First Principles September 2006

The Height of Inequality

America’s productivity gains have gone to giant salaries for just a few

This is (pretax) wage and salary income, not investment income. Many commentators attribute rising American inequality to growth in profits at the expense of salaries and wages. That’s wrong: labor’s share of national income does not seem to be trending up or down. What has changed is how much of labor’s share goes to top earners. Since the mid-1970s, and especially since the mid-1990s, the dramatic rise in the share of national income earned by the very rich is due not to the strength of their investment portfolios but to their growing share of labor income.

Productivity growth has always been seen as perhaps the single most important indicator of rising, broad-based prosperity. But remarkable growth in top-end pay, together with the relative constancy of labor’s overall share of income, has an obvious implication: the highest earners are now capturing most of the gain in national income caused by economy-wide productivity growth.

This is quite disturbing. Historically, rising productivity has been a tide that lifted nearly all boats. For more than twenty years during the long surge of productivity growth that followed the Second World War, median incomes in the United States rose as quickly as the highest incomes. This came to be regarded as normal—and, seen from a global vantage point, it still is. The dispersed benefits of high aggregate productivity are the reason why jobs of almost every kind pay better in rich countries than in poor ones.

Mechanics and hairdressers are paid far more in America than in Mexico, even though their individual productivity may not be that different in the two places; north of the border, workers share in the economy’s higher overall productivity. A lot depends on whether this continues to be true. It is the very point that the new findings call into question.

The study by Dew-Becker and Gordon asks, “Where Did the Productivity Growth Go?” Over the past thirty-five years, that growth did not lift most boats, or even very many boats. Between 1966 and 2001, only 10 percent of American workers saw their incomes rise at least as fast as economy-wide productivity did. More astonishing still, according to the study’s authors, from 1997 to 2001, the top 1 percent captured far more of the real national gain in wage and salary income than did the bottom 50 percent. And even within that highest percentile, the gains were heavily concentrated at the top.

Such extreme skewness is new. It suggests that a huge proportion of the economy’s productivity gains are neither being passed on to consumers through lower prices—which would have the effect of raising real incomes very broadly—nor being distributed to investors as profit, nor even being used to raise the wages of most employees in industries seeing rapid productivity growth. Rather, they’re being diverted to a comparative handful of employees.

Why is this happening? Nobody is sure, but Dew-Becker and Gordon suggest a combination of two things: for one small group, sports and media celebrities, income growth has come from a perfecting of the labor market; for a different group, top corporate executives, it has come from a breaking down (or even an overthrowing) of the market. Those two segments account for most of the 13,000 people in the 99.99th percentile—with total earnings of $83 billion in 2001.

A classic 1981 study by the late economist Sherwin Rosen worked out “The Economics of Superstars” and anticipated part of what has happened. The demand for stars in the sports and entertainment industries is such that small differences in talent cause disproportionate gaps in earnings. As technology puts stars in front of bigger audiences, their incomes multiply. Rosen could not have foreseen the media innovations of the past decade, but they have plainly given stars access to far more fans.

I find it interesting that there is no popular unease over the stupendous sums paid to Tiger Woods, or Eminem, or Tom Cruise. And, you might ask, why should there be? They are worth the price of the ticket, at least in the view of their audiences. If they are in demand worldwide, good luck to them. An economist would say the market is working.

The case of fat-cat chief executives arouses different feelings—as it should. In most cases, there is no audience- multiplication factor to account for the dramatic rise in CEO pay. If a Rosen-type process were at work, you would not expect to find that CEO pay had surged only in the United States (and to a lesser extent in Britain). Numerous widely reported cases of pay for no performance are also awkward to explain. When boards give big noncontractual severance packages to bosses fired for incompetence, you have to ask whether this second stratospheric zone of the labor market, unlike the superstar zone, is working properly.

Corporate-governance reforms that would help shareholders keep CEOs in check might do some good. If I’m skeptical, it’s partly because shareholders already have some (admittedly limited) powers, and they usually let things slide. That might change if CEO pay continues to rise. At some point, the subdued “outrage constraint” that some corporate- governance activists wish to revive might kick in again. That would be a good thing.

Perhaps the CEOs’ appetites can be curbed. Maybe the superstars will find that their audiences cannot widen without limit. And perhaps, if both those things happen, productivity growth will again raise incomes broadly, as it once did, and as it is supposed to. If not, how much longer before the dwarves get restless?

Clive Crook is a senior editor of The Atlantic.
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