Chapter 1

The Causes of Growing Inequality

It seems as though you can't pick up a newspaper today without reading an article blaming the 1 percent for the stagnant wages of the middle class. If people aren't accusing the 1 percent of using crony capitalism to steal what they haven't earned, then they are accusing them of inventing technology that hollows out the middle class or stifles the advancement of the underprivileged by underfunding education.

In 2003 renowned economists Thomas Piketty and Emmanuel Saez burst into the public's consciousness with convincing evidence that income inequality had increased dramatically, especially in the United States, and that middle- and working-class incomes had stagnated. Their work showed that income inequality had increased not so much because of an increase in the earnings of the top 10 percent of Americans or the top 5 percent or even the top 1 percent, but chiefly among the top 1 hundredth (0.01) of 1 percent.

Demagogues and politicians favoring income redistribution were quick to link the success of the 0.1 percent to the alleged stagnant wages of the middle class. They insisted that the rich were succeeding at the expense of the rest of America. They seized on this linkage to demand higher taxes on the rich for greater income redistribution.

In his 2013 book Capital in the Twenty-First Century, for example, Piketty insisted the rich "by and large have the power to set their own remuneration, in some cases without limit and in many cases without any clear relation to their individual productivity," using nepotism, corruption, and corporate politics, or by conspiring with "hierarchical superiors." According to Piketty, the 1 percent were merely the beneficiaries of gradually eroding social norms that previously held their pay in check. Success, he claimed, was earned at the expense of the middle class. The alleged growth of CEO pay from thirty times the median wage in 1980 to over three hundred times by 2007 for the largest companies is held out as prima facie evidence.

The financial crisis of 2008 only fueled the flames of anger toward the wealthy. Banks were accused of predatory lending, the sale of fraudulent securities, and ultimately for recklessly causing the "Great Recession." The 1 percent were held responsible.

The list of allegations and complaints against the most successful Americans continued unabated. The technology they create supposedly hollows out middle- and working-class jobs. They own and manage companies that lay off employees and hire offshore workers. They are accused of failing to provide appropriate funding for education and other benefits that may alleviate poverty and increase income mobility or allow for infrastructure investments that may spark faster economic growth.

At first glance, these accusations seem reasonable. The growth of middle-class and working-class incomes has slowed. Crony capitalism does exist. Automation and offshoring seem to have reduced the number of high-paying factory jobs. Companies like Apple, Google, and Facebook scarcely seem to employ any Americans, especially not middle- and working-class Americans. Academic test scores are not improving. And it seems impossible to break the generational cycle of poverty.

Yet despite these facts, the growth of the U.S. economy has accelerated relative to other high-wage economies with more equally distributed incomes-the opposite of what one would expect if crony capitalism or other unfair means of income distribution had increased in the United States on a scale necessary to account for rising income inequality. U.S. employment grew twice as fast as employment in Germany and France since 1980. This growth has created a home for 40 million foreign-born adults, their 20 million native-born adult children, and the 20 million children of these 60 million adults.

And America has achieved this employment growth at median household incomes that are 15 to 30 percent higher than other high-wage economies, such as Germany, France, and Japan.

Careful scrutiny of the evidence reveals U.S. median household incomes have grown as fast as, or faster than, other high-wage economies. Piketty and Saez's use of tax returns instead of household income ignores the fact that an increasing number of workers live alone instead of in families with more than one worker and that an increasing portion of workers' pay is now provided as untaxed health and retirement benefits, which are difficult to measure. Middle-class tax rates have also fallen as government services have grown.

At the same time, workforce participation has fallen as Americans have grown more prosperous. Social Security and Medicare, for example, now allow older workers to retire instead of working. It's misleading to count them as households without earned income. And the demographics of the workforce have shifted toward lesser-skilled Hispanic immigrants who logically earn less than more highly skilled Americans on average. When these factors are properly considered, real wages have grown more robustly than they appear to have. And there has been no hollowing out of the middle class whatsoever. Belief that wages have stagnated nevertheless persists.

The notion that the growing success of America's 0.1 percent is the cause of slower middle- and working-class wage growth is mistaken. Entirely independent forces drive the two phenomena.

