Why Rich Are Getting Richer, And How Poor Can Catch Up

by Kathryn Shelton and Richard McKenzie

Source: Investor’s Business Daily

President Barack Obama has tagged the growing inequality of income over the past three or four decades as "the defining challenge of our time," an often-repeated claim recently echoed by economist Thomas Piketty in "Capital in the Twenty-First Century."

Numerous social and economic factors explain why the income and wealth gaps have grown, from the rise in family breakdown, to the incentives embedded in government welfare programs, to growth in executive control over their own compensation.

However, there are reasons for the gaps that have gone largely, if not completely, unrecognized. These explanations make the relative growth in the income (and wealth) of the rich practically inevitable — at least as officially measured.

Much of the income inequality debate in the United States has focused on "fifths," "tenths" or "the top 1 percent" of households. Such divisions give the appearance of inequality, but there are far more people and workers in the top income brackets than in the lower ones.

Further, people in different income divisions do not remain at those income levels throughout their lives.  The Federal Reserve Bank of San Francisco found that absolute mobility remains high. For example, of all U.S. adults, 67% had higher incomes than their parents; and among those born into the lowest income bracket, 83% exceeded their parents' income.

The success of people at the bottom of the income distribution can increase the growth in inequality, because their newfound success does not improve the average incomes of the lower income brackets they left behind; rather, their economic gains are treated as gains to the higher income and wealth brackets they reach.

An analysis of portfolio investment over time reveals an unheralded reason the "rich" have become richer absolutely and relative to the "poor." The top 1% of households hold over a third of the country's total wealth, while the bottom two quintiles hold a fraction of that wealth.

As such, the rich are able to develop and maintain highly diversified portfolios of investments, including stocks, bonds, derivatives, insurance, precious metals, degrees, multiple homes and other real estate holdings. Because the rich can diversify their portfolios more so than the poor, the rich can assume more risks that can increase their rates of returns.

Moreover, pundits often fail to appreciate the direct and indirect ties between the Federal Reserve's monetary policy and the distribution of wealth and income.

When the Great Recession emerged with force in 2007, the Federal Reserve pushed down interest rates.  The drop in interest rates negatively affected many low-income people who relied on a small amount of interest income earned from bank savings accounts.

At the same time, the Fed padded the pockets of firms deemed "too big to fail," giving the privileged firms a form of government-backed insurance for their future profit streams.

As the Fed has pushed interest rates down, it has increased the present discounted value of firms' profit streams — a major force behind the two-and-a-half-fold increase in the Dow Jones Index since 2008. As a consequence, the wealth of rich people has escalated over the last several years.

Finally, family breakdown is a large contributor to poverty. Households in the top income brackets are far more likely than those at the bottom to be married and have children after marriage. Researchers believe these trends in family structure could explain over two-fifths of the change in income inequality from 1976 to 2000.

Instead of imposing draconian wealth taxes, as proposed by Piketty, which can undercut growth in income-producing jobs, policymakers should begin with major strategies to improve economic opportunities for the poor.

In the main, this means improving dreadful schools in many low-income neighborhoods. It also means insisting that more students in those schools understand that their "ticket" out of their economic standing requires them to stay in school and, with the help of their parents, to hit their books for longer hours — a well-worn path for their increasing the diversity of their 'portfolios' of job opportunities."

• Shelton is a research associate at the O'Neil Center at Southern Methodist University.

• McKenzie is an NCPA senior fellow at the National Center for Policy Analysis and economics professor emeritus in the Merage Business School at the University of California, Irvine.