Exploring The Problem Of Income Inequality

April, 2016
S&P 500: 2060

OUTLOOK MEMORANDUM
Exploring The Problem Of Income Inequality

A rising death rate among middle-aged, high school educated, non-Hispanic Whites is a symptom of the stress and frustration being expressed by that demographic during the current political campaign. The average nominal incomes of the Middle Class and the top income groups all have continued to rise since 2000, although the pace of annual increases has slowed from 8-10% pre-2000 to about 2% since then. Since 2000, however, all groups have experienced declines in their inflation- adjusted incomes. When viewed as shares of total income, the Middle Class lost share to the top groups from 1967-2000, with especially large share-shifts having occurred during the early 1990s. This share-shift was not a national issue at that time because the real incomes, and thus the living standards, of all groups were increasing during the 1990s. Since 2000, share-shifts have slowed, and contrary to common belief, the Top 5% has gained no share since 2000. Share-shift has become a major issue, however, because economic growth has slowed and real incomes of all groups have declined. Middle Class real income historically has risen with productivity, but since 2000 real incomes have fallen as productivity has continued to rise. We estimate that almost two-thirds of this gap can be explained by the increased cost of employee health insurance paid by employers. Thus, we conclude that part of the solution to the income inequality problem is to find ways to slow the sharp rise in the cost of healthcare. Another cause of this problem is the recent slowdown in worker productivity growth resulting from lagging capital investment by business and US workers becoming less educationally competitive.

In our investing, we try to understand important trends in our economy. For the past ten years, there has been increasing discussion of income inequality and it has become an important national issue. We recently have spent time researching it, and despite its being emotional and politically-charged, we think a dispassionate presentation of our findings may be interesting and informative to our clients. Our insights may also point to the most likely ways that this problem may be fixed.

It is widely acknowledged that there is anger and frustration among some sectors of the electorate that is having a significant influence on domestic political developments. This frustration has real economic roots and is reflected in research published in the Proceedings Of The National Science Foundation in December. Princeton Professors Anne Case and Angus Deaton uncovered the startling fact that while death rates (deaths per 10,000 in the population) had fallen sharply in most major countries, and for most groups in the US, the death rate for white, non-Hispanic US citizens between the ages of 45 and 54 with no more than a high school education had increased between 1999 and 2013 by 134 deaths per 10,000, a rise of 22%. They found that the primary cause of this increased death rate was suicide and drug abuse, supporting the conclusion that this segment of our population has become increasingly stressed by the declines in real incomes it has experienced. To the extent that this demographic group is the one most inclined to see job competition from immigrants and foreign producers, some of this year’s political themes, including income inequality, become more understandable.

Our research has uncovered both confirmations and misunderstandings about this topic. In this paper we will deal only with income inequality and leave the related topic of wealth inequality for another time. We do this partly because we think most families are more focused on paying the mortgage or rent, providing for the daily needs of their families, having some money for vacations, and having something left from their paychecks so they can save for the future. Most people do not expect to become wealthy, but they do expect to be able to provide for their families and send their children to college.

Most of the data used in our study come from the US Census Bureau’s extensive databases on US household income based on tax filings and other surveys from 1967 through 2014. This data is available at http://www.census.gov. The Census Bureau segments US households into quintiles, providing data on the bottom 20%, the next 20%, and so on through the top 20%, as well as for the top 5% of households. For our study, we combined the middle three quintiles accounting for 60% of the households to represent the US “Middle Class”. This segment included about 75 million households in 2014 with household income between $21,432 and $112,262, averaging $57,554. We also examine the Top 20% of households, a group of about 25 million households with 2014 income exceeding $112,262 and averaging $194,053. Finally, we examine the 6.2 million households comprising the Top 5% that had 2014 income of at least $206,568, averaging $332,347.

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The Incomes Of All Three Groups Continued To Rise Through 2014. As shown in the chart on the previous page, from 1967 through 2000, the average income of the middle three quintiles (blue lines using the left scale) rose at an average rate of 8.3% per year. The average income of the Top 20% (green lines using the right scale) increased at an average rate of 9.5% per year, and the average income of the Top 5% (red lines using the right scale) rose at a 10% rate. There has been a dramatic trend change, however, since 2000 that has affected all three groups. First, the average incomes of each of the three groups (Middle Class, Top 20%, and Top 5%) have continued to rise. Thus, statements such as “the average worker has not had a raise in years” is a misperception. Second, the slowdown in income growth has been similar across all three groups, with the rate of increase having dropped to about 2%. Thus, the notion that the slowdown in Middle Class income growth during the past fifteen years has come as a result of another group having taken its share does not seem to be supported by this and other data.

