Thursday, January 15, 2015

What's Fair? Perceptions and Realities of Income Inequality

In 2012 the median income for CEO's at S&P 500 companies was $11,952,669 and $8,124,542 for those at Russell 1000 businesses (Governance Metrics International, 2013). These figures are total compensation, including base salary, bonuses, vested stock options, company contributions to retirement accounts, and other perks.  The overall 2012 ratio of CEO income to that of the average worker was 354:1, up rather dramatically from a ratio of 20:1 in 1965 (Kiatpongsan & Norton, 2014).

While CEO compensation has increased over the years, the average income of workers has not, and in fact the average household income has declined 9% from its peak in 1999.  From 2011 to 2012 the income of average workers increased hardly at all, whereas the compensation for S&P 500 CEO's rose by 19.65%  and by 15.74% for Russell 1000 CEO's (Governance Metrics International, 2013).  During the 2009-2012 recession recovery period, incomes for 99% of the workforce rose less than 1%, whereas incomes for the top 1% grew by 31.4% (Saez & Zucman, 2014).  In 2010, nearly half of the income in the U.S. went to just the top 10% (Piketty & Saez, 2014).

Of course, income translates into wealth in terms of savings, possessions, and investments.  In a thorough analysis of wealth trends over the years, Berkley economists Emmanuel Saez and Gabriel Zucman show that the income gap parallels the gap in overall wealth owned by different segments of society:
Despite an average growth rate of wealth per family of 1.9% per year, for 90% of U.S. families wealth has not grown at all over the 1986-2012 period. This situation contrasts with the dynamics of the average wealth of the top 1%, which was almost multiplied by 3 from the mid-1980s (about $5 million) to 2012 ($14 million), fell by about 20% from mid-2007 to mid-2009, but quickly recovered thereafter (Saez & Zucman, 2014, p. 24).
With respect to the middle class, their analysis is equally sobering:
Contrary to a widespread view, we find that despite the rise in pensions and home ownership rates, the middle class does not own a significantly greater share of total wealth today than 70 years ago.The share of wealth owned by the middle class has followed an inverted-U shape evolution: it first increased from the early 1930s to the 1980s, peaked in the mid-1980s, and has continuously declined since then...(Saez & Zucman, 2014, p. 24).
A few years ago I presented research that documented widely held misperceptions of how wealth in America is distributed (Misperceiving Wealth in America, 7/2/11 ).  Specifically, people tend to greatly underestimate the difference between the wealthiest and those with less economic means (Norton & Ariely, 2011)  -- the actual gap in wealth distribution is more than three times the size people think it is. The source of the error is that people believe the wealthy control less wealth than they actually do (59% versus 85%) and that the large middle class own more than is really the case (37% versus just 15%).

What about people's perceptions of the income gap?  Do they misperceive the size of it as well, perhaps by  underestimating the size of the gap? Also, a related question that seems relevant to informing economic policy regarding the gap is what difference in income levels do most people perceive as fair and reasonable?  Finally, do Americans differ in their perceptions from those in other countries?

These questions have recently been investigated by Michael Norton of the Harvard Business School and Sorapop Kiatpongsan of the Graduate Institute of Business Administration of Thailand's Chulalongkorn University (Norton & Kiatpongsan, 2014) and their results appear in the November 2014 issue of Perspectives on Psychological Science. Norton & Kiatpongsan surveyed 55,000 people in 40 countries and asked them to estimate average incomes for CEO's  and unskilled workers. The respondents also gave estimates of how much they thought those in each group should earn. Norton & Kiatpongsan then calculated the ratio of estimates of CEO to worker income and also the ratio of estimates of ideal incomes.

Estimated pay ratios of CEOs to unskilled workers ranged from 3.7:1 in Denmark to 41.7:1 in South Korea, whereas ideal ratios ranged from 2.0:1 in Denmark to 20.0:1 in Taiwan.  Despite this variation in estimates of pay differences, in all 16 countries for which actual income data were available, the estimated ratio was significantly smaller than the actual ratios.  This was particularly true in the U.S., where the estimated ratio of  29.6:1 was considerably less than the actual ratio of 354:1.  Americans clearly think the income gap is smaller than it really is, underestimating its size by more than a factor of 10.

