the symptom of capital destruction/misallocation. That people don't understand this is why they always claim that WWII ended the Great Depression. The Great Depression did not end until after WWII.
Posted by: Yancey Ward at Sep 23, 2007 3:07:13 PM
"As you can see, the share of the top ten percent (not counting capital gains) falls steeply at about 1937..."
Count the dots... that's 1941.
Posted by: Will at Sep 23, 2007 4:05:14 PM
Pardon me... Precisely what is the definition of "economic talent" if not the ability to thrive economically in whatever the given economy of the day happens to be? The ability to thrive economically in some sort of imaginary laissez fair system?
Posted by: Anthony Damiani at Sep 23, 2007 4:47:11 PM
Good lord, the quality of the comments on this post has degenerated.
happyjuggler,
The top marginal income tax rate remained as high as 91% until 1964 in the US. However, there is little
evidence of a large underground economy of unreported income during 1940-64. If anything, it is larger
today than then, despite our much lower marginal tax rates. Part of what was going on was that there were
some perfectly legal available loopholes for the rich, which got vigorously used, the oil depletion
allowance being one of the more notorious and famous. Plus, social capital in the US has declined
since that period, with there being serious evidence that rising inequality has contributed to that,
and people are less honest and less willing to pay taxes when social capital is lower. Indeed, there
is considerable evidence of a negative relationship between inequality and the rate of people paying taxes.
Sailer,
Umm, you really want to argue that the cumulative effects of the restrictions on immigration in
1924 suddenly showed up in 1940-42 as a massive decline in the Gini ratio? I am a long student
of models of nonlinear dynamics in which gradual changes in control variables suddenly trigger
("out of the blue") discontinuous changes in state variables. But this strains credibility. Just
looks like more of the current anti-immigration hysteria that has gone way off the rails.
Half Sigma,
"You can say that again!" OK, I will. Your remarks also look like anti-immigration hysteria gone
way off the rails.
To wit (or witless): You say that the graph of foreign-born pop in the US parallels this graph displayed
by Tyler. Really? There was only a small change in the foreign born between 1924 and 1940 and then an
enormous change, and then almost no change after that in foreign born in the US? (Uh, no.)
As for the labor-capital ratio, you are just wrong. There are plenty of countries with much higher
labor-capital ratios that have much greater income equality than the US, think most of East Asia (although
not China). Also, there is no reason for that ratio to rise with immigration if the immigrants include
a lot of well-off entrepreneurs who start new businesses and engage in lots of capital investment, and
plenty of the waves of immigration to the US have included many such individuals.
Am I denying that some of the recent increase in inequality may be due to the high rate of immigration
of low-skill labor from Mexico and Central America? No, I am not. But I think that changes in immigration
had very little effect on the income distribution of the US until very recently, and had a big fat zero effect
on the sudden increase in equality that occurred between 1940 and 1942 that is under discussion here.
Posted by: Barkley Rosser at Sep 23, 2007 6:28:01 PM
Barkley,
I am confused. What Happyjuggler wrote was that it was not evasion he was talking about, but rather the use of legal loopholes that you wrote of.
Also, very few immigrants today, or in the early 20th century, were "well-off entrepreneurs" when they arrived in this country. Many of them became such people within a generation's time, yes, but not on arrival.
Posted by: Yancey Ward at Sep 23, 2007 9:57:30 PM
Ok, if we're just making up alternative stories:
11. New Deal Keynesianism imparts economic stasis, so a business that is regulated is also protected. For example, company A's revenue shows only a few percent year-to-year variability.
12. In this environment, management can rationally allow fixed costs, like wages and salaries, to creep up to 95+% of revenue. In fact, they generally have no choice. Labor and government are happy, fat cats are skinny, wealth distribution is egalitarian.
13. But growth is slow. Over time, laissez-faire doctrines come back into vogue; deregulation and globalization occur.
14. Creative destruction ensues. Production shoots up, but uncertainty does as well. Competition and unplanned obsolescence push company A's revenue variability up to, say, 25% over time.
15. Company A responds by incrementally dialing down the proportion of fixed costs, notably wages and salaries, to ~75% of expected revenue. Productivity increases permit this. How can they rationally do otherwise?
