June 8, 2015

Here’s What’s Driving Inequality

Scott Sumner

Ralph G. Hawtrey Chair of Monetary Policy

Kevin Erdmann

Summary

Why are wealth and income inequality increasing? Why is labor, relative to capital, commanding a declining share of national income? These have become the central questions in the economics profession, and they’re increasingly central to our political debates as well.

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Why are wealth and income inequality increasing? Why is labor, relative to capital, commanding a declining share of national income? These have become the central questions in the economics profession, and they’re increasingly central to our political debates as well. Much of the discussion seems to suggest that there is some sort of mystery to be explained. Perhaps corporations are getting better at lobbying in Washington. Or maybe there has been a cultural change that makes CEOs bolder in demanding high pay. 

We find those sorts of explanations to be unsatisfactory. Once we consider recent structural changes in the economy, there may not be much left to explain. Here are three key factors: first, obstacles to building and subsidies to homeowners, which raise rents in residential real estate; second, the increasing complexity of regulation, which imposes burdens on smaller firms and discourages new entry; and third, the growing importance of intellectual property. 

In all three cases, government regulation has probably contributed to inequality.  

Why Are Housing Rents So High? 

Until recently, economists tended to assume that the labor share of national income in the U.S. was fairly stable, as labor had earned about 50 to 59 percent of GDP since the Bureau of Economic Analysis began tracking the data in 1929. Given that the economy has grown by nearly 500 percent over that time (in real terms, per capita), most economists thought that long-run economic growth was far more important than distributional issues. In the last few decades, however, the labor share has dropped modestly, while the share of national income going to capital has increased. 

Last year a French economist named Thomas Piketty created a sensation in the world of economics with a major historical study of capital and wealth inequality. Piketty argued that the recent slowdown in economic growth was likely to lead to even greater concentrations of wealth at the very top. More recently, an MIT graduate student named Matthew Rognlie took a closer look at Piketty’s data and found that almost the entire change in the share of domestic income going to capital in major developed economies was explained by rising rents on residential real estate. Non-rental capital income (including the corporate sector) still has a fairly stable share of domestic income. 

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