TCS Daily

What's Really Happening in the Economy?

By David R. Henderson - December 13, 2006 12:00 AM

How often have you heard that the vast majority of families' incomes in the United States are rising little or not at all, that the middle class is shrinking, that real wages are stagnating, that the top 20%, or 5%, or 1% are getting the lion's share of the gains in the U.S. economy, that average CEO pay is getting to be a couple of orders of magnitude larger than average people's pay, or that mobility across income groups has declined? Princeton economist and New York Times columnist Paul Krugman has made a good part of his living credulously repeating most of these claims. Wall Street Journal reporter David Wessel has also often written long articles laying out some of these claims. It seems that not a month has gone by in the last few years that a major respected newspaper hasn't made such statements as if they were well-established facts.

When I teach my classes to U.S. military officers, whose median age is about 30, the most informed of them will often cite one or more of these claims. They see themselves and many of those around them as doing well, but some of them tend to think that they are exceptions to the rule. The claims have been repeated so often in so many respected publications that they have begun to doubt the evidence of their own lying eyes.

Moreover, as documented in an article by the above-mentioned Wessel ("Rebalancing Act: Democrats Target Wealth Gap and Hope Not to Hit Economy," Wall Street Journal, November 21, 2006, page A1), the Democrats who take over Congress next month are basing many of their policy proposals on the assumption that these claims are correct.

In short, these claims matter beyond idle cocktail-party chatter. Well, guess what? All of the above claims are either absolutely false or at least highly misleading. I wrote an article in 2005 laying out the fact that income mobility has not declined, in which I pointed out David Wessel's misleading use of language that left most readers thinking that mobility had declined. I wrote another article pointing out that it's not true that only people in the top income groups are seeing their incomes increase. Charles Hooper and I wrote an article laying out the fact that if one looks across the whole world's population that has ever existed, the vast majority of Americans are in the top 1%.

But now a whole book has come along that demolishes the above claims or shows that they are misleading. Income and Wealth, by economist Alan Reynolds, is an empirical Howitzer that leaves little of the content of these claims standing.

Income and Wealth will prove to be the most important book on the U.S. economy in 2006 and possibly one of the five most important in the decade. The reason is that the issues Reynolds discusses matter so much to so many people, and Reynolds provides the facts, showing how sloppy the critics have been with evidence. Reynolds lays out, careful step by careful step, what's wrong with the data behind the claims at the start of this article. One short review cannot do justice to Reynolds's powerful book. Therefore, this is the first of three weekly articles on the book. In this first article, I focus on Reynolds's analysis of two claims: first, that the average family is getting little or no increase in real income and, second, that the middle class is disappearing.

A Family Affair

Start with the claims about the average family's progress or lack of same. In a 2004 article in Nation, Paul Krugman wrote:

"According to estimates by the economists Thomas Piketty and Emmanuel Saez—confirmed by data from the Congressional Budget Office—between 1973 and 2000 the average real income of the bottom 90 percent of American taxpayers actually fell by 7 percent." (Reynolds, p. 38)

But Reynolds shows that Krugman's statement is wrong for two reasons. First, CBO estimates go back only to 1979. Second, the CBO data show that between 1979 and 2000, average after-tax income in each quintile (fifth) of the household income distribution rose. For the lowest quintile, it rose from $13,500 to $14,600 [all numbers in this sentence are in 2003 dollars]; for the second-lowest quintile, it rose from $27,300 to $30,900; for the middle quintile, it rose from $38,900 to $44,800; for the second-highest quintile, it rose from $50,900 to $63,600; and for the top quintile, it rose from $89,700 to $138,500. So for Krugman's claim (CBO reference aside) to hold true, average income in the bottom 90 percent would have had to have fallen drastically between 1973 and 1979, to more than offset the later increase. Reynolds uses U.S. Census data to show that no such thing happened.

As for the Piketty-Saez study that Krugman and many others have cited, Reynolds points out just how implausible their data are as a measure of family income. Piketty and Saez write that in 2000, "the median income, as well as the average income for the bottom 90% of tax units is quite low, around $25,000." Note the use of the term "tax units." "Tax units" are not the same as families. In my family, for example, we have two tax units: my wife and I file our taxes jointly and our daughter files on her own. But that has not stopped people, including Krugman, from writing as if "tax unit" and "family" are synonymous. Reynolds points out that if tax units were the same as families, highly implausible implications would follow. Given the meaning of the word "median," 45 percent of families (half of 90 percent) would have had to make less than $25,000 in 2000. But U.S. Census data show that for 2000, median family income was $50,732, which means that we know, to the extent we can trust Census data, that 50 percent of U.S. families made more than $50,732 in 2000. That means that the 5 percent of the family income distribution not accounted for (100 percent minus 50 percent minus 45 percent) would have had to be the people with incomes above $25,000 but below $50,732. While that is mathematically possible, it is empirically virtually impossible. The problem stems from the equation of "tax unit" with family.

Meet Me in the Middle

How about the "vanishing middle class?" To say that the middle class is vanishing, one must have a definition of the middle class. A sensible person would probably define it as the group of people in the middle, say the middle quintile or the middle three quintiles. But that's not how the commentators who have made the claim have defined the middle class. Instead, they take the group of people making income within a fixed range in inflation-adjusted dollars, say, between $35,000 and $50,000, and show that the percent of the overall number of families within this range is falling. In commenting on this way of defining the middle, Reynolds points out an obvious but, nevertheless, often completely overlooked fact:

"Such a fixed definition ensures that the proportion of households in the middle group must decline with a rise in general prosperity, because rising prosperity causes a rising percentage of families to earn more than $50,000." (emphasis his)

Reynolds continues by telling of a 2004 story in the Washington Post titled, "The Vanishing Middle-Class Job." The Post article pointed out that in 1967, nearly a quarter (22.3 percent) of households made between $35,000 and $49,999 in inflation-adjusted terms, but that that share was down to 15 percent by 2003. Reynolds notes that the same article showed that the percentage of U.S. households with a real income higher than $50,000 rose from 24.9 percent in 1967 to 44.1 percent in 2003. Moreover, the percentage with income lower than $35,000 fell from 52.8 percent to 40.9 percent. In other words, the "middle class" was shrinking because people were moving out of the Post's statically defined middle class into a higher income class. Comments Reynolds: "The article could have been more aptly titled, 'The Vanishing Lower-Class Job.'" But because Reynolds shows elsewhere that higher-income households tend to have more than one worker, one can't simply equate households and jobs. Therefore, the article would have been even more aptly titled, "America's Families are Getting Wealthier." But that's not exactly the message or the tone the Post was shooting for.

I can't do justice in this short space to Reynolds's analysis of similar mistaken claims about family income or the vanishing middle class. But the above are certainly some of the highlights. Next week, I'll discuss his analysis of the common claim that real wages are stagnating.

David R. Henderson, is a research fellow with the Hoover Institution and an economics professor at the Graduate School of Business and Public Policy, Naval Postgraduate School in Monterey, Calif. He iis author of The Joy of Freedom: An Economist's Odyssey and co-author, with Charles L. Hooper, of Making Great Decisions in Business and Life (Chicago Park Press, 2006).


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