The American Middle Class, Income Inequality, and the Strength of Our Economy

7/31/2019 The American Middle Class, Income Inequality, and the Strength of Our Economy

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The American Middle Class,Income Inequality, and the

Strength of Our EconomyNew Evidence in Economics

Heather Boushey and Adam S. Hersh May 2012

www.americanprogress.o


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The American Middle Class,Income Inequality, and theStrength of Our EconomyNew Evidence in Economics

Heather Boushey and Adam S. Hersh May 2012


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Contents 1 Introduction and summary

9 The relationship between a strong middle class,

the development of human capital, a well-educated

citizenry, and economic growth

23 A strong middle class provides a strong

and stable source of demand

33 The middle class incubates entrepreneurs

39 A strong middle class supports inclusive political and

economic institutions, which underpin growth

44 Conclusion

46 About the authors

47 Acknowledgements

48 Endnotes


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1 Center or American Progress |The Amer ican Middle Clas s, Income Inequal ity, and the Strength o Our Economy

Introduction and summary

o say ha he middle class is imporan o our economy may seem nonconro-

versial o mos Americans. Aer all, mos o us sel-ideniy as middle class, and

members o he middle class observe every day how heir work conribues o

he economy, hear weekly how heir spending is a leading indicaor or economic

prognosicaors, and see every monh how jobs numbers, which primarily reec

middle-class jobs, are aken as he key measure o how he economy is aring. And

as growing income inequaliy has risen in he naions consciousness, he pligh o

he middle class has become a common opic in he press and policy circles.

For mos economiss, however, he conceps o middle class or even inequal-

iy have no had a prominen place in our hinking abou how an economy

grows. Tis, however, is beginning o change. One reason or he change is ha

he levels o inequaliy and he nancial sress on he middle class have risen

dramaically and have reached levels ha moivae a closer invesigaion. Te

ineracion and concurrence o rising inequaliy wih he nancial collapse and

he Grea Recession have, in paricular, raised new issues abou wheher a weak-

ened middle class and rising inequaliy should be par o our hinking abou he

drivers o economic growh.

Over he pas several decades, he Unied Saes has undergone a remarkable

ransormaion, wih income growh salling or he middle class while he

incomes o hose a he op coninued o rise dramaically compared o he res o

he working populaion. Beween 1979 and 2007, he las year beore he Grea

Recession, median amily income rose by 35 percen, while incomes or hose

a he 99h percenile rose by 278 percen. (see Figure 1) Families in he middle

class have also pulled away rom hose a he botom, bu achieved hese modes

income gains only by working longer hours, increasing heir labor supplypar-icularly among wives and mohersand increasing household debs o mainain

consumpion as wages ailed o keep pace wih inaion.


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In 1979 he middle hree household income quiniles in he Unied Saesha

is, he populaion beween he 21s and 80h perceniles on he income scale

earned 50 percen o all naional income. Bu by 2007 he income share o hose

in he middle shrank o jus 43 percen. Evoluion o he Gini coecien, which

measures how much a disribuion deviaes rom complee equaliy, also shows a

similar patern o rising inequaliy. Beween 1979 and 2007 he Gini coecienincluding capial gains, in he Unied

Saes climbed rom 48 o 59, ranking he

Unied Saes in he op quarer o he

mos unequal counries in he world.1

Teories o economic growh, however,

do no ypically include models or

invesigaing he implicaions o changes

in he srengh o he middle class. I

you ask an economis wha makesan economy grow?, hey will almos

cerainly begin heir answer by poining

o an economys level o knowledge

abou how o produce goods and

services (knowledge and echnology),

he skills o he poenial labor orce

(human capial) and he number o

workers, and he sock o physical

capial (acories, oce buildings,

inrasrucure). Te economy grows

when echnological improvemens or

invesmens in human or physical capial

boos produciviy, when he labor

orce increases, or when invesmen in physical capial adds o he economys

producive sockand hus oal oupu expands.

Bu his begs he quesion: Wha booss produciviy or creaes incenives o

inves? Economiss difer in heir specic answers o hese quesions, bu he di-

eren heories poin o ve primary acors:

Te level of human capital and wheher alen is encouraged o boos he

economys produciviy

FIGURE 1

Cumulative growth in average after-tax income,by income group, 1979-2007

Between 1979 and 2007, the last year before the Great Recession, median faincome rose by 35 percent, while incomes for those at the 99th percentile roby 278 percent

Source: Congressional Budget Office, Trends in the Distribution of Household Income from 1979-20

-50

0

100

150

200

250

300

197

9

198

1

198

3

198

5

198

7

198

9

199

1

199

3

199

5

199

7

199

9

200

1

200

3

200

Top 1 percent

81st to 99th percentiles

Median21st to 80th percentiles

Lowest quintile

50


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Cost of and access to financial capital, which allow rms and enrepreneurs o

make real invesmens ha creae echnological progress o use in he economy

Strong and stable demand, which creaes he marke or goods and services and

allows invesors o plan or he uure

Te quality of political and economic institutions, including he qualiy o

corporae governance as well as poliical insiuions and a legal srucure ha

enorces conracs

Investment in public goods, education, health, and infrastructure, which lays

he oundaion or privae-secor invesmen2

Srong empirical evidence in economics and oher social sciences suggess ha he

srengh o he middle class and he level o income inequaliy have an imporan role

o play or each o hese ve acors boosing produciviy and spurring invesmen.

Te research or his projec began wih a series o inerviews and a naional coner-

ence wih leading U.S. economiss o learn heir views abou he mechanisms hrough

which income inequaliy and he srengh o he middle class afec economic growh

and economic sabiliy.3 Tis paper summarizes wha we have learned rom hese

conversaions, alongside our analysis o he economic research in he academic arena.

We have idenied our areas where lieraure poins o ways ha he srengh o he

middle class and he level o inequaliy afec economic growh and sabiliy:

A srong middle class promoes he developmen o human capial and a well-

educaed populaion.A srong middle class creaes a sable source o demand or goods and services.A srong middle class incubaes he nex generaion o enrepreneurs.A srong middle class suppors inclusive poliical and economic insiuions,

which underpin economic growh.

We deail he evidence or hese our poins in he main pages o our paper, bu

briey we encapsulae he economic research here. As we will demonsae, he

ways in which a srong middle class is imporan or economic growh are bohinerrelaed and muually reinorcing.


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A strong middle class promotes the development of human capital

and a well-educated population

Economiss agree ha human capialknowledge, skills, and he healh o pu

hose o workis a key componen o growh. o be mos efecive, opporuniies

o build human capial mus be broadly available in he populaion. For he naiono make he mos o is human poenial, a child rom a low- or moderae-income

background needs his or her alens and abiliies o be nurured and mached o

he mos suiable occupaion. Te evidence is airly clear ha inequaliy and he

srengh o he middle class have direc efecs on access and use o human capial:

As he Unied Saes has grown more unequal in erms o income, here has

been boh a decrease in he rae o improvemen in educaional oucomes and

hese oucomes have become more unequal.

Te daa poin o he conclusion ha human capial, and he higher incomesha go along wih i, are increasingly passed rom parens o ofspring hrough

social (no biological) channels. Tis means ha individuals are being rewarded

or privileges conveyed by heir parens socioeconomic saus, no jus heir

produciviy characerisics, which will pull U.S. economic growh down.

Te conribuion o human capial o growh is no only abou access o educa-

ion: Individuals also mus be able o make use o heir skills, maching alen o

appropriae occupaions. I inequaliy sands in he way o hose maches, hen i

is having a pernicious efec on our naions growh pah.

A strong middle class creates a stable source of demand for goods

and services

A srong middle class gives cerainy o business invesors ha hey will have

a marke or heir goods and services. Supply-side hinkers argue ha ligh ax

and regulaory policies will lead o high invesmen, employmen, and economic

growh. Bu many economiss acknowledge ha an increase in supply does no

auomaically lead o an increase in aggregae demand. Raher, economies mayhave prolonged periods o unemploymen and underuilized capial, which can be

boh he cause and he resul o depressed and unsable demand.


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I demand maters or economic growh, he quesion is hen, how do high

inequaliy and he srengh o he middle class impac demand? Economiss have

developed a number o heories abou how inequaliy afecs demand:

As more o he naions economic gains go o hose a he op o he income

disribuionand i hose amilies have a lower propensiy o consumehenhis will pull down demand rom poenially higher levels given more equi-

able disribuion.

Heighened inequaliy and a squeezed middle class leads amilies o eiher con-

sume less, lowering demand, or pu in place shor-erm coping sraegies, such

as borrowing more, which has long-erm implicaions or growh and sabiliy.

