The middle class is doing fine By Scott Sumner

When I start reading an article there are a few red flags I look out for. If the writer starts discussing income inequality data as if it tells us something useful about economic inequality, I know I can pretty much ignore anything the author has to say. The same is true if the author claims that the middle class has seen declining living standards since the 1970s. Anyone old enough to remember the 1970s (like me) knows that isn’t true. One big problem in both areas is that people tend to ignore the relationship between age and income. People often have low incomes when they are young or old, and higher incomes when middle-aged.

Scott Winship has an excellent article discussing some of the problems with income data. If you look at total income plus benefits adjusted for taxes and transfers, then real incomes for the middle quintile rose by 36% between 1979 and 2010. (Think of this quintile as roughly the median income.) Pessimists point to the fact that this gain in purchasing power was almost entirely due to taxes and transfers, and that wage and salary income actually fell for middle income Americans, in real terms. But Winship points out that this is highly misleading, as that decline is entirely due to the rapidly growing number of retired people in the middle quintile. Because those people rely heavily on non-wage income, it makes it look like wage and salary income for the middle class has done very poorly since 1979. Here’s Winship:

The growth of elderly households is the entire reason that wages and salaries detracted from income growth and that taxes and transfers accounted for nearly all of the growth. People in such households grew from 15 percent of all people in the middle fifth in 1979 to 26 percent of them in 2010. It is not just that the retiree population has grown–thanks to Social Security and Medicare, the number of retirees in the middle fifth specifically has grown much faster than their rate of growth in the general population. Wages and salaries are the single biggest factor explaining income growth for those middle class families living in households with children. Wages and salaries are nearly as important for childless nonelderly households.

Winship also notes that some pessimists argue that we should look at how incomes are doing net of taxes and transfers, as that’s an indication of how well the free market system is serving Americans. That reminds me of the first time I ever challenged a professor in class. I was a sophomore at Wisconsin, taking intermediate price theory. The professor (who also worked at the Poverty Institute) made a similar argument—that income net of taxes and transfers shows how the free market would distribute income. I made what I thought was a pretty obvious point. If we didn’t have all those transfer programs then wage and salary data would look very different. Indeed before we had welfare and Social Security the poor and elderly used to work at a much higher rate then they do today. Those programs might be beneficial, but it’s absurd to assume they don’t impact wage and salary incomes. Thus incomes net of taxes and transfers do not provide any sort of indication of what sort of income growth you’d expect in a free market economy.

I highly recommend reading the entire Winship article, and all of his other articles on income.

PS. You can make a good argument that middle income living standards have declined somewhat since 2007, but that’s a different issue.

HT: David Levey