Fighting inequality is key to preparing for the next recession
The failure to make a serious dent in high levels of economic inequality in recent years will make responding effectively to the next inevitable recession more difficult, both economically and politically.
Rising income and wealth inequality, combined with financial deregulation and the expanding financialization of the U.S. economy, led to the credit boom and crash that substantially deepened the resulting economic crisis in 2008. Fiscal stimulus during the Great Recession prevented the economy from collapsing completely but was still insufficient and phased out too soon. What’s more, instead of taking lessons from our experiences a decade ago and strengthening our recession-fighting tools, recent policies passed by Congress have focused on cutting taxes, reduced the perceived space we have to increase spending in a downturn and exacerbated income and wealth disparities in the United States.
First, let’s zoom out. Recessions aren’t just one-offs. They are part of the economic cycle. Aggregate demand in the economy expands and contracts over time and recessions occur during prolonged contractions, which are more likely when economic inequality distorts consumption and savings. Inequality also affects the time it takes to recover from recessions because it subverts our institutions and makes our political system ineffective. Lifting the economy out of a downturn requires decisive government action to boost spending and aggregate demand, which often runs counter to the primary interests of those with economic and political power. As entrenched interests continually hamstring the government’s capacity to respond to a recession, policymakers should act now to prepare for the next one by addressing inequality in the United States.
Inequality makes recessions more likely
The U.S. economy is amid what will be the longest recovery in history if it lasts past June 2019. While no one can predict the next recession, it will happen. And, evidence from around the world indicates that our high inequality makes that even more likely.
Economists are examining how higher inequality is associated with slower income gains among those lower down the income and wealth ladder.1 The question has been most prominently explored by Jonathan Ostry and a group of his colleagues at the International Monetary Fund. In a book released early in 2019, Ostry and fellow IMF economists Prakash Loungani and Andrew Berg showed that inequality was associated with more frequent economic downturns.2 Growth may happen, but if inequality is high then the economic gains are more likely to be destroyed by the recession—or depression—that follows, with the economic pain all-too-often compounded for those at the lower end of the income spectrum.
These findings represent a radical shift for researchers at the IMF and their longstanding view on a trade-off between growth and equity. While many economists had asked the question about the role of inequality in the last global economic crisis, the IMF’s research team provided the answer first seen widely to be credible. They conclude: “[Looking at a] diversity of experiences and empirical analysis suggest that there is no systematic adverse trade-off between increasing growth and decreasing inequality.”3
They aren’t the only ones. When Moody’s Analytics’ chief economist Mark Zandi integrated inequality into the Moodys.com macroeconomic forecasting model for the United States, he found that adding inequality to the traditional models—ones that do not take into account economic inequality at all—did not change the short-term forecasts very much. But when he looked at the long-term picture or considered the potential for the system to spin out of control, he concluded that higher inequality increases the likelihood of instability in the financial system.4
One pathway through which inequality contributes to economic fragility consists in the way it increases the supply of credit. There’s strong evidence that the financial deregulation of the early 2000s led to a rise in the availability of credit. Lenders became less risk-adverse as the consequences of debt were passed on to others—investors and families—and lending standards fell sharply. Many people left out of the gains from economic growth turned to borrowing more to make up for that lost income. As the 2008 crisis demonstrated, a rise in the credit supply makes economic crises more likely, especially when combined with looser regulations and political power conferred on the financial industry.5
In the United States, inequality fuels long-term stagnation
Recessions are bad—and so is long-term economic stagnation. Inequality distorts and reduces total consumption while at the same time increasing the stock of savings. The combination of lots of savings but too few attractive opportunities for profitable investments creates a long-term trajectory of slow growth. This is not a short-term problem; it’s a medium- to long-term one tied to a well-documented decades-long lack of income growth for the bottom half of the income distribution. The term economists use to describe this combination of trends is “secular stagnation,” an especially fragile state when not in a recession.
On the consumption side, we know from research that as income and wealth inequality rise, less money makes its way through the economy as income that turns into consumption, which implies that there’s less overall consumer demand. A 2004 paper by economists Karen Dynan at Harvard University, Jonathan Skinner at Dartmouth University, and Stephen P. Zeldes at the Columbia Business School shows that while Americans on average spend about 80 cents of every dollar they earn and save about 20 cents, this varies widely depending on age and whether a household is rich or poor. The very richest households—the top 1 percent—spend only 51 percent of their income, while those in the bottom 20 percent spend 99 percent.6
Inequality also creates more savings for the simple reason that the rich—who have become much richer—save more because they have more. Recent data compiled by University of California, Berkeley economists Emmanuel Saez and Gabriel Zucman show that savings rates among the wealthiest one percent of households is 40 percent. Given that the incomes of the top one percent increased by about $19,000 annually since 1980, on average, this means an additional $7,600 in savings per family each year—more than offsetting the decline in savings rates for the bottom 90 percent.7
High corporate profits also contribute to high savings. Corporate profits, which recovered quickly toward the end of the Great Recession and stayed high, resulting in disproportionate income gains from financial investments for wealthy households. There also is accumulating evidence that the way U.S. corporations are structured and financed is encouraging them to pay out profits in dividends or share repurchases rather than reinvest them in the firms. Publicly traded firms face intense pressure to make short-term gains and pursue fewer investment opportunities.8 In sum, corporate profits aren’t financing productive investments to the wide extent that they could but instead are largely ending up in the hands of wealthy investors who save their returns.
