Friday, January 17, 2014

The Income Inequality Boogeyman: Compound Interest

We can’t seem to make it through a single opinion page or White House press conference without hearing about the terrible and destructive problem of income inequality.   Post after post, tweet after tweet, highlight the income gains achieved by the top 1% versus those gained or lost by other income percentiles. 

Today, Paul Krugman lectures us on “Why We Talk About the One Percent” noting that the top 1% achieved a 182.4% increase in their inflation adjusted income from 1979 to 2012.  A gain he infers as “spectacular.”  He also notes that the top 2-5% gained 51.9% over the same period, a gain he generalizes as “good.” 

For some much needed context, these figures equate to an annual, inflation-adjusted, growth rate of 3.2% for the top 1% and 1.3% for the next 4%.   These figures don’t strike us “spectacular”, nor would it suggest something evil or destructive.  After all, that income isn’t just buried in backyards; it’s spent and invested in the economy, providing new business with capital, creating jobs, etc.. 

These “spectacular” income gains are always provided as evidence of a problem – i.e. the incomes of the top 1% are growing faster than those of the next 4%, or more worrisome, the next 95%.  In a logic and information vacuum, that could seem like a reasonable problem - why do incomes at the top grow faster than those not at the top? 

However, we’d hope that Krugman, et al are not operating in a logic and information vacuum (although sometimes we wonder) and would answer one simple question:  

How much of the “income inequality problem” is a result of the simple compounding of interest? 

Those in the top 1% of incomes not only rely on their labor for income, but a large percentage of their income is likely to have been earned by large piles of cash.  These piles of cash dwarf anything seen in the lower percentile of earners.  Some of this cash is spent (i.e. income for someone else), but for the vast majority of 1%ers, this cash is deployed into the economy in the form of savings, stocks, bonds, property, new businesses, etc.  These investments generate interest, dividends and capital gain income, which in turn generates more cash, which in turn generates even more interest, dividends and capital gain income.  Rinse and repeat.  Over thirty years, compound interest is a very powerful force.  In fact, it’s said that Albert Einstein himself noted that “the most powerful force in the universe is compound interest.” 

Therefore, isn’t compound interest the most logical and innocuous explanation for why the top 1% have experienced “spectacular” income gains over the last 30 or so years?  Doesn’t this also explain why incomes of people with piles of money are growing faster than those with smaller or nonexistent piles money?

If so, is this really a problem?  Is there a need for a “solution”?  Do we ban compound interest?  For the last few years, the Feds actions have been trying just that with a Fed Funds rate of roughly zero.  Or should we just back an IRS semi up to the 1%’s houses and just start confiscating those piles of cash?  In many states we’re already half way there with combined federal and state tax rates above 50%. 

The focus should be on why incomes are flat for those outside the top 10%, and what policies and attitudes can be adopted to create income gains across the board.  Hint: denigrating or confiscating success does not create more success.  Bellowing about the “spectacular” income gains of the top 1%, or 5% or 10% over the last 30+ years generates clicks and populist outrage, but does nothing to help the flat (or falling) incomes of everyone else.  


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