The issue becomes clearer when we look at inflation-adjusted data. Since inflation requires a household to have more income each year just to be able to purchase the same amount of goods and services, the Census Bureau adjusts the nominal income data presented above for annual changes in the Consumer Price Index. This series enables us to make judgments about whether households’ living standards are improving or deteriorating. This inflation-adjusted (called “real income”) data is presented in the following chart.

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It shows similar patterns of rising real incomes for each of the three groups from 1967 through 2000, although the increases in the two top groups (green and red lines) were faster than the Middle Class group (blue line) at 2.5% and 3.0% per year versus 1.4% per year. Then, the data show that progress in real incomes for all three groups ceased after 2000, with Middle Class average real income declining at a -0.4% per year rate since then, the Top 20% slipping at a -0.1% rate, and the Top 5% falling at a -0.3% rate. We also observed similar trends for all three quintiles of the Middle Class group with consistently worse outcomes for the lowest quintile. Thus, when we look at this inflation-adjusted data, we see that all groups have failed to progress since 2000, but that the Middle Class group has regressed somewhat more than the others. There is a basis for the frustration felt by everyone, especially the Middle Class group.

The Middle Class’ share of aggregate income has been declining since 1967. In the following chart, the blue line represents the share of total national household income earned by the Middle Class. Despite the frequent discussion of this throughout the past ten years, the chart shows that most of the decline occurred during the 1967-2000 period, with the Middle Class’ share having fallen from 52.3% of the total in 1967 to 46.7% in 2000, a decline that averaged -0.17 percentage points per year over those 33 years. The pace of decline has slowed considerably since 2000, with the Middle Class’ share having slipped by only one additional percentage point to 45.7% over those 14 years, with the decline averaging just -0.07 percentage points per year. The share lost by the Middle Class during the 1967- 2000 period (-5.6%) was gained by the Top 20% (+6.2%), with most of this going to the Top 5% (+4.9%). It is worth noting that a significant portion of the 1967-2000 share shift occurred in 1993, when the Middle Class’ share dropped by 1.8 points and the Top 20% and Top 5% gained 2.0 points and 2.4 points, respectively. We think this likely was related to the strong stock market during that period and a resulting 37% increase in reported capital gains income that presumably went primarily to the Top 20% group. Since 2000, there has been no share gain by the Top 5%, disproving that the richest portion of our population has taken share from the Middle Class recently, but the 25 million households in the Top 20% have continued to gain share, albeit at about half the rate prior to 2000.

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A number of explanations have been offered for the declining Middle Class share during the 1967- 2000 period. One factor was the decline in union membership, and with it, the many higher-paying union jobs. The increased participation of women in the labor force also likely played a role. In 1980, a husband-wife couple each earning a middle-income salary of $24,000 would have had $48,000 of combined household income, exceeding the $46,500 needed that year to qualify for the Top 20%. During the latter half of this period, the increasing technical nature of many jobs and competition from lower-wage foreign workers likely contributed to lower domestic salaries and a loss of middle income share.

If share-shifts have been small over the past fourteen years, why has income inequality now become such an emotional issue? It might seem curious that share-of-income has become such an issue currently when it rarely was mentioned during the 1990s when the Middle Class was losing 2.8 points of share and the Top 20% was gaining 3.2 share points. We think the explanation is that during the 1990s, real economic growth averaged 3.4% per year, enabling Middle Class real incomes to rise 1% per year. Thus, Middle Class living standards were rising each year despite the significant loss of share. The economic pie was growing at a sufficient rate that all groups were experiencing rising standards of living. By contrast, during the period since 2000 annual real economic growth has slowed to a 2.0% pace and, and as shown in our second chart, Middle Class real incomes have declined at a -0.4% annual pace, driving living standards down. With real incomes having declined for all groups, our society now is fighting over shares. Many years ago we read that democracy requires that the country’s economic pie grow sufficiently fast that most people’s piece of that pie is increasing in size; for if the growth of the economic pie slows, people will begin fighting for a larger share of the pie, and the social contract will break down. We seem to be living that prediction now.