In the simplistic story, as long as there’s money available to invest—that is, sufficient savings—and not too much regulation, then investment will happen. Yet the evidence shows the story isn’t so simple. Even with the rise in wealth and savings, U.S. investment has remained stagnant. In 2018, private residential investment hovered just below 4 percent of gross domestic product, which is at the low end of the historical range of between 4 percent and 6 percent.9 This is even though we have relatively low interest rates.
It’s just as the late British economist John Maynard Keynes predicted. He argued that high inequality would lead to the perverse outcome of having more savings available for investment but less incentive to invest: “Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate.”10
Inequality also makes finding the political will to solve these distortions more challenging
These problems are not intractable from an economic standpoint, but our politics isn’t cooperating. For a bit of recent history, look no further than the American Recovery and Reinvestment Act of 2009. The legislation did not receive a single vote from Republican members of the House of Representatives and got support from only three Republican senators, one of whom switched to the Democratic Party later in the year.11 The addition of supply-side policy inducements in the form of tax breaks for new business investment not only failed to win additional Republicans over, but also meant the legislation wasn’t as well-targeted at the consumption side of the economy as many would have liked. Less than 40 percent of the stimulus measures went to Medicaid, unemployment insurance, nutrition assistance, and refundable tax credits—programs explicitly targeted to families most likely to spend additional income quickly.12
Instead of strengthening and supplementing the Recovery Act, which many economists at the time concluded would not be sufficient, the federal government by 2011 had tacked toward austerity and mostly phased out additional spending on the programs targeted at those at the low end of the income spectrum, exacerbating economic trends in the states. The downward shift in the nation’s path was a preventable policy tragedy.
Today, we’re moving in the wrong direction. The Tax Cuts and Jobs Act of 2017 is exhibit A. The legislation largely benefits the wealthy: The Tax Policy Center estimated that after-tax income in 2018 would rise by 2.9 percent for the top quintile and 3.4 percent for the top 1 percent, compared to 0.4 percent for the lowest quintile.13 Though it’s too early to know the tax cuts’ long-term effect on investment, the dominant response from corporations so far has been a bump in stock buybacks, not capital spending. In 2018, companies in the S&P 500 spent more than $800 billion to repurchase their own stock, up 55 percent from 2017.14 Private nonresidential fixed investment rose by just 6.9 percent over the same period.15 If the costs of the tax cuts—estimated at $1.9 trillion over ten years—prompt spending cuts reflected in President Trump’s proposed 2020 budget request, then poorer Americans will lose out and our economy will be left even weaker.16
One once-promising development following the Great Recession was the move to rein in the financial services industry and establish the Consumer Financial Protection Bureau to regulate financial products, under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Yet, less than a decade since the crisis, a more conservative Congress began to dismantle Dodd-Frank, requiring fewer and fewer financial institutions to adhere to the law’s supervisory rules and regulations, and gradually stripping the CFPB of its authority and funding. The disproportionate political power of financial institutions and other wealthy stakeholders means policymakers are loosening regulations and undermining consumer protections—at a time when they should instead focus on ensuring that the financial services industry supports sustainable and productive investment.
The way forward
Not addressing economic inequality before the next recession would be foolhardy. But what are the best ways to do so? Focus first on ensuring there is ample government revenue to pump-prime the economy by taxing wealth (not just income). And the bonus is this—we’ll have all the money we need for automatic stabilizers such as expanded unemployment insurance, family income supports, and more targeted supplemental nutrition assistance.
The top marginal U.S. income tax rate is now less than half what it was in the mid-20th century. This sharp drop has allowed individuals at the top to amass wealth and power far beyond what previous generations of wealthy Americans could. Nobel laureate economist Peter Diamond and UC-Berkeley economist Emmanuel Saez note that if the United States had approximately doubled the tax burden on the top 1 percent of income earners in 2007, that “would still leave the after-tax income share of the top percentile more than twice as high as in 1970.”17 Policymakers have lots of room to raise taxes at the top of the income ladder and, indeed, doing so might have economic benefits beyond the extra revenues it would raise.
Given the top one percent controls over 40 percent of U.S. wealth, policymakers should focus on how to increase taxes on wealth and ensure maximum compliance. Doing so would also help to close the persistent racial wealth gap in the country, where the median white family owns ten times as much wealth as the median black family. In a report for the Washington Center for Equitable Growth, New York University legal scholar David Kamin lays out a number of possible avenues to change how we tax capital.
