The Evolution of Top Incomes

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Among economists, there has been general dissatisfaction with existing international data on income inequality. The data are difficult to compare over time or across countries, and cover only a few isolated years per country, generally being restricted to the post-1970 or post-1980 period. They almost never offer any decomposition of income inequality into its labor income and capital income components. Yet economic mechanisms can be very different for the distribution of labor income (demand and supply of skills, labor market institutions, and so on) versus the distribution of capital income (capital accumulation, credit constraints, inheritance law and taxation, and the like). The fact that existing data are not long run is also problematic, because structural changes in income and wealth distributions often span several decades. In order to properly understand such changes, one needs to be able to put them into broader historical perspective.

This rise in top income shares is not due to the revival of top capital incomes, but rather to the very large increases in top wages (especially top executive compensation).

In The Evolution of Top Incomes: A Historical and International Perspective (NBER Working Paper No. 11955), authors Thomas Piketty and Emmanuel Saez construct a high quality, long-run, international database on income and wealth concentration using historical tax statistics. The resulting database includes annual series covering most of the twentieth century for a number of (mostly Western) countries.

They find that most countries experienced a dramatic drop in top income shares in the first part of the century because large wealth holdings dropped precipitously during the wars and The Depression. Top income shares did not recover in the immediate post-war decades. However, over the last thirty years, top income shares have increased substantially in English speaking countries, while not at all in the continental European countries or Japan. This increase is attributable to an unprecedented surge in top wage incomes that began in the 1970s and accelerated in the 1990s. As a result, top wage earners have replaced capital income earners at the top of the income distribution in English speaking countries.

The fact that the drop in income concentration in the first part of the twentieth century is primarily due to the fall in top capital incomes, and that the fall took place mostly during wartime and the Great Depression in most of those countries, suggests an obvious explanation. For the most part, income inequality dropped because capital owners experienced severe shocks to their capital holdings during the 1914 to 1945 period, including destructions, inflation, bankruptcies, and the fiscal shocks of financing wars. The available wealth and estate data for countries such as France, the United States, or Japan confirm this interpretation.

The more challenging issue for the authors to explain is the lack of recovery of top capital incomes after 1945. Their proposed explanation is that the capital shocks between 1914 and 1945 had a permanent effect because the introduction of progressive income and estate taxation (there was virtually no tax progressivity prior to 1914, and top rates increased enormously between 1914 and 1945) made it impossible for top capital holders to fully recover. Simple simulations suggest that the long-run impact of tax progressivity on wealth concentration is indeed large enough to explain the magnitude of the observed changes.

After 1970, the authors observe a major divergence among rich countries. While top income shares have remained fairly stable in Continental European countries or Japan over the past three decades, they have increased enormously in the United States and other English speaking countries. This rise in top income shares is not due to the revival of top capital incomes, but rather to the very large increases in top wages (especially top executive compensation). As a consequence, top executives (the "working rich") have replaced top capital owners at the top of the income hierarchy over the course of the twentieth century.

Understanding why top wages have surged in English speaking countries in recent decades, but not in continental Europe or Japan, remains controversial, with three broad points of view. The free-market view claims that technological progress has made managerial skills more general and less firm-specific, hence increasing competition for the best executives from segregated, within-firm markets to a single economy-wide market. While this view can possibly account for U.S. trends, it cannot explain why executive pay has not changed in other countries, such as Japan or France, which have gone through similar technological changes. A second view claims that impediments to free markets attributable to labor market regulations, unions, or social norms regarding pay inequality, can keep executive pay below market. Such impediments have been largely removed in the United States but still exist in Europe or Japan, explaining the trends. Under this view, the surge in executive compensation actually represents valuable efficiency gains. A third view claims that the surge in top compensation in the United States is attributable to an increased ability of executives to set their own pay and to extract rents at the expense of shareholders.

-- Les Picker