A strong middle class incubates the next generation of

entrepreneurs

Enrepreneurship is a mater o aking risks, and here are a variey o ways ha

a srong middle class and less inequaliy can creae he kinds o condiions ha

reduce he risks o innovaors and give hem he skills o sar up a business:

Middle-class amilies can provide enrepreneurs wih he nancial securiy and

access o credi so hey have he ime o nurure heir ideas and ake he risk o

sar a new business.

An individual in a middle-class amily is more likely han someone rom a low-

income background o have access o he kind o educaion ha provides he

raining and skills necessary o sar a business.

As described in above, less inequaliy is associaed wih greaer macroeconomic

sabiliy, which allows enrepreneurs o make inormed invesmen decisions wih

greaer condence abou economic condiions and he risks o saring a business.

A strong middle class supports inclusive political and economicinstitutions, which underpin economic growth

Tis dynamic o a srong middle class booss ecien and hones governance o an

economys enerprises. In he U.S. conex, less inequaliy and a sronger middle


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class suppor more inclusive poliical insiuions and seer poliics away rom

only responding o an economically powerul elie. Tis provides he oundaion

or more inclusive economic insiuions, which, in urn, promoe growh. Tis

includes encouraging efecive governance ha suppors broad-based economic

growh hrough esablishing secure propery righs; invesing in public goods

and quasi-public goods, such as educaion, healh, and inrasrucure; and a levelplaying eld, including ransparen and accounable legal and regulaory srucures.

A srong middle class prevens he concenraion and exploiaion o power ha

led o enrenched privilege in arisocracieshe anihesis o dynamic socieies

hroughou human hisory.

The evidence of the role of the middle class in economic growth

o be clear, we do no asser ha he middle class is he only acor afecing

economic growh. Te price o capial, axes, resource endowmens, luck, chance,and oher causes all have imporan roles o play. Bu aer surveying he available

heories and evidence, i is dicul o poin o anyhing else so cenral o so many

causes o economic growh as a srong middle class. Tis paper explains he mos

curren, empirically grounded economic evidence showing how income disribu-

ion afecs he ecien uncioning and growh poenial o our economy.

In his paper he conceps o inequaliy and middle class are broadly con-

srued. When we say middle class, we mean more han jus amilies who are,

broadly, in he middle o he income disribuion. By middle class, we do no

mean rich, bu we do mean amilies wih enough nancial securiy o make ends

mee, provide invesmens in he nex generaions success, and have a litle margin

o saey o boo. A middle-class amily has some economic securiy, be ha a

good job wih healh insurance and a reiremen plan, or some savings in he bank

o ide hem over in an emergency, send a child o college, or even oa a loan o a

amily member who wans o sar up a business. Tis is consisen wih individu-

als percepions: Surveys show ha mos Americans believe hey are in he middle

class, rom hose generally in he 20h or 30h percenile o he income disribu-

ion o he 80h and even above.4 Our concepion o inequaliy is ied mosly o

income, alhough here is a high degree o overlap beween individuals wih veryhigh incomes and individuals wih high ne worh.5

Troughou he paper we examine he ways ha eiher caegory afecs economic

growh. Tere are disinc ways in which each can relae o he growh poenial or


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an economy. Te securiy ha a middle-class amily provides goes beyond wages o

include a sense o a longer ime horizon or economic decision making han a amily

hovering on he edge o povery, or he way ha a middle-class child may be able o

pursue a eld o sudy suied o heir ineress. Neverheless, given he inerrelaion-

ship and overlap beween he wo, i makes sense o include boh in our hinking as

we discuss causal relaionships wih macroeconomic perormance.

Finally, we wish o make a noe on our approach o he subjec o he relaion-

ship o inequaliy and he srengh o he middle class and U.S. economic growh.

Tere is, o course, a rich lieraure on he relaionship beween inequaliy and

growh. (see box on nex page) Alhough here are many conicing views, here

is ample evidence ha inequaliy can, in ac, hur growh under many circum-

sances. Bu his lieraure ocuses mosly on he experience o developing coun-

ries, and is applicabiliy o he challenges currenly acing he Unied Saes is

no enirely clear.

Te Unied Saes is a developed economy a he edge o he echnological ron-

ier, wih he highes levels o income inequaliy i has ever seen. Panel daa sudies

analyzing how inequaliy afecs growh across a range o counries are unlikely o

ell us much abou his unique siuaion. Tus, we have aken a diferen approach

in his invesigaion. Insead o looking broadly a analyses o inequaliy and

growh in oher counries, we have looked a he evidence regarding he specic

ways in which inequaliy and he srengh o he middle class migh afec eco-

nomic growh in he U.S. conex. I, in ac, here are specic ways ha growh is

afeced, hen i is reasonable o assume ha here is a relaionship overall.

A he end o he day, he conclusions ha economiss come o abou wha makes

an economy grow are imporan or how we undersand he complexiies o an

economic sysem. Economiss are oen seen as he arbiers o credibiliy abou

wha is good or he economy. Tus, siing hrough how disparae pieces o he

economic evidence ogeher o ell a cohesive sory abou how inequaliy and

he middle class afec economic growh is a criical and imely ask. We urn

now o examining in deail he leading channels hrough which he middle class

impacs economic growh.


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Economists have long debated the eects o income inequality on eco-

nomic growth. In 1975 Yale University economist Arthur Okun argued

that income equity and economic eciency are in tension because

inequality provides incentives or work and investment, and additional

inequality provides additional incentives. There is, in his words, a big

tradeo between the two. In his estimation income inequality is a

orce or economic good. However, empirical research over the past

two decades looking across countries or across U.S. states shows a mix

o results about exactly what eect inequality has on growth.

Much research conicts with Okuns tradeo hypothesis, instead

showing that inequality is detrimental to long-term economic

growth, although this is not a unanimous conclusion o the literature.

Ultimately, data and methodological issues mean that analyses are

too imprecise to deliver defnitive answers to this old and central

question in economics research. We believe a dierent approach

that identifes direct causal mechanisms between inequality and theactors known to be critical to economic growth is needed to under-

stand this relationship.

In an early attempt to summarize the research, Roland Benabou o

Princeton University surveyed 23 studies analyzing the relationship

between inequality and growth. Benabou ound that about hal (11)

o studies showed inequality has a signifcant and strongly nega-

tive aect on growth; the other hal (12) showed either a negative

but inconsistently signifcant relationship or no relationship at all.

None o the studies surveyed ound a positive relationship between

inequality and growth.6

Similarly, World Bank economists Klaus Deininger and Lyn Squire, as

well as Nancy Birdsall and Juan Luis Londono, president o the Center

or Global Development and an economist or the National University

o Colombia, respectively, ound asset inequality to be negatively

related to economic growth.7 And Danny Quah o the London School

o Economics ound no consistent statistical relationship between

inequality and growth.8

Others fnd a more nuanced relationship. An ot-cited study byHarvard Universitys Robert Barro fnds mixed evidence o a rela-

tionship between inequality and growth, including evidence o a

nonlinear (quadratic) relationship such as that initia lly hypothesized

by Nobel Prize winner Simon Kuznets.9 This result could suggest that

inequality may be negatively associated with growth in poor coun-

tries and positively associated with growth in rich countries. Francisco

Rodriguez o Wesleyan University characterizes Barros results a

indicating that higher inequality may boost growth in the shor

but is bad or economic growth in the long run. 10

A number o studies specifcally test the relationship between

inequality and growth in the United States. States are not idea

o observation because, among other things, the political boun

do not necessarily coincide with regional economies. Still, muc

be learned rom such analysis. Ugo Panizza o the U.N. Conere

on Trade and Development fnds a negative relationship betwe

inequality and growth.11 In a separate study examining data o

states rom 1960 to 2000, however, Mark Partridge o The Ohio

University fnds that in the short run inequality is positively rela

to growth, while in the long run the income share o the middl

is positively associated with growth, seeming to confrm Rodrig

observation rom above.12 Mark Frank and Donald Freeman o

Houston State University, using dynamic panel data methods apanel cointegration analysis, fnd a strong, negative relationsh

between inequality and growth.13

In a new book,Just Growth: Inclusion and Prosperity in Americas

Metropolitan Regions, Chris Benner, associate proessor o com-

munity and regional development at University o Caliornia-D

and Manuel Pastor, proessor o American studies and ethnicity

University o Southern Caliornia, show that economic equity w

regional economies is linked to regional prosperity. They show

both quantitative and qualitative methods why and how regio

economic growth is associated with greater equity across metr

tan regions in the United States, concluding that growth with e

is not a contradiction but a necessity.14

Benner and Pastors work is consistent with that o the Federal

Reserve Bank o Cleveland where economists fnd that a skilled

orce, high levels o racial inclusion, and progress on income eq

correlate strongly and positively with economic growth.15

Research using panel data aces concerns about data quality and

statistical methodology. As Harvards Dani Rodrik underscores, mor analyzing cross-sectional time series data are ill-suited to add

undamental questions about the relationship o government po

and inequality with growth outcomes.16 For this, we need to und

the mechanisms through which inequality and the strength o th

dle class aect the economy, both in terms o economic stability

economic growth. This is the subject o the main pages o this rep

Inequality and growth: What have we learned?