As the economy grows, it values innovation more. As such, successful innovators who achieve economy-wide success, like Steve Jobs or Bill Gates, grow richer than innovators have in the past. It's simple multiplication. And they grow richer relative to doctors, schoolteachers, bus drivers, and other median-income employees whose pay is limited by the number of people, or customers, they can serve.

At the same time, information technology has opened a window of new investment opportunities and increased the productivity of the most productive workers.

Moreover, in today's knowledge-based economy, companies can scale to economy-wide success with little need for capital. Successful innovators need not share their success with investors. Successful individuals like Google's Larry Page and Facebook's Mark Zuckerberg look like corporations of a bygone capital-intensive era.

Without much need for capital, start-ups become all-or-nothing lotteries. The chance for enormous payoffs attracts a larger number of more talented gamblers. More gamblers produce more outsized winners, and more innovation, too-whether the risk-adjusted returns are good, on average, or not.

Their success has compounding benefits. It provides American workers with more valuable on-the-job training, at companies like Google and Facebook, than they can get in other high-wage, slower-growing manufacturing-based economies. It creates synergistic communities of experts, like Silicon Valley. And it puts equity into the hands of successful risk-takers who use their equity and expertise to underwrite further risk-taking that produces more innovation, faster growth, and compounding benefits. Higher and more certain payoffs coupled with the growing success of others motives increased risk-taking.

No surprise, the U.S. economy has produced a disproportionate share of innovation. As a result, the nation has more income inequality but also faster employment growth at higher median incomes than other high-wage economies. Rising income inequality is the by-product of an economy that has deployed its talent and wealth more effectively than that of other economies-and not from the rich stealing from the middle and working classes.

In truth, the outsized success of America's 1 percent has been the chief source of growth exerting upward pressure on domestic employment and wages. The success of America's 1 percent is an asset, not a liability.

In the face of the evidence, it's no surprise that even Paul Krugman, a leading liberal economist, admits, "I'm actually a skeptic on the inequality-is-bad-for-performance proposition. . . . The evidence . . . is weaker than I'd like."

At the same time, a near-unlimited supply of low-skilled, low-wage workers-both offshore and immigrant-has put downward pressure on lesser-skilled wages relative to higher-skilled wages. The U.S. economy's ongoing shift from capital-intensive manufacturing to knowledge-intensive services increased the demand for properly trained talent and reduced the need for capital. Normally, the increased availability of capital would make it easier to raise the productivity and wages of lower-skilled workers. But competition from an abundance of low-wage offshore workers combined with the productivity gains it demands from domestic producers with higher-wage workers leaves a smaller and smaller share of less-skilled workers employed in highly productive capital-intensive manufacturing jobs.

Today U.S. growth demands properly trained talent and a capacity and willingness to take the risks needed to produce innovation. A shortage of properly trained talent and of the economy's capacity and willingness to take risk limit the entrepreneurial risk-taking, investment, and supervision needed to expand higher-wage, lower-skilled American employment opportunities. As a result, an influx of low-skilled immigrant workers has increased lower-wage work. In turn, the availability of low-wage immigrant workers puts downward pressure on low-skilled wages.

It's true that trade with low-wage economies lowers the cost of goods more than the wages of domestic lower-skilled labor. Were that not the case, it would be cheaper to produce goods domestically, rather than import them. But middle- and working-class workers bear 100 percent of the burden of lower wages for only a portion of the benefits of lower-priced goods. The rich, retirees, and the non-working poor also enjoy the benefits of lower-priced goods but without suffering the cost of lower wages. So while international trade benefits everyone on average, because the costs are shared disproportionately, it slows middle- and working-class wage growth relative to the growth of everyone else's income.

Growing income inequality is a real phenomenon, but a misdiagnosis of its causes and consequences leads to policies that slow growth and damage an already slow-growing economy. If the public mistakenly blames the success of the 1 percent for the stagnant wages of the middle class, while leaving the true sources of slow-growing wages-trade, trade deficits, and immigration-unaddressed, a dangerous feedback loop is likely to ensue. Raising taxes on success will reduce risk-taking and innovation. This will slow growth and reduce middle-class wages, and, in turn, increase the demand for redistribution.