Middle Class Real Income growth has not kept up with Productivity gains since 2000. In economic theory, and in reality, workers’ real incomes should rise in line with increases in their productivity, where productivity means how much they produce for each hour worked. In the chart on the next page, the red line is the US Bureau of Labor Statistics’ Productivity Index for the Non- Farm Business Sector for 1967-2014. The blue line plots the annual average real income of the Middle Class (middle 60%) for this period. Clearly, real incomes closely followed productivity until 2000. But, while productivity has continued to rise since 2000, real incomes have declined. It would appear that Middle Class real incomes have fallen below where they otherwise should be. If we make the assumption that average Middle Class real income in 2014 normally would have been at about the same point on the chart as productivity, then their real income would have been about $65,000 in 2014 instead of $57,654. This is a difference of $7,346 that more than accounts for the loss of share since 2000. The anger seems justified.

Rising healthcare costs may be at the core of this problem. Healthcare costs have risen rapidly since this divergence began in 2000.Aon Hewett, a human resources consulting firm, calculates that the annual cost of employer-based health insurance in 2014 was $10,717 per employee. They indicate that the average employer paid 75% of those premiums, resulting, by our calculation, in an employer cost of $8,037. The Kaiser Family Foundation presents data indicating that the cost of employer-based health insurance for a Family plan increased by 161.5% between 2000 and 2014, and that the cost of Individual coverage under employer-based plans increased by 143.8%. Combining these two we estimate that total employer-based health insurance costs rose by roughly 150% between 2000 and 2014. Businesses, on average, paid a bit more than 75% of health insurance premiums in 2005, so we assume that they paid a similar percentage in 2000. Using this data, we calculate that the average cost of employer-based health insurance in 2000 was $4,287 per employee, and that the employer’s 75% share of this was $3,215 per employee. Thus, we estimate that the cost of employer-based health insurance increased from $3,215 per employee in 2000 to $8,037 per employee in 2014, an increase of $4,822 per employee. By paying for this sharp increase in the cost of the employees’ healthcare insurance, employers have provided this as additional non- payroll compensation. When this amount is added back to the average Middle Class income in 2014 of $57,654, it brings the income total up to $61,986. Thus, we estimate that the payment by employers of much of the increased cost of health insurance since 2000 explains about 65% of the gap that opened between Middle Class incomes over the past fourteen years and where they would have been if they had kept up with productivity growth ($4,822 / $7,346 = 65.6%). While business owners view this additional expense as part of their compensation of their employees, the employees do not see it in their paychecks and thus feel that they are “falling behind”. The increased insurance premiums also do not get reported to the government as income, so they are not reflected in Middle Class income totals. While increases in employer-paid healthcare premiums have applied to all income groups, the impact has been greatest on the Middle Class as a percentage of total income. Specifically, the higher insurance cost accounts for roughly three years of 3% raises to the Middle Class, while it represents less than one year’s 3% raise to the Top 20%.

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To make matters worse for the workers seeing their real paychecks declining, the actual cost of health insurance has risen even faster than have the premium costs as businesses have opted for policies with higher deductibles, coinsurance, and co-pays in order to hold down the rapidly rising cost of the insurance. According to Aon Hewitt, the result has been that the average employee’s cost of healthcare, including his share of the increased premiums and the higher deductibles,coinsurance, and co-pays, increased by almost $2,000 since 2010. For the average Middle Class household, this significant additional cost has had to be paid from their declining real incomes. It is not hard to understand their current stress and frustration even if much of the lack of growth in their real paychecks has a valid economic explanation.

One obvious conclusion from this research is that the rapid rise in healthcare costs underlies much of the decline in the Middle Class’ standard of living since 2000 and is linked to any share-shifts because the increased cost of employer-paid health insurance has had a larger impact on Middle Class raises than it has had on Top 20% incomes. A slower rate of healthcare inflation would certainly help Middle Class real incomes to begin to recover. How this might best be accomplished is beyond the scope of this paper.