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The relationship between a strong

middle class, the development

of human capital, a well-educatedcitizenry, and economic growth

Te economic lieraure is clear ha human capial is one o he mos imporan

acors driving economic growh, primarily hrough is efecs on produciviy and

innovaion. Empirical evidence rom mulicounry analyses rouinely nds ha

human capial invesmen indicaors, such as he level o high school enrollmen,

are a leading correlae o growh.

In a widely regarded 1992 sudy, Harvard Universiy economis Gregory Mankiw,

Universiy o Caliornia-Berkeley economis David Romer, and Brown Universiy

economis David Weil ound ha human capial invesmen had a roughly

equivalen or larger efec on economic growh raes han did invesmen in physi-

cal capial.17 Consisen wih his, Harvard economis Rober Barro and Korea

Universiy economis Jong-Wha Lee ound ha among he developed naions

in he Organisaion or Economic Co-operaion and Developmen, he posiive

efec o human capial on economic growh was hree imes larger han he efec

or physical invesmen, concluding ha human capial, paricularly atained

hrough educaion, is crucial o economic progress.18

A well-educaed populaion is criical o U.S. compeiiveness. Economiss have

long argued ha he Unied Saes has hisorically had a srong economy because

he populaion is highly educaed relaive o oher naions, because individuals

have been able o mach heir skills and alens o opporuniies, and because we

have culivaedand prizedinnovaors.19 Harvard economiss Claudia Goldin

and Lawrence Kaz observe ha U.S. college graduaion raes increased dramai-

cally hroughou he rs hal o he 20h cenury bu have sagnaed since he1950s.20 Ye McKinsey Consuling Group researchers conclude ha gaps in access

o educaion are seriously huring he Unied Saes:


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10 Center or American Progress |The Amer ican Middle Cl ass , Incom e Inequali ty, and the Strength o Our Economy

I he Unied Saes had in recen years closed he gap beween is educaional

achievemen levels and hose o beter-perorming naions such as Finland and

Korea, GDP in 2008 could have been $1.3 rillion o $2.3 rillion higher. Tis

represens 9 o 16 percen o GDP.21

So wha does economics ell us abou how individuals build up human capial andhow hey use i? And wha role does he level o inequaliy and he srengh o he

middle class play in his process?

Firs, rising inequaliy has indeed been associaed wih slower growh in educaional

atainmen overall and increasing dispariies in access o human capial. Tere is a

growing body o research ha shows ha where a amily sis on he income specrum

afecs a childs abiliy o access and make use o human capial, and ha his sars

long beore kindergaren and ollows children hroughou heir academic careers.

Te reasons why rising inequaliy and a shrinking middle class afec educaionaloucomes include he realiy ha srapped middle- and lower-class amilies do

no have he same ime or resources o inves in heir childrens human capial.

Furher, sruggling middle-class amilies may be orced ino hinking in erms

o shorer nancial ime horizons and making choices beween wage work and

unpaid caring work a home. Making an invesmen in educaion requires no only

he resources bu also he abiliy o cope wih he long ime horizon o saying in

school and building skills unil he invesmen pays of.

Second, heighened inequaliy also has been associaed wih an increasing en-

dency or human capial and a higher income o be passed down wihin amilies,

which means ha individuals are being rewarded or who heir parens are, no

heir produciviy characerisics or efor. Tis reduces he incenives or hose

rom non-elie backgrounds o accumulae human capial and provide high

efor. o he exen ha income inequaliy and a weak middle class are leading o

decreased economic mobiliy, his provides evidence ha here may be a serious

underuilizaion o alen due o he growing educaion gap beween low-income

and high-income children. I is clearly a problem i childrens uures, and heir

abiliy o conribue o he economy, are being decided by heir parens economic

saus insead o he naural alens.

Tird, he conribuion o human capial o growh is no only abou access o

educaion, however. People wih educaion mus be able o make use o hose

skills, maching alen o appropriae occupaions. Inequaliy or a weak middle

Making an

investment in

education requi

not only the

resources but al

the ability to co

with the long tim

horizon o stayin

in school and

building skills u

the investment

pays o.


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class can mean ha workers do no have he securiy o make career or even job

swiches ha may be beter maches. Inequaliy can reduce worker moivaion and

psychological well-being, reducing produciviy. Managemen pracices ha sup-

por inequaliy or seek o weaken he middle class can erode social rus, which

can reduce on-he-job produciviy.

Limiing access o educaion or economic opporuniy means ha sociey ails o

pu his alen o workand hus loses poenial economic growhha would

have been creaed i here were ruly equaliy o opporuniy. According o daa

rom he U.S. Deparmen o Educaion, 70 percen o high-scoring sudens rom

low-income backgrounds and 50 percen o high-scoring sudens rom middle-

income backgrounds do no pursue a college degree, compared o only a quarer

o high-scoring high-income sudens, indicaing a massive wase o human poen-

ial.22 Tis squandering o poenial is especially pernicious since high levels o

inequaliy in he Unied Saes have been associaed wih very high povery raes,

relaive o oher developed naions. Poor amilies in he Unied Saes ge inad-equae access o proper nuriion, healh, and educaion, all o which afec heir

lie chances as well as our naions overall produciviy and growh.

We now look more in-deph a he available evidence.

Rising inequality has been associated with slower growth in

educational attainment overall and increasing inequality in access

to human capital

Tere is empirical evidence ha income inequaliy limis childrens access o

human capial boh direcly rom heir parens, as well as hrough public educa-

ion insiuions. o produce children wih skills and human capial, parens have

o make invesmens in heir childs developmen and educaion and research-

ers are showing ha wha happens beore a child even eners school is criical o

uure educaional (and career) success.

Universiy o Chicago economis and Nobel Laureae Gary Becker heorized ha

amilies inves in children based on he expeced reurns o hese invesmens andha he reurns difer across he income disribuion. In Beckers ormulaion,

poorer amilies have incenives o have more children bu o inves less in child-

rearing and subsequen human capial ormaion, while richer amilies have incen-

ives o have ewer children bu o inves more in heir childrens human capial.


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Tis would mean ha as inequaliy rises and he middle class weakens in a given

sociey, here would be less invesmen in human capial overall.

Even i, however, amilies wan o inves in heir childrens educaion, nowih-

sanding Beckers poin, here are pracical limis on he abiliy o many o do so.

Educaion is expensive. Families have o pay or mos o he expenses o earlychildhood and possecondary educaion, and while kindergaren-hrough-12h-

grade educaion is osensibly ree, he qualiy varies remendously depending

on a amilys abiliy o live in a communiy wih good schools.23 Universiy o

Pennsylvania economis Flavio Cunha and Universiy o Chicago economis and

Nobel Laureae James Heckman have summarized hese ndings by saying, Te

bes documened marke ailure in he lie cycle o skill ormaion in conem-

porary American sociey is he inabiliy o children o buy heir parens or he

lieime resources ha parens provide.24

Ye many parens, especially single parens, and amilies where boh parens workare srapped in erms o ime and resources o inves in heir childrens human

capial. Furher, he public K-12 educaion sysem has inequaliy buil ino is

nancing srucure, so children who live in he riches neighborhoods atend he

bes-unded schools.

Mos low- and middle-income amilies do no have a ull-ime, say-a-home

paren and in many amilies, parens work nonradiional schedules, which mean

hey may no be able o be home when children are home rom school. Mohers

are now breadwinners or co-breadwinners (bringing home a leas a quarer o

he amilys earnings) in approximaely wo-hirds o amilies wih children.25

Tis increase in paid hours o work has occurred across he income disribuion.

Beween 1979 and 2000 annual combined hours o work or amilies wih chil-

dren increased by 18.4 percen or amilies in he second-lowes income quinile,

by 13 percen or amilies in he op income quinile, and by 15.8 percen or all

amilies.26 Te greaer hours a work have le amilies sruggling o cope wih care

issues, boh or children, he sick, and he elderly.