In terms of ideal income ratios, in all 40 countries these were significantly lower than the estimated ratios, and significantly lower than actual ratios for the 16 countries with income data, including the U.S.  This suggests that the current income gap -- estimated or actual -- is seen as far from ideal.  Norton & Kiatpongsan found that the differences between people's estimates of actual and ideal pay levels held across demographic groups (age, education level, and socioeconomic status), political beliefs (left, center, right), and beliefs about what factors influence income (level of responsibility, competence, effort).  Note that this doesn't mean that everyone agrees on what the size of the income gap should be, but it does indicate that there is a strong international consensus that it should be smaller than it is now. And the fact that ideal ratios are smaller than estimated ratios even for those at higher socioeconomic levels reveals that this phenomenon isn't just a reflection of those who are less well off wanting to take away the wealth of the rich.  As Norton & Kiatpongsan put it: "These results suggest that—in contrast to a belief that only the poor and members of left-wing political parties desire greater income equality—people all over the world and from all walks of life would prefer smaller pay gaps between the rich and poor."

The question of how to reduce the income gap is a difficult one and likely will involve considerable political debate, as it has begun to do so in the U.S. with calls to raise the minimum wage, place caps on executive compensation, restructure income taxes, etc.  It is nevertheless an important issue affecting not only worker morale and productivity, but possibly overall economic growth, as suggested by a recent analysis of historical data on the impact of efforts to reduce income inequality.  The authors of the study, economists at the International Monetary Fund, concluded that :..lower net inequality is robustly correlated with faster and more durable growth..." and "...the combined direct and indirect effects of redistribution -- including the growth effects of the resulting lower inequality are on average pro-growth."  It seems to make sense that a healthy economy needs people with enough money to make capital investments that create jobs, but it also needs those who fill those jobs to have enough income to buy the products and services that are created. 

It is also a matter of fairness. As Deborah Hargreaves of London's High Pay Center has put it, "Top chief executives worldwide often take home far more in one year than most people will earn in their entire lifetime...It is important that we put pressure on businesses and policy makers to develop measures to stop pay gaps opening up even further, and to share the rewards of success more fairly — for everyone’s benefit" (New York Times Opinion Piece, 2014).  This may sound like a conservative's worst nightmare -- some socialistic/communistic forcible redistribution of the income and accumulated wealth of the rich to the (undeserving) poor.  But a fair society isn't necessarily one where there is no income gap.  It is one in which inequality exists without disadvantaging or exploiting any segment of society and in which all citizens have the opportunity to live satisfying and enriching lives.

Sources and Resources:

Misperceiving Wealth in America,  Snow Crash, 7/2/11

2013 CEO Pay Survey - Governance Metrics International Ratings

"Wealth Inequality in the United States Since 1913:  Evidence from Capitalized Income Tax Data."Emmanuel Saez &Gabriel Zucman.  National Bureau of Economic Research Working Paper.

How Much (More) Should CEOs Make? A Universal Desire for More Equal Pay.  Sorapop Kiatpongsan & Michael I. Norton. Perspectives on Psychological Science, 2014.

Income Inequality in The Long Run. Thomas Piketty and Emmanuel Saez.  2014 Science article.

Redistribution, Inequality, and Growth.  Discussion Note of International Monetary Fund, 2014. Jonathan D. Ostry, Andrew Berg,  & Charalambos G. Tsangarides

Can We Close the Pay Gap?  New York Times Opinion Piece, 2014, by Deborah Hargreaves.

US CEOs break pay record as top 10 earners take home at least $100m each | Business | The Guardian, 10/22/13.


Dennis Nord said...

Decades ago I did some calculations based on poorly researched figures on wealth of the newly deceased and came up with an estimate of what each new-born American could start life with if there were a total re-cycling of those funds. I won't bore you with facts, but let me say that each child by the age of majority would have a significant bankroll to start college education, a small business or to squander as they thought appropriate. With a more even playing table things might turn out a bit different. Of course my "plan" has no chance of ever being funded and doesn't address early childhood ed inequities or a "wealth" of other issues, but it was fun to consider social implications.

Thanks for another stimulating anti-dementia issue of Snow-Crash!

Anne Jantzen said...

This is a powerful piece and one I want to share with many others. Thanks for researching and writing it.

Coleen Hanna said...

I spend a lot time around the "man on the street." Unfortunately, their take on economic inadequacy/inequality seems to lean more toward the problem as "the people on welfare" rather than the CEO's you've researched.

Roger Goodell, football commissioner, made 44.2 million in 2012 (New York Times, 2/14/14). Think about that one.

Richard Sherman said...

Coleen --

I think most of us in the middle want to distance ourselves from those less well off as a defensive maneuver that allows us to identify with the wealthy. Sort of a "blaming the victim" phenomenon?

Anonymous said...

Good comment Richard. Given the best congress money can buy and the Roberts Court, prospects for a redress are dim.