A slowdown in productivity growth also has contributed to this problem. We previously noted the strong link between productivity growth and increases in worker compensation. The more capital equipment an employee has to work with, and the better that equipment is, the more productive that employee can be. Ultimately, this is what drives our standard of living upward by increasing the ability of businesses to provide rising real wages and salaries to their employees. During the 1990s, US non-farm business productivity increased at a 2.2% annual rate, but it has slowed to a 0.4% pace over the past five years. If a business is to cover the rising cost of health insurance and also provide real wage and salary growth, productivity growth must return closer to historical rates. This would boost the rate of overall economic growth and increase the size of the economic pie as occurred during the 1990s. Returning to our last chart, if productivity had risen at a more normal 2% rate rather than its actual 0.4% rate over the past five years, we estimate that Middle Class salaries might have been 8%, or $4,700, higher. Thus, boosting economic growth by increasing productivity is an essential part of the solution to the income inequality problem.

To accomplish this, it might be helpful to put in place additional incentives to increase capital investment by business. One step for increasing incentives for businesses to invest in the US would be to bring US corporate taxes more in line with those existing at our trading partners. Reducing regulatory burdens also could help. Such steps to improve productivity would have the added benefit of slowing our country’s loss of jobs to overseas workers.

Worker productivity also would be enhanced if our education system became more effective. According to the Pew Research Center, 15-year old high school students in the US on average ranked 35th in math scores versus similar students in 68 advanced economies, and 27th in science. Equally disturbing are the results of a study conducted by the Organization for Economic Cooperation and Development (OECD) that found US workers ranking last out of eighteen industrial countries in “problem solving in technology-rich environments” due to inferior literacy and numeracy skills. The study notes that middle-class jobs in fields like manufacturing and healthcare are becoming increasingly complex, and that workers lacking the necessary skills either will “lose their jobs” or “face stagnant wages.” Therefore, some of the Middle Class’ real income decline likely reflects a portion of our workforce having been left behind by our education system. Consequently, we think improving the international competitiveness of our education system is another part of the process to boost productivity and raise Middle Class real incomes.

How our country deals with these issues will have investment implications. The list of potential investment effects includes those that are macro in nature and many that are industry- or company- specific. If we choose policies that fail to get at the underlying causes of this problem or exacerbate them, investors will anticipate the damage and the investment environment will be harmed. We have tried to show that reducing healthcare inflation is an important element of fixing the income inequality problem. As policies are developed to continue reforming our healthcare system to make it more cost- efficient, the healthcare industry, accounting for almost 15% of the S&P 500, will be affected both positively and negatively. We also have identified our need to increase productivity through capital investment if Middle Class real income growth is to accelerate. If our country takes steps to encourage capital investment to grow the economic pie, there are many capital goods companies that will be seen as beneficiaries, as would consumer goods companies. At this point, all we can do is to monitor the national debate carefully, keeping in mind that the policy outcomes of past presidential campaigns sometimes have been very different from the directions suggested by the rhetoric of the campaigns.

Conclusions: This paper began by noting that a rising death rate among middle-aged, high school educated, non-Hispanic Whites is a symptom of the stress and frustration being expressed by that demographic during the current political campaigns. We showed that the average nominal incomes of the Middle Class (middle 60% of the income quintiles) and the top income groups all have continued to rise since 2000, although the pace of annual increases has slowed from 8-10% pre- 2000 to about 2% since then. Since 2000, however, real incomes (incomes discounted for inflation), have declined at similar rates for all three groups, although the rate of decline for the Middle Class group has been a bit faster than the others. When viewed as shares of total income, the Middle Class persistently lost share to the top groups from 1967-2000, with especially large share-shifts having occurred during the early 1990s. We noted that this share-shift was not a national issue at that time because Middle Class real incomes, and thus their living standards, were increasing during the 1990s. Since 2000, share-shifts have slowed, and contrary to popular belief, the Top 5% has gained no share since 2000. We think share-shift now has become a major issue because economic growth has slowed and real incomes across the board have declined since 2000. We then discussed how Middle Class real income historically has risen with productivity, but since 2000 income has fallen while productivity has continued to rise. Our research suggests that almost two-thirds of this gap can be explained by the increased cost of employer-paid health insurance. Thus, we conclude that solving the income inequality problem requires that we find ways to slow the sharp rise in the cost of healthcare. Slower productivity growth in recent years has contributed to the slowdown in real income growth. This productivity slowdown likely reflects a slower pace of business capital investment and a loss of international competitiveness in our education system. Improved incentives for capital investment and making our educational system more competitive versus those of our trading partners would seem to be essential components of a program to accelerate productivity growth in order to help to boost Middle Class real incomes.