In addiion o more engagemen in paid employmen, low- and moderae-income

working parens oen sruggle wih conics beween inexible workplaces andheir care responsibiliies. Low- and moderae-income workers are less likely han

higher-paid workers o be ofered a exible schedule or o have access o job-

proeced, paid ime of or care giving. Tese workers are more likely o sruggle

wih nonradiional work-shis ha do no allow hem o be home in he evening


16/56


o go over homework,27 and jobs ha do no provide paid sick days ha hey can

use o care or sick children, which research shows speeds childrens recovery and,

in urn, means ha children can ge back ino school, ready o learn aser.28

Furher, low-income children may also be suck in heir own ime-bind. Low-

income children are more likely o need o work o help suppor heir amily or useheir ime o care or oher amily members while a paren works when a amily can-

no aford o purchase care. Even in he Unied Saes, or many children, working or

caring or a sibling while a paren is a work prevens hem rom atending o heir

sudies. Among amilies paricipaing in sae welare programs, increased reliance

on sibling care has been shown o hur adolescen schooling oucomes.29

Ye here is a large and growing body o evidence ha he qualiy o care or children

in he rs years o lie is criical or heir uure academic (and career) success. 30 A

series o new books rom he Russell Sage Foundaion documens he imporance o

income inequaliy on economic mobiliy, paying close o atenion o he preschoolyears. In a volume o he series edied by economiss Greg J. Duncan, Universiy

o Caliornia-Irvine, and Richard J. Murnane o Harvard, auhors Duncan and

Kaherine Magnuson, proessor a he School o Social Work a he Universiy o

WisconsinMadison, nd ha, on average, among kindergareners, children rom

low-income amilies exhibi weaker academic and atenion skills, as well as a higher

probabiliy o demonsraing anisocial behavior compared o children rom high-

income amilies. Tis disadvanage ha is seen among kindergareners is correlaed

wih uure academic success or hese children. Duncan and Magnuson conclude

ha his patern suggess ha diferences in early skills and behaviors relaed o am-

ily income may be imporan mechanisms hrough which socioeconomic saus is

ransmited rom one generaion o he nex.31

In a separae sudy, researchers a he Brookings Insiuion are racking wha hey

erm he social genome, mapping when and how children drop of he pah o

higher educaion. Tey have idenied, among oher hings, ha being born ino

a nonpoor, wo-paren amily; being ready or school a age 5; and masering core

academic and social skills by age 11 are all acors ha predic a childs even-

ual economic success.32 Tese benchmarks idenied by Brookings economis

Isabelle Sawhill and her colleagues are highly correlaed wih parenal involvemenand qualiy o child care, especially in he preschool years.

Geting children ino high-qualiy early childhood educaion maters or heir

evenual educaional success. James Heckman, Nobel laureae and Universiy o

Perhaps most

stunningly, ther

evidence that lo

income children

who demonstra

aptitude or

postsecondary

education do

not have the

same access as

children rom

higher-income

backgrounds.


17/56


Chicago economis, has researched he efecs o inensive pre-educaion pilo

programs on low-income children hrough adulhood and nds ha children who

paricipae in hese programs do beter in school, are more likely o graduae and

atend college, and are less likely o smoke, use drugs, be on welare, or become

eenage mohers.33 Similarly, research conduced by he Naional Insiue o

Child Healh and Human Developmen Early Childcare Research Nework ndsha he qualiy o early child care was he mos consisen predicor o young

childrens behavior.34 Oher research also shows ha children who receive high-

qualiy child care have beter developmenal oucomes in early childhood, includ-

ing beter cogniive, language, and communicaion developmen, which, in urn,

promoes learning.35

Low- and moderae-income amilies are much less likely, however, o have access

o high-qualiy child care and preschool relaive o higher-income amilies. Te

Cener or American Progress, led by is Senior Economis Heaher Boushey (a

co-auhor o his repor), conduced a deailed analysis o he Survey o Incomeand Program Paricipaion, based on daa rom he lae 2000s, nding ha (all

values are in March 2009 dollars):

Low-income amilies pay around $2,300 a year per child or child care or chil-

dren under age 6, or abou 14 percen o heir income.

Middle-income amilies pan an average o $3,500 a year, or 6 percen o 9 per-

cen o heir income.

Upper-income proessional amilies pay abou $4,800 a year, or jus 3 percen o

7 percen o heir income.

While low-income children may be eligible or subsidies, copaymens can sill

be airly high as a percenage o income and waiing liss are long and growing.36

Furher, lower-income amilies are more likely han high-income ones o rely on

inormal raher han ormal care, which may no be as educaionally enriching.37

According o a repor by he Naional Insiue or Early Educaion Research, only

40 percen o 3-year-old children rom low- and moderae-income amilies are

enrolled in pre-kindergaren, while 80 percen o 3-year-old children rom he opincome quinile are enrolled in pre-K.38

Tis shows ha wo levels o efec are a play. Firs, low-income amilies end o

use child care ha is less expensive and hereore likely o lower qualiy. Second,


18/56


even a a lower price poin, child care is a higher share o amily incomes a

lower income levels.

Inequaliy also afecs he opporuniies or qualiy K-12 educaion available o

children rom low- and middle-income amilies, and subsequen achievemen.

Alhough diferences in educaion oucomes have long been shown o vary byamily income levels, Sanord Universiy educaion researcher Sean Reardon

nds ha he achievemen gap beween high- and low-income groups is 30

percen o 40 percen larger oday han i was a generaion ago.39 Rising income

inequaliy is he main, hough no he only, culpri. Tis yawning achievemen gap

is presen when children rs ener kindergaren and persiss as children progress

hrough he educaional ranks.

Poliical scienis David Madland and his colleague Nick Bunker o he Cener or

American Progress ound ha U.S. saes wih a larger share o income going o

middle-class amilies exhibi higher achievemen in mahemaics on he NaionalAssessmen o Educaional Progress.40 Madland and Bunkers resul is due in par

o saes wih a sronger middle class providing more scal suppor or public

educaion (characerisic suppor or insiuions public goods invesmen, as

discussed below), bu also due o independen social acors relaed o he level o

inequaliy.41 Tis is consisen wih oher research, which nds ha counries wih

lower levels o economic inequaliy do beter academically han counries wih

greaer levels o economic inequaliy.42

Wha is rue or he Unied Saes seems o be rue or oher counries as well.

Economiss Ming Ming Chiu and Lawrence Khoo o he Chinese Universiy

o Hong Kong and he Ciy Universiy o Hong Kong, respecively, show ha

counries wih higher levels o inequaliy are worse in erms o es scores on

academic achievemen ess.43 Oakland Universiy sociologis Dennis Condron

nds ha counries wih lower Gini coeciens (more income equaliy) end o

score higher on he Organisaion or Economic Co-operaion and Developmens

sandardized Program or Inernaional Suden Assessmen, or PISA, ess.44

Furher, while low- and moderae-income amilies sruggle o nd he ime and

resources o inves in heir childrens educaion, high-income amilies are able okeep upping he invesmen. Privae uors, music or dance lessons, spors eams,

or college enrance exam preparaion classes are all more common among high-

income amilies who can aford such exras. Ten, once high-income children are

in high school or college, hey can aford o ake unpaid inernships, which are


19/56


increasingly he precursor o sable employmen.45 Tese exras up he ane or

low- and middle-income sudens who nd ha hey canno compee.

Tere is also evidence ha communiy or environmenal acors associaed wih

low-income saus may consrain childrens developmen. Universiy o Souhern

Caliornia economis and poliical scienis Manuel Pasor documens ha chil-dren o color in he Los Angeles Unied School Disric sufer rom exposure o

harmul air oxinsexposure ha is associaed wih relaively poor es scores.46

Perhaps mos sunningly, here is evidence ha low-income children who dem-

onsrae apiude or possecondary educaion do no have he same access as

children rom higher-income backgrounds. Te U.S. Deparmen o Educaion

repors ha he probabiliy ha a op-scoring low-income suden complees col-

lege is abou he same as he probabiliy ha a low-scoring high-income suden

does, while he probabiliy ha a op-scoring middle-income suden complees

college is abou as likely as amiddle-scoring high-income

suden.47 (see Figure 2)

Tere is also evidence ha

low- and moderae-income

childrens access o a college

educaion has allen relaive

o high-income childrens. A

new paper by wo Universiy o

Michigan economiss, Marha

Bailey and Susan Dynarski,

nds ha he racion o

children atending college has

risen markedly or children

rom high-income amilies, bu

ar less so or children rom low-

and moderae-income amilies.

While college compleion raes

or children in amilies in heop income quarile rose by

18 percenage poins beween

birh cohors born in 1961

FIGURE 2

College completion by income status and 8th grade test scores

A top-scoring, low-income student has about the same chance of completing collegeas a low-scoring, high-income student

Note: Low income is defined as the bottom 25%, middle income middle 50%, and high income is top 25%.