16. Over time, company A's revenues still average 100% (assuming it survives) and the fat cats scoop up the difference.
It seems to me that the paternalistic institutions of inviolate wages and salaries keep individual workers from benefiting from economic turmoil, while hardly protecting them from layoffs and bankruptcies. But I'm no economist. What's wrong with this simplistic picture?
Posted by: ArtD0dger at Sep 23, 2007 10:30:30 PM
"War does not increase economic wealth- it destroys it in the most efficient way possible short of boating capital out to the middle of the ocean and sinking it."
Actually, war DOES boat capital out to the middle of the ocean and sink it. WWII especially.
And the USA is lucky that it was one country in WWII that didn't change its statistics by reducing the denominator.
Posted by: doctorpat at Sep 23, 2007 10:46:20 PM
Yancey,
happyjugglar does refer to using "tax vehicles" but those vehicles did not involve disappearing or not stating one's income, unless one is using AGI as one's source for income. He argues that the tax simplification of 1986 suddenly led to all kinds of income being stated that was not reported. The stuff in the vehicles was visible and in the official stats. For his story to work, he has to argue that these folks were not reporting their income and it was therefore in the "underground economy."
Regarding immigrants, depends on where they come from. Think about ones from India and Korea. Many first generation immigrants started businesses, and the ones from India have tended to be very high income. Indeed, last time I checked, the ethnic group in the US with the highest per capita income are the east Indians (as opposed to the Native American Indians, who were at the bottom of the heap, at least until recently).
ArtDoger,
If you are referring to the period from 1942 to 1986, I would note that in particular, the sub-period of 1940 to 1973 experienced more rapid economic growth than the period after 1986. The slowdown in growth coincides with the ending of the increase in equality in the early 1970s, although growth did pick up after 1986 compared to the 1973-86 period.
Posted by: Barkley Rosser at Sep 23, 2007 11:52:56 PM
With all of the caterwauling that Krugman does on behalf of economic justice, why does he not simply support a move to a consumption tax, adjusted so as to first untax family spending to the poverty level (a/k/a FairTax).
The effective percentages, that different income groups would pay under a FairTax consumption tax, is calculated by crediting a monthly "prebate" (advance rebate of projected tax on necessities) against all likely spending by citizen families (1 member and greater per Dept. of HHS poverty-level data). (Under the plan, a single person would receive ~$200/mo; a family of four ~$500 - in addition to working members no longer having tax withholding confiscated from the fruits of their labor every two weeks.) Prof.'s Kotlikoff and Rapson (10/06) concluded,
"...the FairTax imposes much lower average taxes on working-age households than does the current system. The FairTax broadens the tax base from what is now primarily a system of labor income taxation to a system that taxes, albeit indirectly, both labor income and existing wealth. By including existing wealth in the effective tax base, much of which is owned by rich and middle-class elderly households, the FairTax is able to tax labor income at a lower effective rate and, thereby, lower the average lifetime tax rates facing working-age Americans.
"Consider, as an example, a single household age 30 earning $50,000. The household’s average tax rate under the current system is 21.1 percent. It’s 13.5 percent under the FairTax. Since the FairTax would preserve the purchasing power of Social Security benefits and also provide a tax rebate, older low-income workers who will live primarily or exclusively on Social Security would be better off. As an example, the average remaining lifetime tax rate for an age 60 married couple with $20,000 of earnings falls from its current value of 7.2 percent to -11.0 percent under the FairTax. As another example, compare the current 24.0 percent remaining lifetime average tax rate of a married age 45 couple with $100,000 in earnings to the 14.7 percent rate that arises under the FairTax."
Further, per Jokischa and Kotlikoff (circa 2006?) ...
"...once one moves to generations postdating the baby boomers there are positive welfare gains for all income groups in each cohort. Under a 23 percent FairTax policy, the poorest members of the generation born in 1990 enjoy a 13.5 percent welfare gain. Their middle-class and rich contemporaries experience 5 and 2 percent welfare gains, respectively. The welfare gains are largest for future generations. Take the cohort born in 2030. The poorest members of this cohort enjoy a huge 26 percent improvement in their well-being. For middle class members of this birth group, there's a 12 percent welfare gain. And for the richest members of the group, the gain is 5 percent."