Politicians who rely on middle- and working-class votes may relish this dynamic. Some may even advance the misunderstandings necessary for the problem to endure. Unfortunately, they either don't realize or don't care if they're cooking the goose that lays the golden egg.

Lower marginal tax rates would increase the payoff for successful risk-taking needed to produce innovation. Higher payoffs would motivate increased risk-taking. And increased risk-taking would have gradually compounding effects on America's ability to produce innovation-more people motivated to acquire and use the proper training, more valuable on-the-job training, growing communities of experts, and equity in the pockets of knowledgeable investors. These capabilities would magnify the value and likelihood of success. In turn, this would motivate prudent risk-taking and accelerate growth just as it has in America relative to other high-wage economies.

But unless we cut government spending, which seems highly unlikely, lower taxes would blow a huge hole in the deficit in the interim. And lower marginal tax rates would increase income inequality.

A more practical solution increases the pool of properly trained talent. America is full of high-scoring talent unwilling to endure the training and take the risks necessary to grow the economy. Their reluctance sets the price for success.

America could take a number of steps to increase its pool of properly trained talent. It could reduce subsidies to students and colleges studying curricula that do little to increase employment-psychology, history, and English, for example. There is an enormous mismatch between what high-scoring students study and what employers value. As the rest of the world trains its talent and grows increasingly competitive, America can no longer afford to waste a large share of its talent.

America needs to replace the current ethos, which discourages students from learning practical skills, with one that insists that talented people have a moral obligation to put their talents to full use serving their fellow man-whether serving them as customers or philanthropically. America could also nurture high-scoring students from low-socioeconomic families, as large numbers of these students are failing to graduate from college.

But training the next generation of students more effectively will have little effect on growth for decades, and then only with a slow compounding effect that won't fully saturate the workforce for decades after that. And like all good intentions, it is unlikely to be implemented.

In the interim, America should recruit properly trained talent from the rest of the world through more logical immigration policies. It could also recruit employers with a lower marginal corporate tax rate, perhaps by offsetting lost tax revenues with a higher tax rate on capital gains or other taxes. These steps would not only have more immediate effects but may also reduce income inequality.

In the absence of substantial changes, retiring baby boomers threaten to eat our economy alive with their unquenchable demand for retirement benefits. And China looms as a growing existential threat to national security. Neither threat appears to be solvable on its own. Embracing ultra-high-skilled immigration is America's best shot at avoiding permanent damage from these otherwise unsolvable problems.

Unless we fully understand the economics underlying growing income inequality-both the accelerating growth in the payoffs for success and the slowing growth of middle- and working-class pay-we will not understand the corresponding consequences of alternative policy changes. Without these understandings, we are likely to damage the economy rather than accelerate employment and wage growth.

So let's begin by examining the economics underlying the growing success of the 0.1 percent before turning to slowing middle-class wage growth. Then we can scrutinize alternative explanations for the facts as we find them in the second part of the book, before considering alternative proposals for change and making recommendations in the last part.

A Larger Economy Values Innovation More

While a number of economic factors drive the growing success of the 0.1 percent, this group grows richer for no other reason than the economy is growing larger. As the economy grows larger, the pool of customers grows larger. Today successful innovators, business leaders, and entertainers can serve more customers than they could have fifty years ago. As a result, the payback for economy-wide success is bigger than it used to be. An entertainer like Taylor Swift, for example, can reach a much larger market for her music than the Beatles could have in the 1960s.

Few people recognize the extent of the growth of the world economy. In 1964 the entire world economy was only as large as China's economy is today! That growth has had a big impact on the success of the most successful workers.

Over the same period, the incomes of doctors, schoolteachers, plumbers, and other tradesmen remain limited by the number of customers they can serve. The size of the economy doesn't change that. All other things being equal, economy-wide success, like Taylor Swift's success, will grow larger relative to the income of typical workers. This increases income inequality.

The pay of entertainers and other successful entrepreneurs grows larger relative to the pay of the typical workers, not because these innovators charge customers more. If anything, they are charging customers less and less. They earn more because they have more customers.