Source: Elise Gould, High-scoring, low-income students no more likely to complete college than low-scoring, rich s The Economic Policy Institute Blog, March 9, 2012, available at http://www.epi.org/blog/college-graduation-score

levels/. See also Mary Ann Fox, Brooke A. Connolly, and Thomas D. Snyder, "Youth Indicators 2005: Trends in the We

of American Youth," (Washington, DC: U.S. Department of Education, 2005).

3%7%

30%

8%

21%

51%

29%

47%

74%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Low Income Middle Income High Income

Percent completing college

Low score

Middle score

High score


20/56


1964 and 19791982, he share compleing college in all oher income groups

grew by less.48 (see Figure 3)

A key acor in access o

possecondary educaion

in he Unied Saes iscos, boh in erms o he

direc cos o school as

well as he opporuniy

cos o no working and

he abiliy o have he

kind o long ime horizon

o make an invesmen

in college. Te high

coss o college limi

access or poeniallycollege-bound children

rom low- and moderae-

income amilies. Furher,

when children rom

nonwealhy backgrounds

are able o atend college,

hey are more likely o have o ake ou loans.49 No all o hose poenial sudens

see aking on such deb as worhwhile even hough, on average, i is. Ohers, o

cover heir coss, have o work longer hours during he school year, which can

limi heir abiliy o concenrae on heir sudies or atend school ull ime.

Tis demonsraes he commimen among hese sudens o geting a degree. Bu

i also indicaes how he combinaion o rising college coss and he shi in he

composiion o suden aid oward loans raher han grans increases he relaive

cos burden or sudens rom lower-income backgrounds.

Heightened inequality has also been associated with an increasing

tendency for privileged access to human capital and higherincomes to be inherited

Tere is evidence ha higher inequaliy and a weak middle class are creaing a

negaive eedback loop in erms o access o educaion, which resrains developmen

Fraction completing college

FIGURE 3

Fraction of students completing college, by income quartile and birth year

The fraction of children from high-income families completing college has risen markedly, whilefraction of children from low- and moderate-income families has grown by much less

Source: Martha Bailey and Susan Dynarski, "Inequality in Postsecondary Education." In Greg Duncan and Richard Murnane, eds.,

Opportunity? (New York: Russell Sage, 2011), p. 120.

0.75

0.50

0.0

Lowest quartile 2nd quartile

Income quartile

3rd quartile Top qu

1979 to 1982 birth cohorts

1961 to 1964 birth cohorts

0.25

0.09

0.05 0.14

0.17

0.0.21

0.32

0.


21/56


o human capial and hereore limis economic growh over he long erm. Equaliy

o opporuniy is being diminished by he exisence o highly unequal economic

oucomes, which public educaional insiuions are increasingly no overcoming.

Increasingly, here is evidence ha ones amily o origin, raher han alen,

deermines access o human capial. Tis is conrary o American radiion and

values and dampens produciviy. In a sociey where access is based on herediy,alened individuals may no inves in heir human capial, as hey see ha only hose

who are well conneced are able o move up, or may be unable o aford or access he

kinds o opporuniies ha would make he mos o heir alen.

Te research described here nding ha poor educaional oucomes are closely

relaed o parenal income is consisen wih a growing body o lieraure ha

shows income inequaliy is associaed wih less social mobiliy. Bhashkar

Mazumder, a senior economis a he Chicago Federal Reserve, recenly summa-

rized he mos recen evidence on U.S. economic mobiliy:

Aer saying relaively sable or several decades, inergeneraional mobiliy

appears o have declined sharply a some poin beween 1980 and 1990, a

period in which boh income inequaliy and he economic reurns o educaion

rose sharply. Tis nding is also consisen wih heoreical models o inergen-

eraional mobiliy ha emphasize he role o human capial ormaion. Tere

is airly consisen evidence ha inergeneraional mobiliy has sayed roughly

consan since 1990 bu remains below he raes o mobiliy experienced om

1950 o 1980.50

Anoher way o looking a he connecion beween odays income inequaliy

and uure economic mobiliy is hrough wha has been called he Grea Gasby

Curve, developed by Otawa Universiy economis Miles Corak. In Figure 4 he

Gini coecien, which is higher he more unequal a counrys incomes are, is he

x-axis. On he y-axis is he inergeneraion earnings elasiciy, which measures how

imporan a parens earnings are o predicing heir childs uure earnings (in his

char, Proessor Corak only shows daa or ahers and sons). A smaller elasiciy

means ha ahers and sons earnings are less correlaed, which means here is

greaer economic mobiliy.51 Te curve shows ha counries wih higher income

inequaliy oday have less economic mobiliyha is, income is more highly cor-relaed across generaions in highly unequal counries.

Te Unied Saes is an oulier among developed naions in ha we have higher

inequaliy and, conrary o he myh, less social mobiliy. Tis char suggess ha

Equality o

opportunity is

being diminishe

by the existence

o highly unequ

economic

outcomes, whic

public educatio

institutions are

increasingly not

overcoming.


22/56


equaliy o opporuniy is undermined by high degrees o income inequaliy. In

oher words, an equal opporuniy sociey is no compaible or consisen wih a

highly unequal sociey.

I is imporan o noe ha here is

no solid empirical evidence show-ing ha he poor are poor because o

geneics. Tis was, or example, he

argumen o Charles Murray, ellow

a he American Enerprise Insiue,

and Richard Herrnsein, behavioral

economis a Harvard, in heir 1994

book, Te Bell Curve, which made he

argumen ha he poor in he Unied

Saes are poor because o low inel-

ligence, no because hey did no haveaccess o educaion or job opporu-

niies. Ta analysis was summarily

rebuted by a special askorce esab-

lished by he American Psychological

Associaions Board o Scienic

Afairs, which ound no evidence o

geneics deermining diferences in

inelligence beween groups.52

Talented individuals must be able to make use of their sk il ls

When New York Knicks poin guard Jeremy Lin walked ono he baskeball cour

in February 2012, he provided a much-needed produciviy boos o he eam. Lin

became he rs Naional Baskeball Associaion player o score a leas 20 poins

and have seven assiss in each o his rs ve sars. Te media quickly buzzed wih

quesions abou where he came rom and why i had aken so long o ideniy his

alen. Lin is he rs U.S.-born Asian American o sar or an NBA eam, and he

media quickly eased ou a sory o how racial bias had clouded he view o his al-en. Tis Harvard-educaed Asian American could be he mos producive poin

guard or he Knicks. Ye up unil ha day in February, he had no been able o

make he mos o his skills and hus he eams he played or had been less produc-

ive han hey could have been.

FIGURE 4

The Great Gatsby curve

An equal opportunity society is not compatible or consistent

with a highly unequal society

Source: Miles Corak (2012), "Inequality from Generation to Generation: The United States in Comparison," i

Rycroft (editor), The Economics of Inequality, Poverty, and Discrimination in the 21st Century, ABC-CLIO, fo

0.8

0.6

0.4

0.2

Denmark

NorwayFinland

Canada

AustraliaNew Zealand

Singapore

Argentin

Peru

China

United States

ItalyUnited Kingdom

Pakistan Switzerland

France

Spain

Germany

Sweden

Japan

C

20 30 40 50

Inequality (Gini coecient)

Intergeneration earnings elasticity


23/56


In mos cases he underuilizaion o alen by an employer or alen insucienly

nurured is no quie so obvious as i was in he case o Jeremy Lin. Bu i is a

revealing case sudy ha shows how boosing produciviy largely depends on

wheher a rmor socieycan make he mos o human skills and alen. Like

he Knicks, when he U.S. economy ails o make he mos o Americans human

capial poenial, perormance sufers. Even when individuals enjoy he opporu-niies o develop heir human capial, here are a number o poenial ways ha

inequaliy pressuresseen in an increasingly nancially sressed middle class

can inhibi he abiliy o people and o he economy as a whole. A secure middle

class, in conras, can creae an environmen ha acceleraes he produciviy o

individuals and he economy overall. So les review his dynamic briey.

Firs, high inequaliy and a weak middle class means ha many workers do no have

he securiy o make he bes career mach and may be so insecure as o no job

swich. For example, Massachusets Insiue o echnology economis Jonahan

Gruber has documened how access o healh insurance can creae job lock,whereby workers are less likely o change jobs or ear o no being able o access

healh insurance.53 o he exen ha middle-class jobs are associaed wih his kind

o bene, as he middle class is squeezed, his will lead o more o his kind o lock.