The robust growth of consumption, since the Great Depression, has been relentless. As a tax base, it seems far superior to current wage (indiv) /current year (business) earnings. The added bonus is that it would be, essentially, self-regulating: the more one spends, the more tax is paid. And gone, for good, the the many tax shelters that are available to the rich, only.
Posted by: Ian at Sep 24, 2007 12:18:56 AM
To all those who say that WW2 was a economic disaster: under what criteria? Of course (private)consumption fell during that period, but war production is a form of public consumption, so overall consumption rose. Arguably, the investments in mass production and R&D during the war set up the period of high growth after the war.
Posted by: Seer at Sep 24, 2007 7:47:47 AM
To all those who say that WW2 was a economic disaster: under what criteria? Of course (private)consumption fell during that period, but war production is a form of public consumption, so overall consumption rose. Arguably, the investments in mass production and R&D during the war set up the period of high growth after the war.
Posted by: Seer at Sep 24, 2007 7:50:03 AM
"To all those who say that WW2 was a economic disaster: under what criteria?"
The one that likes it when people don't get killed.
Posted by: josh at Sep 24, 2007 7:50:51 AM
To all those who say that WW2 was a economic disaster: under what criteria?
There are two ways an economy can "recover" from a depression: (1) the economic capital is reallocated and remade to produce things that consumers want, or (2) consumers are convinced to want what economic capital finds easy to produce.
War does the latter. Certainly, beating the daylights out of Germany and Japan is a second best solution to economic depression. Nonetheless, it is preferable to getting the daylights beat out of yourself. During World War II, consumers wanted war production and the placement of valuable labor in foxholes. Calling it a recovery, however, means paying too much attention to numbers and too little attention to what people actually want.
Posted by: MikeP at Sep 24, 2007 8:27:20 AM
A couple of comments: on tax shelters and on Fair Tax.
The way a tax shelter, especially a real estate version, works is that the investor buys into a partnership (or possibly an S-Corp) as a limited owner. The revenues go almost entirely to the general partner and to maintaining the property. The depreciation and other, "passive" deductions are then passed to the limited partners. The effect in the graph would be to reduce the income, but not show the eventual gain.
Pre-1986, those passive deductions (and tax credits) would offset ordinary income from such things as wages. Later, when the property is sold, the gain on the sale is treated as a capital gain, and thus the income offset by the passive losses is then taxed at the reduced Cap Gains rate. Hence the name, Tax Shelter.
The "Fair Tax" is a crock. For one thing, the assumption is that the States will collect the tax. Yeah, right. The bill states that the Secretary of the Treasury will negotiate with the various States for the operation of the law. Proponents should review the reasons that the Constitutional Convention was called, and why the Bureau of the Internal Revenue became the Service.
Then there's the idea that everything will be assessed a tax at the same rate. Do they have ANY evidence to support the notion that such a condition would last through consideration of the Bill? For an example of how one can expect Congress to operate, look at all the various excise taxes and their rates, and at the long list of tariffs for different products.
And don't even start thinking about how the IRS would go away ... it will, and the employees will all be given positions in the successor organization (with appropriate pay increases).
Posted by: Paul McMahon at Sep 24, 2007 8:44:12 AM
Can we agree that Krugman needs his PhD revoked? Or at least have an asterisk next to his name, saying "Not an actual economist."
Posted by: Russ Nelson at Sep 24, 2007 9:34:32 AM
When I read Paul Krugeman’s blog I was struck that he made it sound like the years of my childhood were so great but I remember growing up in Providence RI. Back then some poor people where skinny because they did not get enough food. I remember one poor girl who wore the same shabby dress to school everyday she was obviously poverty stricken. Even just being a kid (being a stupid kid pf course I did nothing for her), I really felt for her. I just do not see that kind of poverty today. Also I thought, like I think Tyler was alluding too, that steady growth would tend to help investors and particularly risk taker investors. Few rich people go bust in good times. Thus the rich would tend to get richer and richer as long as no major disruptions occur.
Posted by: Floccina at Sep 24, 2007 10:01:29 AM
Barkley,
I maintain that my hypothesis that the big jump in individual income after the 1986 tax act was in fact due to the 1986 tax act, and that that was because people were legally handling their income somewhere other than on their individual income tax forms.
