Why are wealth and income inequality increasing? Why is labor, relative to capital, commanding a declining share of national income? These have become the central questions in the economics profession, and they’re increasingly central to our political debates as well. Much of the discussion seems to suggest that there is some sort of mystery to be explained. Perhaps corporations are getting better at lobbying in Washington. Or maybe there has been a cultural change that makes CEOs bolder in demanding high pay.
We find those sorts of explanations to be unsatisfactory. Once we consider recent structural changes in the economy, there may not be much left to explain. Here are three key factors: first, obstacles to building and subsidies to homeowners, which raise rents in residential real estate; second, the increasing complexity of regulation, which imposes burdens on smaller firms and discourages new entry; and third, the growing importance of intellectual property.
In all three cases, government regulation has probably contributed to inequality.
Why Are Housing Rents So High?
Until recently, economists tended to assume that the labor share of national income in the U.S. was fairly stable, as labor had earned about 50 to 59 percent of GDP since the Bureau of Economic Analysis began tracking the data in 1929. Given that the economy has grown by nearly 500 percent over that time (in real terms, per capita), most economists thought that long-run economic growth was far more important than distributional issues. In the last few decades, however, the labor share has dropped modestly, while the share of national income going to capital has increased.
Last year a French economist named Thomas Piketty created a sensation in the world of economics with a major historical study of capital and wealth inequality. Piketty argued that the recent slowdown in economic growth was likely to lead to even greater concentrations of wealth at the very top. More recently, an MIT graduate student named Matthew Rognlie took a closer look at Piketty’s data and found that almost the entire change in the share of domestic income going to capital in major developed economies was explained by rising rents on residential real estate. Non-rental capital income (including the corporate sector) still has a fairly stable share of domestic income.
To understand Rognlie’s argument, it is important to distinguish between the consumption of housing and the ownership of housing. Both tenants and owners consume housing in the same way, but only one pays a rent check that can easily be counted toward statistics such as the national income. To address this problem, the government estimates the “implicit rent” on owner-occupied housing by looking at rental equivalents — the rent on comparable properties.
In terms of labor vs. capital income in the U.S., in the eight years leading to the fourth quarter of 2014, compensation declined from 53.7 percent to 52.4 percent of Gross Domestic Income — a significant decline, considering the tight range of this measure over time. But rents moved relentlessly higher during this period, and as a result, rental income to homeowners climbed from 1.3 percent to 3.7 percent of GDI. If we add homeowners’ implicit rental income to compensation, then the combined share has actually grown by 1.1 percent instead of falling by 1.3 percent over this period.
Interest rates are now quite low, even in real terms, and one would expect the combination of high rents and low interest rates to lead to an enormous boom in housing construction. However, since 2006, the construction of new homes has plummeted to historically low levels. What explains this discrepancy?
It’s not enough to point to the severe recession, as that would have been expected to depress construction by depressing rents. As can be seen in the following graph, renters have seen a rising share of their incomes going to rent. The rent/income ratio briefly leveled off during the housing boom, but has jumped during the bust because of the shortage of new housing. Housing may have been overbuilt in some locations, but nationwide a growing scarcity of housing has hit renters hard.
We see two important regulatory factors in high rents. One that has been of increasing importance in recent decades is restrictive zoning. Today it is much harder to get approval for large new housing developments in many of the coastal states — where one can still observe quite elevated house prices in addition to high rents — partly for environmental reasons and partly due to “NIMBYism.” Many environmentalists favor “smart growth,” such as more high-density development along transit lines in bigger cities. But those developments are often blocked by regulations such as rules requiring parking spaces for each housing unit. Many economists on both the left and the right have become highly critical of these restrictions on new-home construction.
The second factor is that it became much harder to get a mortgage in the U.S. after 2006. This is partly due to the large losses that banks and homeowners suffered during the subprime crisis, but it’s also because regulation has been tightened. Those unable to buy new single-family homes because of a lack of new construction were pushed into the rental market, driving rents higher despite the relatively weak economy. Because renters tend to be less wealthy than homeowners on average, this worsens economic inequality.
Our owner-biased tax code already puts renters at a disadvantage, relative to homeowners, because the rent they pay must cover all the income and capital-gains taxes that landlords pay but homeowners do not. Rent inflation from the limits to homebuilding that we have described further worsens economic inequality, because homeowners tend to have higher incomes than renters, spend less of their income on housing, and are immune to rent increases because they own their homes.
The housing bust, made worse by regressive zoning and tax laws, is creating haves and have-nots — owners and renters.