Second, inequaliy may also disor he kinds o elds ha sudens choose o

sudy in ways ha reduce long-erm produciviy. Te exremely high incomes

earned in he nancial secor, or example, have creaed a srong incenive or an

increasing share o he op sudens o ener ha eld, which means ha ewer

sudens are going ino oher occupaions.54 Tis may make sense or individual

sudens, bu or sociey overall i means ha he mos alened sudens are no

enering elds ha have a sronger, long-erm impac on economic growh, such

as basic science, engineering, educaion, public healh, and research and develop-

men.55 I inequaliy is aking he orm o nancial salaries rising disproporionae

o oher occupaions and he bes sudens choose nance, hen his will afec he

pah our economy akes in he years o come as we see ewer brigh minds ocus-

ing on, or example, medical or scienic breakhroughs.

Tird, here is a growing body o behavior research ha shows individuals end o

preer more equiable oucomes; i ha sense o airness is regularly violaed, i canreduce moivaion. Alhough people have a sophisicaed undersanding o wha

is air when i comes o assessing he causes o inequiy, here is a growing body

o experimenal research indicaing how high levels o income inequaliy can have

perverse incenives on peoples moivaion o work and inves.


24/56


In one sudy, or example, when universiy employees learned ha hey were paid

less han peers, heir job saisacion decreased and hey looked or anoher job.56 In

an experimen modeling a ournamen wih difering levels o payou or winners,

which he auhors argue is akin o varying levels o income inequaliy, researchers

ound ha ournamens wih he highes levels o inequaliy produced less oal ou-

pu han ournamens wih lower levels o inequaliy.57

Similarly, Purdue Universiyeconomiss imohy Cason and William Masers and Chapman Universiy econo-

mis Roman Sheremea have ound ha proporional prizes elici more enry and

more oal achievemen han he winner-ake-all ournamens.58

Whas more, economiss have ound ha rus in he workplace, which is osered

by less inequaliy, incenivizes workers o do heir bes and be more producive.59

Princeon economiss Alan Krueger and Alexandre Mas examined wheher a con-

enious srike and concessions or workers a Bridgesone/Firesones Decaur,

Illinois, plan reduced produciviy and conribued o he recall o ires a is

Firesone uni. Krueger and Mas nd ha when workers had o cooperae wihreplacemen workers during he srike, errors on he producion line increased.60

Tis runs couner o he argumen proposed by supply siders. ake ormer Bain

Capial managing direcor Edward Conards new book, Uninended Consequences:

Why Everyhing Youve Been old Abou he Economy Is Wrong. In i he argues ha

we need even higher income inequaliy o moivae workers. In an inerview or

TeNew York imes, Conard said:

When I look around, I see a world o unrealized opporuniies or improve-

mens, an abundance o alened people able o ake he risks necessary o make

improvemens bu a shorage o people and invesors willing o ake hose risks.

Ta doesn indicae o me ha risk akers, as a whole, are overpaid. Quie he

opposie. Te wealh concenraed a he op should be wice as large, he said.61

Ye researchers are nding ha his is no he case. No only does high income

inequaliy lead o disorions and reduced moivaion, bu here is also increasing

evidence ha equaliy o opporuniy is incompaible wih high income inequaliy.

Te underuilizaion o alen can have serious economic efecs. New workby Chicago Booh School economiss Chang-ai Hsieh and Erik Hurs and

Sanord Universiy economiss Charles Jones and Peer Klenow nds ha

beween 1960 and 2008, 16 percen o 20 percen o U.S. economic growh

was due o women and people o color enering proessional occupaions and

Economists hav

ound that trust

in the workplac

which is ostere

by less inequalit

incentivizes

workers to do th

best and be mo

productive.


25/56


making use o heir alen.62 Tus occupaional discriminaion no only hurs

women and minoriies bu also drags down he enire economy. Prior o he

increased labor orce paricipaion o women and people o color, he economy

sufered because alened women and minoriies were being prevened rom

making he mos o heir abiliies.

While his specic research ocused on exclusions by race and gender, he increas-

ingly limied access o low-income children o higher educaion will quie possibly

have similar efecs as here are clearly alened bu low-income children, who are

no atending college and presumably unable o make he mos o heir abiliies.

According o he McKinsey Consuling Group, he gaps in access o educaion

by income in he Unied Saes impose he economic equivalen o a permanen

naional recession.63 McKinsey researchers argue ha i he Unied Saes had

closed he educaional achievemen gap beween low-income sudens and he

res o he sudens in primary and secondary school, U.S. gross domesic produc

in 2008 would have been 3 percen o 5 percen higher.


26/56


A strong middle class provides

a strong and stable source

of demand

A key issue or any business is how hey can develop, produce, and sell a good or

service a a pro. I hey see opporuniies o pro by invesing in new ideas or

expanding heir business, hey will. A he mos basic level, rms will inves when

hey expec ha hey will have cusomers o buy he goods and services hey

produce a a price ha yields a bigger pro han alernaive uses o he invesmen

unds. A rm will no consider hiring more workers or expanding a producion

line unil hey see ha hey are likely o make money of o he invesmen. Simplypu, demand matershe consumpion o goods and services by households

leads businesses o inves, and business invesmen creaes employmen and

incomes or households. When demand is low, businesses will inves less (and

people may inves less in hemselves) and he produciviy gains and innovaion

his would generae will be los o ime.

Business owners undersand his argumen. Nick Hanauer, ounder o Seatle-

based venure capial rm Second Avenue Parners and original invesor in

Amazon.com, argues ha having a clear sense o demand rom a srong middle

class is how businesses receive signals regarding proable opporuniies o inves.

In a recenBloomberg Businessweek column, he explained how he decision o

inves is based on he belie in he abiliy o sell:

Te convenional wisdom ha he rich and businesses are our naions job creaors

is alse. [O]nly consumers can se in moion a viruous cycle ha allows com-

panies o survive and hrive and business owners o hire. An ordinary middle-class

consumer is ar more o a job creaor han I ever have been or ever will be.64

Bu here is a conrasing view ha demand is relaively unimporan or economicgrowh. Prior o he work o Briish economis John Maynard Keynes, many econo-

miss argued ha under normal circumsance, inadequae demand was no a possi-

biliy because supply creaes is own demand. Hence he key challenge was hough

o be how o incenivize capialiss o inves and produce, given ha demand would


27/56


auomaically ollow. Aer he conribuions o Keynes and he experience o he

Grea Depression, economiss came o undersand ha demand does no auomai-

cally adjus o supply, bu in ac an economy can have prolonged periods o inad-

equae demand ha causes unemploymen and underuilized capaciy.

Te recen economic crisis has brough o he oreron he realiy ha, in he ace olower demand, invesmen is no auomaically reurning o a level ha can susain

ull employmen. Tis has led economiss and policymakers o ocus heir atenion

on demand. Te heads o sae a he summi or he Group o 20 leading developed

and developing naions in Pitsburgh in 2009 concerned hemselves wih global

demand conracing a pace no seen since he 1930s and how bes o use public

demand o suppor privae demand and resore economic growh.65 Marin Feldsein,

Harvard economis and ormer chairman o Presiden Ronald Reagans Council

o Economic Advisers, wriing recenly on why Americas economic recovery had

salled, poined o problems wih demand: limis o deb- and income-consrained

consumer demand, and inadequae public demand rom scal simulus policies.66

One clear quesion ha has emerged is wheher he srengh o he middle class

and he level o inequaliy afec economic sabiliy hrough heir efecs on

aggregae demand. Many are now poining o he ac ha he Grea Depression

and he Grea Recession boh ollowed decades o rising inequaliy and increased

deb, and many are now quesioning wheher here is no a connecion beween

inequaliy and economic insabiliy.

Tis secion explores wha economic heory and evidence sugges abou how a

srong middle class and inequaliy afec aggregae demand. While invesmen

in equipmen and acories, innovaion, and peopleis he primary driver o

economic growh, as Nick Hanauer poined ou, businesses will only inves i hey

are conden ha hey will be able o sell heir producs a a pro. Ye amilies

will no be able o consume or make invesmens in hemselves and heir children

i hey have insucien incomes or are nancially insecure. In an increasingly

globalized economy, expors can drive demand, bu mos (86 percen) o he U.S.

economy comes no rom expors bu rom domesic demand.67

o be cerain, regulaion and axaion o he economys supply side inuenceinvesmen and growh. Bu hese are no he only acors o subsance, nor are

hey necessarily o primary imporance. Demand, disribuion, and he srengh

o he middle class mater, oo. And demand and he middle class may be more

imporan now han in he pas.


28/56


Tere are hree ways ha inequaliy and he srengh o he middle class afec

demand:

Diferen endencies o spendhe marginal propensiy o consumea varying

levels o income and wealh mean ha high inequaliy weakens aggregae demand.

