Explanations for Rising Inequality

Rising inequality is a fact. There has been a lot of debate on the causes of rising inequality but few of the explanations are based upon data and sometimes there is confusion about what to look at when we discuss inequality. I have attempted to deal with some of these issues in this post by referring to data in this study.

Classical economic theory assumes that income is based upon productivity. Those who make the greatest contribution to revenues and profits will get a larger share of the income pie. Some argue that education level is related to productivity and that rising inequality is due to a higher wage premium paid to those with more education. These explanations are not very helpful. We know that there is relationship between education and income. Those with college degrees earn more than those without higher education. It does not explain the difference in incomes between those with college degrees. The great majority of those in the top income brackets have high levels of education, but that does not distinguish them from those in lower income brackets who are also highly educated.

Its also hard to explain rising income inequality in relation to productivity. In the first place, it is hard to determine the contribution to productivity made by non-production workers. Moreover, it is not easy to argue that executives today are many more times more productive than executives in the past. Their compensation has risen by a factor of 5-10 but certainly they are not that much more productive.

Some argue that globalization, tax policy and other government policies have contributed to rising inequality. Technological changes have also been used to explain the wage premium for those with technical skills. We will look at these factors as well but we will restrict our analysis to the real inequality problem. That is, the increasing share of income going to the top 1% and the top 0.1%.


Between 1979 and 2005, the share of national income going to the top 1% increased from 9.18% to 16.97%. Non financial executives and managers, along with financial executives and managers obtained 60% on that gain in income. During the same period, the top 0.1% saw its share of national income grow from 2.83% to 7.34% 70% of that gain went to the executive class. This is the income inequality issue that we will discuss. The gains among the top 1% mean that the bottom 99% has to divide a smaller share of the national income pie. It also increases the influence of the top 1% on government. It can also lead to social unrest. If people perceive unfairness that can not be resolved via the democratic process they look elsewhere for solutions.

The data do not support the hypothesis that some broad trends in society such as globalization and the use of technology are responsible for the gains that have gone to the top 1%. They are common to other countries like Japan and France which have not seen a similar increase in inequality. They are more common, however, in english speaking countries. There was also a divergence of income gains by occupation. The share going to finance almost doubled. It went from 7.7% of the share going to the top 1% to 13.9% between 1979 and 2005. It share of income going to the top 0.1% also increased during that period. It went from 11% to 18%. It must be explained by factors other than technology and education. Professions like law and medicine have about an 11% share of the income going to the top 1%. Access to these professions is a function of education but these professions have not seen a rise in their share of income going to the top 1%. Moreover, there is a wide spread in income among members of these professions which have similar educational requirements. Professors and scientists are among the most educated professionals but their share, unfortunately, is only a little over 1% of the gain going to the top 1%

The most reasonable explanation of the gains going to the executive class is that changes in how they are compensated and weak corporate governance might be responsible. There has also been a change in the popular culture and the influence of unions that have made the increases in executive incomes more socially acceptable. Tax policy has certainly had an affect as well. Reducing tax rates on capital gains and on dividends has increased their share of post tax income.

Trying to understand the factors that have enabled the top 1% to garner a larger share of national income is complex. Many of the commonly held explanations seem to be guesses that are not supported by data. We need more research that looks at gains within and between occupations. It seems like occupations like finance have benefitted by changes in regulation and the introduction of new products that have high profit margins. The lack of price competition in some of their markets can lead to economic rents. Some have estimated the gains from economic rent in finance to be between 30 and 40 percent of their increase in income. The profession also benefits from swings in asset prices on stocks and other forms of speculation.