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Tuesday, November 11, 2014

Were We Better Off in 1987?

Down and out among the 90 percent

The Washington Post recently published an article on its Wonkblog in which economics reporter Matt O’Brien argues that the bottom 90 percent of American households are poorer today than they were in 1987. This argument is based on a new paper by economists Emmanuel Saez and Gabriel Zucman  that attempts to quantify and analyze the history of wealth inequality in America. It constitutes a serious, scholarly contribution to our understanding of American economic history. Unfortunately, it is being used for questionable, pundit-class potshots.

To be sure, the top 1 percent have done fantastically well for themselves. But an increase at the top does not always mean a decrease at the bottom if the economy’s total wealth is increasing. Put another way, focusing on the relative slices of the pie can mean missing the fact that the pie itself is growing. Would you rather have 10 percent of $1,000, or 1 percent of $1,000,000?

But skeptics say our individual wealth may be decreasing  — not just in relative terms, but in absolute terms. To quote O’Brien’s Wonkblog article,

Once upon a time, the American economy worked for everybody, and even the middle class got richer. But this story has only been a fairy tale for almost 30 years now. The new, harsh reality is that the bottom 90 percent of households are poorer today than they were in 1987.

So is the current condition really a harsh reality? Are we truly worse off today than we were 27 years ago? Is Betamax really better than Blu-ray?

The answer to all of these questions is no. 

Here’s why. There are several important methodological considerations that must be accounted for when discussing the plight of average families. The first consideration is that Saez and Zucman employ the tax unit as their unit of analysis. A tax unit is considered to be either a single individual aged 20 or older, or a married couple. As economist Russ Roberts has noted, we must consider changing demographics, such as rates of divorce and family structure, when interpreting data categorized this way. Divorce is a far more common phenomenon among poorer households than among wealthier ones. As a result, total household income and wealth accumulation will seem smaller, even when the absolute amount has not changed. Put another way, by increasing the number of tax units, we are lowering average total wealth. But the total number of tax units tells us little about income distribution. Instead, it muddies the issue.

A second methodological consideration comes in how we calculate a tax unit’s total wealth, defined as the current market value of all assets minus debts. There are some important caveats about what is counted as an asset and, more importantly, what is excluded, such as certain types of pensions, human capital, and the quality of consumer goods. These excluded components constitute significant aspects of individual welfare that are being neglected when we focus solely upon income.

First, let’s address pensions. Many pensions are “unfunded,” meaning that their obligations are not fully backed by underlying assets. These pensions offer a mere promise, not a guarantee, of future payment. The problem with these unfunded benefits, as Saez and Zucman note, is that they are notoriously hard to quantify. Social Security is excluded as an asset for this reason. These pensions are promising to write checks in the future, but because they might change their expected payouts, the current methodology assigns such promises a value of zero. This method likely underestimates, then, the level of wealth and savings many employees actually have or will enjoy.

Next, consider human capital, which is best understood in this context as spending on education. College enrollment has been steadily increasing over the last three decades, from 26 percent to 41 percent among the key demographic of 18- to 24-year-olds. Human capital is supposed to increase workers’ productivity and therefore allow them to earn higher wages. The issue with human capital is that, unlike a traditional asset, it cannot be resold, and so it is also given a value of zero and is not counted as an asset. This calculation not only lowers the quantified value of real assets, but increases the debt side as well. 

Outstanding student loan debt totals $1.2 trillion. Two-thirds of all graduating students are in debt, with the average student borrowing $22,600. One in 10 will borrow more than $40,000. If you take out a loan to buy a house, your portfolio will show an asset with a corresponding liability that will have a net impact of zero. If you instead take out a loan to invest in your education, your portfolio will only show a large debt, at least as measured by the study. But this accounting should strike us as counterintuitive at the very least if we’re considering whether people are better off.

Finally, when measuring our quality of life, we should consider not just how much we are consuming, but also what we are consuming. When comparing consumption over time, we must make adjustments not only for inflation, but also for quality improvements. Many goods and services that we take for granted today  — such as cell phones and the Internet  — were not widely available 27 years ago. Services like Skype are a clear improvement over their older long-distance-plan counterparts. Next-day shipping from Amazon has replaced mail-order catalogs’ promises of delivering purchases within six to eight weeks. And digital streaming services like Netflix put Blockbuster out of business. These are all reasons to prefer living today to 27 years ago — and not just if you’re in the top 10 percent of earners.

For those concerned with inequality, it is much easier to destroy the wealth at the top than it is to increase the wealth at the bottom. While our living standards are qualitatively improving, it is important to recognize that many government regulations actively impede an individual’s ability to enjoy this rising standard of living. This is particularly true for those at the bottom. For example, labor laws that require employers to pay a living wage and provide comprehensive health-care coverage significantly increase the cost of hiring. As a result, many firms are looking into labor-saving technologies as a way of reducing costs. This situation makes it much harder for the least-skilled workers to find and keep their jobs. Regulation with the ostensible purpose of promoting workers' interests destroys those interests instead.

The reality is that we are only better off now due to the creative innovations of the marketplace, which have so far outpaced the obstructions put up by government. By fixating on income inequality, we enable pernicious regulations that destroy our wealth-generating capacity, and we lose sight of the low-cost technological wonderland that we find ourselves in.

  • Adam C. Smith is an assistant professor of economics and director of the Center for Free Market Studies at Johnson & Wales University. He is also a visiting scholar with the Regulatory Studies Center at George Washington University and coauthor of the forthcoming Bootleggers and Baptists: How Economic Forces and Moral Persuasion Interact to Shape Regulatory Politics.
  • Stewart Dompe received his PhD in Economics from George Mason University. He has published articles in Econ Journal Watch and is a contributor to Homer Economicus: Using The Simpsons to Teach Economics. Follow him on Twitter @stewartdompe