Changes in he disribuion o incomeacross households, and beween pros

and worker wagesafec he sabiliy o aggregae demand.

Having a large middle-class marke creaes business synergies and spillovers

benecial o economic growh.

I a nancially sressed middle class and higher income inequaliy are associaed

wih middle-class amilies coping in ways ha increase economic ragiliy, hen

hese rends are ulimaely bad or economic growh. Economic insabiliy dis-

rups invesmen planning. Recessions, jobless recoveries, and nancial crises allreduce invesors opimism and condence while creaing more uncerainy ha

businesses will be able o sell heir producs and services. Tey also reduce bank-

ers condence and may make hem less likely o lend unds, especially o business

venures perceived o be more risky.

We now look a each o hese in urn.

The rich consume less of their income: Recent evidence

As he rich ge richer and he middle class is squeezed, his afecs wha and how

much people buy in he markeplace, which afecs economic growh. Legendary

Briish economis John Maynard Keynes argued ha rising incomes among hose a

he op o he income disribuion will afec he economy very diferenly han will

rising incomes a he botom o he income disribuion. He developed his idea ino

he concep o he marginal propensiy o consume, wriing in Te General Teory:

i is also obvious ha a higher absolue level o income will end, as a rule,

o widen he gap beween income and consumpion. For he saisacion o heimmediae primary needs o a man and his amily is usually a sronger moive

han he moives owards accumulaion, which only acquire eecive sway when a

margin o comor has been atained. Tese reasons will lead, as a rule o a greaer

proportion o income being saved as real income increases (bold in original).68

I a fnancially

stressed middle

class and highe

income inequal

are associated

with middle-cla

amilies coping

ways that increa

economic ragil

then these trend

are ultimately

bad or econom

growth.


29/56


Keynes argued, he sabiliy o he economic sysem essenially depends on his

rule prevailing in pracice.69 Te marginal propensiy o consume direcly afecs

he size o wha Keynes called he muliplier efec. Tis is he idea ha increased

spending, be i rom consumers, governmen, greaer expors, or invesmen, will

be amplied as i works is way hrough he economy. I addiional income goes

ino he hands o hose wih a high marginal propensiy o consume, hen hemuliplier or consumpion demand will be relaively larger; i addiional income

goes ino he hands o hose wih a lower marginal propensiy o consume, he

muliplier on consumpion demand will be relaively weaker. Arihmeically, hose

consuming less will save more, bu his does no necessarily mean ha savings will

auomaically ranslae o more invesmen as is someimes assumed.

Bu Universiy o Chicago economis and Nobel Laureae Milon Friedman

argued agains he proposiion ha obviously he rich will consume less o

heir income by hypohesizing ha rich households only appear o consume less

because hey seek o mainain a sable level o consumpion hroughou heir lives,despie unsable income levels.70 While i is well-esablished ha Keyness hypoh-

esis was rue ou o curren income, deermining he propensiy o consume ou o

lieime income urned ou o be more challenging. In he rs several decades o

ollow eiher economiss hypohesizing, researchers could no come o consensus

on he relaionship beween lieime income and saving raes.71

While he concep o lieime income is cerainly an imporan insigh, Friedmans

heory is clearly wrong a he exremes o he income disribuion. Low-income

amilies who say low income heir enire lives will spend all heir income o sur-

vive. We know, or example, ha hose wih a lieime o lower incomes are much

more likely o have inadequae savings o replace heir income in reiremen.72

Furher, he Unied Saes may now be in a siuaion where incomes a he op are

so high hao he exen i was ever rueFriedmans heory no longer applies

o he wealhies segmen o households. I is inconceivable ha hose a he op o

he U.S. income disribuion can consume all heir income, given ha, or exam-

ple, he op 0.1 percen o U.S. income earners had average incomes o $5 million

in 2010 and capured 10 percen o all U.S. income.73

wo recen economic papers conclude ha he rich appear o spend a lowerproporion o heir income han do oher amilies over a longer ime horizon.

Tis body o work poins in he direcion o here being imporan implicaions o

changes in he disribuion o income or demand.


30/56


Using longiudinal daa, Brookings Insiuion economis Karen E. Dynan,

Darmouh Universiy economis Jonahan Skinner, and Columbia School o

Business economis Sephen P. Zeldes developed a se o measures ha approxi-

mae permanen income., including educaion, pas and uure earnings, he

value o vehicles purchased, and ood consumpion. Tey measure how much

individuals have saved ou o heir permanen income and nd ha savings raesrange rom less han 5 percen or individuals in he botom 20 percen o he

income disribuion o more han 40 percen or hose in he op 5 percen.74

Signicanly, Dynan, Skinner, and Zeldes ound ha his relaionship was no due

o high-income enrepreneurs saving a a greaer rae han nonenrepreneurs as

he posiive correlaion beween income and saving rae remained even aer hey

resriced heir sample o nonenrepreneurs.

U.S. Census Bureau economis David S. Johnson, Norhwesern Universiy Kellogg

School o Managemen economis Jonahan A. Parker, and Nicholas S. Souleles,

economis a he Universiy o Pennsylvanias Wharon School o Business, usedhe random variaion in he iming o he 2001 ax rebaes o separae he efec o a

change in income rom oher acors ha afec spending decisions.75 Tey nd ha

households spen on average 20 percen o 40 percen o heir 2001 ax rebae on

nondurable goods wihin he rs hree monhs aer hey received heir check. Ye

low-income households and households wih ew liquid asses spen a signicanly

greaer share o heir rebaes han he ypical household. Tis suggess ha hese

households eiher expeced o have a higher income in he near uure, which is

less likely, or ha hey have a high propensiy o consume rom one-ime or highly

liquid unds. In similar analysis o he 2008 rebaes, he same auhors, wih Bureau o

Labor Saisics economis Rober McClelland, ound similar resuls, alhough he

liquidiy consrain ndings were no saisically signican.76

Declining social mobiliy, increasing income inequaliy, and he endency or

consumpion o all relaive o income all sugges mechanisms by which demand

could all and be less han ha needed o mainain ull employmen and maximize

economic growh.

Two countervail ing forces to decl ining consumption in the face ofslow income growth: More hours of work and more debt

Te quesion o how changes in he disribuion o income afeced he level and

composiion o demand may have been less apparen in recen years in he Unied


31/56


Saes because o he ways households responded o hese changes in income rends.

As inequaliy rose, consumpion should have declined.77 Ye as growh in low- and

middle-class incomes salled in recen decades, consumpion did no sall bu raher

oupaced wage and salary growh. In ac, real personal consumpion expendiures

as a share o GDP have grown rom 59 percen in 1952 o 70 percen in 2012. 78

Tis poses a conundrum: I he middle class is imporan or growh, bu slow

growh in middle-class incomes did no slow consumpion growh commensuraely,

hen does i really mater o consumpion i middle-class incomes do no rise?

Te answer is, Yes. I is wrong o look only a consumpion and conclude ha

slow income growh does no mater or overall economic growh. Over he pas

ew decades, individual amilies mainained consumpion growh in he ace o

slow income growh hrough increased labor supplyworking more hours and

more women enering he workorce ull imeand increased borrowing. While

boh were clearly viable shor-erm responses o amilies o slower income growh,boh have clear limis, which i appears have been reached. Furher, boh have

negaive efecs on economic growh and sabiliy.

Beween 1969 and 2010 he percen o women on U.S. payrolls increased rom

35.3 percen o 49.9 percen. Comparing he lae 1970s o 2010, among married-

couple amilies wihou a working wie, median amily income has no increased

a all in inaion-adjused dollars. Tus, among married couples, or he ypical

amily, income gains over he pas ew decades have been atribuable enirely

o he increased employmen o wives. As discussed a lengh above, he greaer

hours a work have le amilies sruggling o cope wih care issues, boh or chil-

dren and he sick and he elderly, eeding ino he produciviy concerns discussed

above and consraining he nex generaion rom receiving human capial inves-

mens criical o uure economic growh.79

As he middle class ailed o keep up wih he sandard hey experienced even in

he recen pas, amilies also urned o borrowing, which allowed oal consump-

ion o oupace oal growh in wage and salary income. Up unil he 1980s amily

deb was abou 60 percen o annual income.80 Bu as middle-class income growh

salled, he share o deb rose enormously, so much so ha deb was a whopping130 percen o income by December 2007, beore he Grea Recession.81

Deb rose airly evenly across he income disribuion, bu amilies a he low end

and middle o he income specrum were more likely o ge ino rouble being able

As middle-class

incomes began

alling, the share

o debt rose

enormously, so

much so that de

was a whopping

130 percent

o income by

December 2007

beore the Grea

Recession.


