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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