What is your alternative hypothesis? That the reduction in federal headline taxes paid from 50% to 28% spurred people to work harder a la what Art Laffer and the WSJ predicted? In other words, that Reaganomics worked as advertised? If so, then I don't see how this increase in inequality is a bad thing, it is merely spurring our most productive people to work where before they chose to be idle. They aren't depriving anyone of anything by working harder, on the contrary they are trading something valuable with the rest of us that otherwise wouldn't have existed, and thus by revealed preference is a good thing for the other 99% of us.
Or are you going to simply say that that massive surge in inequality was a random event that just happened to coincide with a major tax act that had as a major part of its intent the notion that individual income would now be reported as individual income? Cough.
I can see why someone on the economic Left would want to try such a head in the sand approach, but it is a glaring flaw in Krugman's notion of increased inequality. However I don't think it is wise for us to allow him to simply finesse away this issue, not if we are going to radically readjust our country's economic policy towards redistributionism like he wants us to.
Posted by: happyjuggler0 at Sep 24, 2007 11:11:38 AM
Barkley Rosser,
No, Happyjuggler simply wrote that the income was reported elsewhere, but not taxed as income, as you yourself admitted. With the tax reform act of 1986, these vehicles were restructured because some of them were legally eliminated, and the incentive to use them was reduced. His point being that the jump in inequality was not real, but was an effect caused by the restructuring of compensation- compensation that had not really increased that much over that short period of time.
On the immigration, is it your contention that a high proportion of immigrants to the US in the last 30 years were east Indian entrepreneurs? The evidence is to the contrary. They are an exception to the rule.
Posted by: Yancey Ward at Sep 24, 2007 11:13:54 AM
I think Steve Sailer was suggesting that immigration might have contributed to income inequality since 1968, but not so much prior to 1924. The difference in income between the average American and average immigrant before 1924 was not as large as it was after 1968.
Posted by: mobile at Sep 24, 2007 11:38:02 AM
It's already been mentioned in the comments, right off the bat, but I'll attach myself to the chorus that finds the exclusion of capital gains bothersome, particularly given the historically recent increase in the breadth of shareholding (both direct and indirect.)
Posted by: Bernard Guerrero at Sep 24, 2007 12:42:23 PM
Immigration increases the size of the total economy, but the biggest gains go to the immigrants, those who own capital, and star professions, like sports, finance, and entertainment. But they weren't the only new participants. Women entered the workforce in large numbers as well.
Rich people were sheltering their income post-New Deal while middle class Americans earned high wages because labor force participation was restricted. In the 1970's, immigration surged and women entered the workforce in large numbers. In the 1980's, the tax shelters disappeared.
Posted by: 8 at Sep 24, 2007 12:51:55 PM
The Fair Labor Standards Act was passed around 1937 (I think). Could overtime premiums -- combined with the surety of OT enforcement in 33% of the union workforce -- account for a good part of the "compression"?
And, conversely, would the unraveling of unions (precipitated in Pres. Reagan's first term and trending downward since) and the reduction in OT being paid result in the "divergence"?
It seems to me, from personal observation and anecdote, that OT rules are generally ignored. And have been for the past thirty or so years.
Posted by: frankie at Sep 24, 2007 1:21:59 PM
It would do wonders here to do a simple google search. I found this paper http://ideas.repec.org/p/nbr/nberwo/3817.html
The structure of wages narrowed considerably during the 1940's, increased slightly during the 1950's and 1960's, and then expanded greatly after 1970. The era of wage stretching of the past two decades has been a current focus, but we return attention here to the decade that was witness to an extraordinary compression in the wage structure. Wages narrowed by education, job experience, region, and occupation, and compression occurred within these cells as well. For white men, the 90-10 differential in the log of wages was 1.414 in 1940 but 1.060 in 1950. By 1985 it has risen back to its 1940 level. Thus the recent widening of the wage structure has returned to it a dispersion characteristic of fifty years ago. We explore various explanations for the rapid compression in the wage structure during the 1940's and for its maintenance during the subsequent decade or more. We first assess the hypothesis that the Great Depression left the wage structure in 1939 more unequal than in the late 1920's, but we find evidence to the contrary. World War II and the National War Labor Board share some of the credit for the Great Compression. But much belongs to a rapid increase in the demand for unskilled labor at a time when educated labor was greatly increasing in number. These same factors caused the wage structure to remain compressed until its expansion during the past two decades.