32/56


o repay heir debs.82 In heir bookTe wo-Income rap, Harvard Law School

proessor Elizabeh Warren and Amelia Warren yagi, chairman o Demos, a

New York-based hink ank, documen how indebedness rose among low- and

moderae-income amilies.83 Tey poin ou ha amilies were more oen ener-

ing bankrupcy due o a healh emergency or amily dissoluion. Families were no

overspending; hey were borrowing o make ends mee.

Deb also grew among he upper middle class due o wha economiss call he

Veblen goods efec, where consumers engage in a keeping-up-wih-he-Joneses

escalaion o consumpion.84 While his may ake he orm o amilies purchasing

oo many high-end sainless seel appliances ha hey really canno aford, here

are indicaions ha some o he ramped-up consumpion was due o produciviy

concerns. Cornell Universiy economis Rober Frank argues ha amilies higher

up he income disribuion were borrowing o mainain heir place in he upper

middle class hrough home purchases in neighborhoods wih he bes schools. As

Frank documens, he hours ha a median earner mus work each monh o earn heimplici ren or he median-priced house have more han doubled since 1970.85 As

hose a he op have shied he rame upwards, o ge ino he bes schools, upper-

class amilies increased heir borrowing or home purchases.86

Ta many amilies borrowed o live in he bes school disrics also brings he

middle class and growh sory back o produciviy and he imporance o access

o educaion, as discussed above. As home prices skyrockeed during he housing

bubble, many amilies aced a ough choice: Borrow beyond heir means or risk

living in a home in a lower-qualiy school disric, which would poenially lead o

lieime implicaions or heir childrens abiliy o move up he economic ladder.

Inequality and the stability of demand

Tere is an emerging body o economic research making he case ha higher

income inequaliy is associaed wih economic insabiliy. Inernaional

Moneary Fund economiss Andrew G. Berg and Jonahan D. Osry nd ha

counries wih more equal income disribuions end o have signicanly

longer growh spells.87

Inequaliy ouweighed oher acors in heir analysis ohe lengh o periods o posiive economic growh across 174 counries. Income

inequaliy was a sronger deerminan o he qualiy o economic growh han

many oher commonly sudied acors also included in heir model, including

exernal demand and price shocks, he iniial income o he counry (did i sar


33/56


ou very poor or wealhy?), he insiuional make-up o he counry, is open-

ness o rade, and is macroeconomic sabiliy.88

Economiss have been working o undersand why income inequaliy and eco-

nomic insabiliy are linked. Many argue ha indebedness associaed wih

inequaliy increases economic ragiliyis suscepibiliy o nancial crisis andgrowh disrupionespecially in ligh o he lack o income growh. Universiy

o Chicago Booh School o Business economis Raghuram Rajan makes his

argumen in he bookFaul Lines: How Hidden Fracures Sill Treaen he World

Economy.89 Rajan poins o rising inequaliy as a key aul line ha led o he eco-

nomic crisis precisely because i increased deb, mosly hrough morgages.

Inernaional Moneary Fund economiss Michael Kumho and Romain

Rancire poin ou ha rising income inequaliy and higher indebedness

occurred in he years leading up o boh he Grea Depression and he Grea

Recession.90 As described above, as middle-class incomes ailed o grow inrecen decades, amilies increasingly urned o borrowing o mainain consump-

ion. In he shor erm his sraegy was no desabilizing, bu in he long erm

i has been. A he same ime ha low-income and middle-class amilies saw

limied income growh, hose a he op o he income disribuion coninued

o see srong income and asse gains, which gave hem boh he wherewihal

and incenives o expand credi. Financial invesmens became relaively more

atracive as consumers needed addiional borrowing o keep up heir spending.

Tereore, on he one hand, hose wih money can earn more by lending i ou,

bu on he oher hand his booss purchasing power.

Economiss reer o his as an endogenous credi marke: As amilies saw heir

inaion-adjused incomes all or remain consan, hey urned o increased credi

o make up he diference in heir amily budges.91 As inequaliy grew and he

demand or credi increased, he credi supply also expanded, paricularly among

low-income households. In he U.S. conex, his was due mainly o hree impor-

an developmens: he sandardizaion o morgages and he inroducion o

morgage-backed securiies; nancial innovaions ha increased he credi supply;

and access o credi increased as nancial compeiion inensied.92

Kumho and Rancire develop an illusraive model o he muually reinorcing

rends o rising inequaliy and nancial insabiliy:


34/56


Whenas appears o have happened in he long run-up o boh criseshe

rich lend a large par o heir added income o he poor and middle class, and

when income inequaliy grows or several decades, hen deb-o-income raios

increase sucienly o raise he risk o a major crisis.93

Te idea ha hose wih money ocused on loaning i o hose wihou i is heconclusion o research conduced by Universiy o Caliornia-Berkeley economis

Ai Mian and Universiy o Chicago Booh School o Business economis Amir

Su. Teir research ound ha in he mid-2000s, zip codes wih high shares o

subprime morgages saw boh an unprecedened expansion in morgage credi

and sharply declining relaive (and in some cases absolue) income growh.94

Following a diferen, bu relaed, line o argumen, Universiy o exas-Ausin

economis James Galbraih argues in his new bookInequaliy and Insabiliy: A

Sudy o he World Economy Jus Beore he Grea Crisis ha increasing income

inequaliy is inexricably linked o he nancializaion o he economy, whichis isel desabilizing.95 Galbraih nds ha growh o nonwage income (capial

gains, sock opions realizaions) being paid ou o a very small number o people

is closely associaed wih he up-and-down movemen o he sock marke. Wih

increased volailiy in nancial markes and increased concenraion o nancial

wealh, capial owners ace increased incenives o acively rade in markes o

deend and expand capial income, magniying volailiy and divering atenions

rom making real, growh-enhancing invesmens in he producive economy.

Tus, as middle-class amilies aced more nancial sress and slowing or sagnaing

incomes over he pas several decades, hey adaped by increasing heir labor sup-

ply and borrowing more. I large numbers o amilies had no been able o urn o

hese kinds o sraegies, U.S. consumpion demand would have only grown in line

wih he earnings, slowing consumpion growh.

Composition of demand and economic growth

Tere is also a concern ha as income shis upward, he composiion o demand

changes in ways ha are derimenal o economic growh. As incomes in heUnied Saes increasingly go o hose a he very op o he income disribuion,

heir spending paterns may afec overall demand and hus producion.

A grea deal o middle-class spending, or example, is on educaion and healh,

which are invesmens in human capial. According o he Consumer Expendiure

As middle-class

amilies aced m

fnancial stress

and slowing or

stagnating inco

over the past

several decades

they adapted by

increasing their

labor supply an

borrowing more


35/56


Survey, middle-class amilies in he Unied Saes ypically spend abou 8 percen

o 10 percen o heir income on educaion and healh care.96 Likewise, a no-

insignican share o invesmen by he very well-of does no, in ac, conribue

o uure growh, such as he purchase o a mansion, ar purchases, and mos sock

purchases ha are no par o an iniial public ofering. Yale School o Managemen

economis William Goezmann and ilburg Universiy economiss Luc Renneboogand Chrisophe Spaenjers examined ar prices over he pas wo cenuries and ound

evidence ha higher income inequaliy leads o higher ar prices.97 Tese are oen

invesmens on which buyers anicipae uure capial gains, bu clearly do litle o

boos produciviy or innovaion or economic growh.

Te link beween income inequaliy, demand, and economic growh may also

be explained in par by unequal socieies devoing more o heir resources o

economic aciviies ha do no encourage economic growh. As inequaliy has

risen, so oo has demand or invesmen goods and labor ha, echnically speak-

ing, allocae resources away rom uses ha expand he economys producionpossibiliies. For example, Universiy o Massachusets-Boson economis Arjun

Jayadev and Sana Fe Insiue economis Samuel Bowles show ha more unequal

socieies devoe more resources o guard laboraciviies ha proec people

and propery and proec agains workers shirking wihin privae rms, bu are

unproducive in ha hey do no conribue o economic growhas well as o

equipmen and soware deployed or similar purposes.98 Jayadev and Bowles nd

ha since 1890, he guard labor porion o he U.S. economy has quadrupled rom

6 percen o oal labor o more han 26 percen by 2002.99


36/56


The middle class incubates

entrepreneurs

Enrepreneurship is a he hear o a capialis economy. Enrepreneurs ideniy

new ideas, develop hem, and bring hem o he markeplace. Vibran enrepre-

neurship means ha alen and new ideas are nding an oule, which helps oser

economic compeiiveness and growh.

While no all enrepreneurs are innovaors, many i

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The American Middle Class, Income Inequality, and the Strength of Our Economy

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