First, while the tax system imposes taxes on capital gains on property, they are too often easy to limit or avoid entirely. Policymakers should fix this through changing how we determine capital gains and when we tax them—such as by moving to so called mark-to-market taxation of investments. Second, policymakers should make it harder for corporations to avoid taxation by shifting income across international borders by moving to either a destination-based system or imposing a minimum tax (higher than the one imposed in the Tax Cuts and Jobs Act of 2017). And, third, we should impose a net worth tax on very wealthy individuals.18
Our failure to address economic inequality since the end of the last recession distorted our macroeconomy in ways that exacerbate recessions—and made them more likely—while subverting our political process in ways that make solving this problem more difficult. Policymakers must act now to reduce inequality and to ensure we have the adequate fiscal infrastructure in place to fight the next recession swiftly and effectively when it hits.
1. For a brief review of this literature, see: Heather Boushey and Carter C. Price, “How Are Economic Inequality and Growth Connected? A Review of Recent Research” (Washington, DC: Washington Center for Equitable Growth, October 2014), http://equitablegrowth.ms.techprogress.org/?post_type=work&p=6900&preview=true.
2. Jonathan D. Ostry, Prakash Loungani, and Andrew Berg Foreword by Joseph E. Stiglitz, Confronting Inequality: How Societies Can Choose Inclusive Growth (Columbia University Press, 2019).
3. International Monetary Fund.
4. Mark Zandi, “What Does Rising Inequality Mean for the Macroeconomy?,” in After Piketty: The Agenda for Economics and Inequality, ed. Heather Boushey, J. Bradford DeLong, and Marshall Steinbaum (Harvard University Press, 2017).
5. See Atif Mian and Amir Sufi, House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again (Chicago, IL; London, UK: University Of Chicago Press, 2014).
6. Karen E. Dynan, Jonathan Skinner, and Stephen P. Zeldes, “Do the Rich Save More?,” Journal of Political Economy 112, no. 2 (April 2004): 397–444, https://doi.org/10.1086/381475.
7. Emmanuel Saez and Gabriel Zucman, “Wealth Inequality in the United States since 1913: Evidence from Capitalized Income Tax Data,” The Quarterly Journal of Economics 131, no. 2 (May 2016): 563, https://doi.org/10.1093/qje/qjw004.
8. John Asker, Joan Farre-Mensa, and Alexander Ljungqvist, “Corporate Investment and Stock Market Listing: A Puzzle?,” Review of Financial Studies 28, no. 2 (February 2015): 342–90, https://doi.org/10.1093/rfs/hhu077. Incentives to reinvest and innovate also drop with greater monopoly power; see Thomas Philippon, The Great Reversal: How America’s Markets Lost Their Competitive Edge (Harvard University Press, Forthcoming).
9. U.S. Bureau of Economic Analysis, “Private Residential Fixed Investment,” FRED, Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/PRFI; U.S. Bureau of Economic Analysis, “Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment,” FRED, Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/Y033RC1Q027SBEA.
10. John Maynard Keynes, The General Theory of Employment, Interest, and Money (New York: Harcourt Brace Jovanovich, 1953), 28.
11. “U.S. Senate Roll Call Votes 111th Congress – 1st Session (Motion to Waive Sec. 201 of S. Con. Res. 21, 110th Congress Re: Amdt. No. 570 ),” February 10, 2009, 111, https://www.senate.gov/legislative/LIS/roll_call_lists/roll_call_vote_cfm.cfm?congress=111&session=1&vote=00060.
12. Congressional Budget Office, “Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output in 2014,” February 2015, https://www.cbo.gov/publication/49958.
13. Tax Policy Center, “Distributional Analysis of the Conference Agreement for the Tax Cuts and Jobs Act” (Urban Institute and Brookings Institution Tax Policy Center, December 18, 2017), https://www.taxpolicycenter.org/publications/distributional-analysis-conference-agreement-tax-cuts-and-jobs-act/full.
14. Kate Rooney, “Share Buybacks Soar to Record $806 Billion, Bigger than a Facebook,” CNBC, March 25, 2019, https://www.cnbc.com/2019/03/25/share-buybacks-soar-to-a-record-topping-800-billion-bigger-than-a-facebook-or-exxon-mobil.html.
15. Bureau of Economic Analysis, “Table 1.1.1. Percent Change From Preceding Period in Real Gross Domestic Product: National Income and Product Accounts,” April 26, 2019, 1, https://apps.bea.gov/iTable/index_nipa.cfm.
16. Congressional Budget Office, “The Budget and Economic Outlook: 2018 to 2028” (Washington, D.C.: Congressional Budget Office, April 2018), https://www.cbo.gov/publication/53651.
17. Peter Diamond and Emmanuel Saez, “The Case for a Progressive Tax: From Basic Research to Policy Recommendations,” Journal of Economic Perspectives 25, no. 4 (December 2011): 167, https://doi.org/10.1257/jep.25.4.165.
18. David Kamin, “Taxing Capital: Paths to a Fairer and Broader U.S. Tax System” (Washington D.C.: Washington Center for Equitable Growth, August 2016).