I do not think this bodes well for Krugman's policy hypotheis. But I think K's hypothesis is more political than economic.
Posted by: Matt Festa at Sep 24, 2007 1:34:03 PM
OK, I am willing to assume Krugman is wrong.
Can we all agree that a strong and vibrant middle class is vital to the national good? And, can we all agree that the middle class has gotten smaller since, say, the beginning of the Viet-Nam war?
If we can agree on this, the question is: what policy will work to have the middle class grow faster, either by raising the level of those in the lower classes (preferable) or reducing the income of those in the upper classes (generally frowned upon)?
Until we can effectively answer this question, we will be stuck in a death spiral, in which, in maybe 100 years, we will be more like Tsarist Russia than America of the 1950s. To wit: we will have a few "noble" families, some middle class professionals (teachers, physicians, attorneys...) who serve the nobles, and a vast majority of serfs (granted the serfs of 100 years from now will be much better off than they were in Tsarist Russia).
Maybe we need another cataclysmic war that will require the rich to pay for it and that will restrict the labor markets to a point that pay for workers will have to rise...
Posted by: Allan at Sep 24, 2007 1:57:15 PM
"Can we all agree that a strong and vibrant middle class is vital to the national good? And, can we all agree that the middle class has gotten smaller since, say, the beginning of the Viet-Nam war?"
No, and no.
"granted the serfs of 100 years from now will be much better off than they were in Tsarist Russia" ... "Maybe we need another cataclysmic war that will require the rich to pay for it and that will restrict the labor markets to a point that pay for workers will have to rise..."
You would like to see a massive war, with millions of deaths come about in order to deplete the resources of the well off, reduce supply of workers and compress incomes so that it appears more equal.
I would like to see the poor - who are not serfs at all, but are free - continually increase their purchasing power just as they have been over all these years, via markets and entrepreneurship, without war and death and regulation. Growth helps the poor-- technology helps the poor in real terms, cheap products help the poor and everyone else by increasing their standard of living. Whether it looks like the middle spectrum is broader or more condensed is really irrelevant to me. The absolute purchasing power of the worst off and of the median are all that matters-- and they continue to rise.
Posted by: liberty at Sep 24, 2007 2:08:30 PM
It's all in the presentation. If you turn the chart upside down, it looks a lot like a bubble. I think it's worth reflecting on all the reasons why postwar America, its previous competitors in rebuilding mode, and much of the rest of the globe simply offline due to the Cold War's barriers or undeveloped status, was in a historically unique position to reward workers, regardless of productivity and regardless of education. It was wonderful but it was a bubble that reverted slowly back to the mean. It won't come back.
Posted by: MT57 at Sep 24, 2007 2:39:07 PM
"10. How about this for an alternative story: "Crush the incomes at the top and then make the fat cats pay much higher wages to protect the world and become a superpower. Impose wage and price controls as well. See how long it takes before these distributional effects -- which don't exactly match the distribution of economic talent-- reverse themselves in the aggregate." I'm not sure that's right but at least it seems to match more of the history."
Thomas Piketty has analysed the french "great compression" in this book, which I think has not been translated into english :
http://www.amazon.com/Hauts-revenus-France-XXe-si%C3%A8cle/dp/2246616514/ref=sr_1_13/002-6391551-3706433?ie=UTF8&s=books&qid=1190661795&sr=8-13
He shows that the first part of the chart is the same in France as in the US. Mostly, french top incomes were reduced in the 30s and the 40s by the great depression, the war economy, and war destructions. But then, top incomes did not come back to their prewar level, and have roughly stayed this way until now : this is why french inequality is now lower than in the US, it has (mostly) not reverted.
Piketty explains this with changes in tax policy. After WW2, France adopted a high level of progressive income tax, and high inheritance taxes, compared to what prevailed before. For Piketty, these tax changes explain why inequality remained low in France, countering the process in which high incomes become family fortunes. Tax policy changed in the US during the early 80s, the progressivity of income taxes, especially, decreased. The same happened in the UK, with the same effect : a rise of the share of top incomes.
