Marxism and The Great Divergence

The Great Divergence refers to the ever growing levels of income inequality in the United States. In this post, we’re going to look at the extent of this divergence and possible capitalist-based causes. I expect this to be the first in a (non-consecutive) series of posts

Divergence

First, let’s see how we know there is a divergence.

One of the most popular measures of income inequality is the Gini index. According to the Census Bureau, this has increased steadily since the late 1960s.

Note, the y-axis does not start at 0. I often don’t let the y-axis start at 0, because I believe that it’s important to notice how a change has related to past variation.

Of course, this isn’t the only measure. The Census Bureau provides other useful statistics: the ratio between the 95th percentile and the 50th percentile has increased from roughly 2.6 to nearly 3.7 over the last 46 years – an increase of 42%.

This y-axis doesn’t start at 0 either.

As we examine the extremes, the growth in this discrepancy only increases. Between 1979 and 2007, even after accounting for federal taxes and income transfers, the top 1% gained 275% while the bottom 18% gained only 20% - a divergence of 218%. The aforementioned Census Bureau data demonstrates that the median income has risen by 8% over the bottom 20th percentile's income. Taken together, this demonstrates that the incomes of the top 1% have increased by 194% more than the median income.

One last graph. The percent of income earned by the top 1% has more than doubled over the past 40 years:

I’m going to stop pointing out when the y-axis doesn’t start at 0. You can see it.

Okay, so this divergence exists. Why?

Greedy Corporations

One naïve guess might be that its because corporations are keeping the money for themselves. This can’t be the cause for two reasons.

First, this is just not true. According to the Bureau of Economic Analysis, the proportion of GDP going towards personal income has actually increased over the past several decades:

Second, even if the proportion of GDP going toward personal income was shrinking, we’re talking about a divergence within the population, not a divergence between the population and corporate incomes. This means we couldn’t use such a fact as a cause of income inequality. On the other hand, we could use such a fact (if it were true) to explain the stagnating median income.

Income Composition

Fine, so corporation aren’t just being greedy, maybe the problem is that corporations are paying Americans smaller salaries, and distributing those profits to their stockholders? This would still count as personal income, because dividends are income to people.

This is similar to the position popularized by Thomas Piketty’s relatively recent book Capital in the Twenty-First Century. Piketty claims that the Great Divergence is a feature of capitalism that can only be solved with state intervention (such as a tax on wealth). This work has political implications, so it’s controversial.

If we examine the data provided by the BEA, we see that Piketty is correct in thinking that financial assets tend to grow as a ratio of overall income and GDP.

This 75% increase in financial net worth over GDP looks promising in explaining much of the divergence. The argument goes that if financial assets increased by 75%, then the income from these assets probably also increased 75% - contributing to income inequality, because the rich disproportionately derive income from financial assets.

However, let’s look at a different set of statistics (again, from the BEA again).

It turns out, that over the past 40 years, the proportion of personal income earned due to capital (i.e. ownership of stocks, bonds, and other financial assets) has increased from 23.7% to 26.0% - a 10% increase. Technically, this is an increase, but if we combine this with the finding that the proportion of wealth held by the top 1% is about 35% (I cite this later), we find that this accounts for only about 8% of the entire divergence.

What happened? How did a 75% increase in financial assets correspond with an increase of only 10% in capital income? I don’t have a solid explanation, but I suspect we are seeing a basic principle of economics: as the supply of funds go up, the interest (and dividends) paid goes down. I hope someone, somewhere analyzes this point in more detail.

Capital-Based Income

We’re not quite done with Piketty. We showed that the increase in capital-based income can account for only 8% of the Great Divergence, but we also have to look at the distribution of that capital-based income.

Between 1983 and today, the share of wealth held by the top 1% grew by just 0.8 percentage points (from 33.8% to 34.6%). Recall that 26.0% of personal income is derived from capital in the United States. Thus, this 0.8% change in capital income actually represents just a reallocation of 0.2% change in total income. This accounts for 0.4% of the 194% divergence.

Thus, overall, we’re looking at probably less than 9% of the Great Divergence being caused by the increase or distribution in financial capital.

For now, I’m not certain whether Piketty will end up being proven right or not. Regardless, Piketty’s theory cannot explain more than 9% of the divergence we have seen to the present.

Taxes

I’m not going to belabor this point, but the average percent of income paid in federal taxes by the top 1% has more-or-less remained steady over the past several decades.

Other Factors

This leaves us with just one conclusion. If capital-income can explain at most 9% of the Great Divergence, and taxes can explain essentially none of it, we must conclude that the distribution of labor-based income explains the remaining 91%. There are many theories concerning why income inequality has increased so much between workers, but I'll be doing a separate post on that.

Caleb Lovell
Very interesting. I've also been reading a decent amount about this lately, but would like to delve deeper... would you recommend Piketty? Or something else? Also, what do you think about the Gini coefficient as an accurate indicator? It is cited frequently without any question of its legitimacy across many works, but I've read quite a few convincing arguments about its weaknesses, especially in explaining the extremes.
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Thomas Faust Redding
I haven't finished Piketty's book yet, so I can't give a recommendation either way yet. Personally, I prefer reading meta-analyses or doing my own analysis. Though, to get a broad overview on topics, I generally read The Economist and Wikipedia. In my experience, Wikipedia articles are often surprisingly quantitatively driven, which is important to me.

I agree about the issues with the Gini index. I'd add that not only is it kind of arbitrary, its hard to interpret. Like, what would it mean to say that "capital based income caused 10% of the change in the Gini index"? That's one of the reasons I relied on the changes in money-proportions instead.

I personally prefer the Atkinson index over the Gini index. Basically, if you think the value someone derives from their income is proportional to the logarithm of their income, then the Atkinson index with coefficient 1 is a measure of what percent of value is lost due to inequality. I'll probably do a post elaborating on this in more detail.
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