So following Piketty, you have it right for the first part of the story : "middle class america" was created by the war economy and the depression, not by new deal policies. But Krugman has it right on the second part : what he calls the "great divergence" came from politically-driven changes in the progressivity of income and inheritance tax, not from a reversion to a "normal" tendency.
Posted by: alexandre delaigue at Sep 24, 2007 3:50:23 PM
Yancey,
The key quote by happyjuggler on Sept. 23 at 1:58:49 comes right after s/he discusses "restructuring vehicles" in the wake of the 1986 tax law change: "suddenly it wound up being recorded as individual income whereas before it was still income but was not recorded as such." Excuse me, but this is simply incoherent gibberish. Was it recorded as income or was it not? Was it supposedly recorded as income but not tied to any individual? If it was not recorded, then it was in the underground economy, as I argued, and I have pointed out that actually the percent of the economy in that category has risen with the rising inequality of the past quarter century, not fallen.
It does not take many successful immigrant entrepreneurs to start very successful companies that carry out lots of capital investment, enough to alter the capital-labor ratio, quite aside from all those ethnic restaurants and mom and pop retail outlets.
mobile,
You also seem to be engaging in nearly incoherent remarks. Sailer was arguing that the income gap before 1924 was not as great as after 1968? Well, one of the reasons that we got the restrictions on immigration in 1924 was because we had the same kind of hysteria we have now, which was exploited by a powerful Klu Klux Klan. Immigrants were seen as dangerous, filthy, wrong ethnic group, and poor.
Regarding "after 1968," well first of all the law was changed in 1965, and inequality continued to decline, if modestly for another full decade, more or less. Basically this whole effort by Sailer and others here to explain all, or even any significant portion of this, by immigration is just ludicrous baloney, indicative again of hysterical obsessions clouding your thinking.
MT57,
Bubbles do not last half a century. If it is a bubble and it ain't coming back, then why have we seen some western European countries that have not engaged in the sort of dismantling of progressive tax codes that the US has been doing for the last 40 years or so, continued to experience further increases in equality. Is that all a bubble? Ah, but yes, some day they will grow up and do what we did and have lots of poverty and inequality around. Hooray!
Posted by: Barkley Rosser at Sep 24, 2007 4:58:41 PM
Liberty,
No, I don't want to see another stupid war that might destroy the economy. Oops, about four years late for that.
I did not say the poor were serfs now. I said that, if something doesn't change, they may well be in 100 years.
Do you really believe that a vibrant middle class is not vital to the economy? And you think the upper and/or the lower classes have gotten smaller in the last 40 years (that would have to have happened if the middle class shrank).
Rising tides may lift all boats. But it helps to first have a boat.
Posted by: Allan at Sep 25, 2007 12:47:37 AM
Krugman hasn’t even paid minimal attention to the facts at hand. If you examine the actual Piketty Saez data (here) you will find the “Great Compression” is even sharper and less New Deal related than Mr. Cowen alleges. In 1940 the P90-100 share was 44.43%, down trivially from 44.57% in 1939, but up from 43.00% in 1938. Over the entire 1925-1940 period the P90-100 share varies from a peak of 46.30% in 1932 (and 46.09% in 1928) down to a low of 43% in 1939 (and 43.39% in 1935 and 43.07% in 1930).
By contrast, the P90-100 share falls to 41.02% in 1941, 35.49% in 1942, 32.67% in 1943, and 31.55% in 1944 (the low). Clearly the decisive factor was war, not the New Deal. Indeed, domestic social reform was put on hold to win the war.
Why inequality didn't decline under the New Deal and then crashed as war production ramped up is unclear. My guess is that slack labor markets yield high inequality and very tight markets even out the income distribution. However, the fall in inequality is so sharp and fast that even WWII may not suffice as an explanation. Perhaps the combination of war production and price/wage controls may be correct.
I have seen some claims that income inequality declined sharply during WWI. The Piketty/Saez data support this assertion. P90-100 was below 40% from 1918-1920 and bottomed out at 38.10% in 1920.
Posted by: Peter Schaeffer at Sep 25, 2007 8:38:24 PM
As the only industrial game in town, US companies could afford to pay its workers more, as they had little to no competition......
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