The Regulatory Burden on Small Firms
The combined forces of globalization and the telecommunications revolution have led to substantial growth in the size of many high-tech firms. Some of this shift is inevitable, and indeed beneficial to the U.S.; the U.S. is better off than it would be if the high-skill jobs created at Apple, Google, and Microsoft had instead been created overseas. But it does increase inequality. In a 2015 NBER working paper, Holger M. Mueller, Paige P. Ouimet, and Elena Simintzi find evidence that wage differentials and skill premiums increase with firm size.
Unfortunately, many government regulations tend to favor larger firms. In recent years we have seen the passage of some extremely complex regulations involving thousands of pages of rules, such as Sarbanes-Oxley, Dodd-Frank, and the Affordable Care Act. The Food and Drug Administration, the Department of Defense, and the public health-care complex tend to create opportunities for uber-firms within industries, which act as clearinghouses for public contracts and regulatory demands.
Many of the new regulations may end up being counterproductive by limiting new entry. The most powerful regulatory force in the world is the threat of new competition. The Richmond Fed notes that from 2011 to 2013, only four new banks were established in the U.S., while historically there have generally been more than 100 per year. They attribute this to low bank profits and more regulatory-compliance demands since the crisis, especially a new 2009 FDIC rule that creates substantial new regulatory burdens aimed specifically at new banks.
In other industries, the well-publicized expansion of occupational licensing, ever-widening labor regulations, and petty local regulatory burdens limits the movement between wage earner and proprietor that once served as a natural safety net for the unemployed, a source of wage competition, and a breeding ground for smaller firms.
While some regulations may be desirable, and even necessary, the recognition that complex regulations benefit large firms, leading to increased inequality, seems oddly absent from much political discourse.
Intellectual Property and Inequality
We’ve already seen that the share of national income going to capital has been fairly stable, if you exclude rental income. But this glosses over some interesting changes within the corporate world. A 2014 NBER study by Erling Barth, Alex Bryson, James C. Davis, and Richard B. Freeman found that in addition to the increased inequality in incomes that comes from larger firm size, there has also been a trend of more variance in returns between firms. It seems plausible that this reflects the increasingly “winner take all” nature of 21st-century capitalism. Peter Thiel’s popular book Zero to One captures the spirit of this trend, with its suggestion that new start-up firms aim for a monopoly position.
It’s hard to say how much of this is due to intellectual-property rights such as patents, copyrights, and trademarks. A study that has recently received a lot of attention shows a huge rise in the share of corporate capital that is “intangible,” from about one-sixth in 1975 to five-sixths today. (Apple, for instance, has a market value of $740 billion but net tangible assets of only $100 billion.) As Robin Hanson recently pointed out, this raises the question of why investors could not compete with a company by replicating all its tangible assets at one-sixth the cost.
Of course, we need to be careful here, as there are many complex accounting issues that may affect these estimates. In addition, the term “intangible” need not imply “protected by intellectual property rights.” Companies such as eBay and Facebook probably benefit from “network effects” – people like to use these services because lots of other people also use them. We have seen a pattern of serial monopolies, where tech firms establish dominance but quickly lose it. Many of the firms that appeared as headline-grabbing IPOs over the past 20 years are already forgotten. Getting intellectual property rights is now more important and more difficult than it was when dominant firms were defined by physical capital.
Many of the newer industries also feature very low marginal costs of production. Large investments are made in areas like software and biotech, with many firms falling by the wayside while the successful firms can earn large profit margins. Producing the first unit of, say, a computer program is extremely expensive, but after that, manufacturing costs may fall close to zero. This winner-take-all feature of modern market economies dramatically increases inequality among capitalists.
There are good arguments for some intellectual-property protection, which can spur innovation. And yet many economists on both the left and the right have argued that the protections have gone too far, into areas with no obvious social benefits. Copyright protections once lasted for 14 years, applied only to maps and books, and could be renewed once if the author was still alive. Now they’ve been extended to many other products, extend for 50 years after the death of the author, and last for at least 95 years for corporations. These extensions are widely seen as reflecting the lobbying power of companies such as Disney. In the high-tech sector, patents are often granted for seemingly minor and obvious innovations. President Obama has recently been pressing the Asian countries to enact stricter intellectual-property protections. This may be in America’s self-interest, but transferring money from Asian consumers to Disney shareholders almost certainly worsens global inequality.
How Capitalism Is Supposed to Work
The market economy should have natural mechanisms to limit inequality. If housing is very expensive in coastal California, more firms should build houses. If Mickey Mouse toys and Barbie dolls are profitable, more companies should produce those toys. If some professions make more than others, people should move into the higher-paying professions.
We certainly don’t wish to suggest that regulation is the only factor increasing inequality, but to the extent that zoning rules, limits on mortgage lending, occupational licensing restrictions, and intellectual-property rights limit new competition, we should not be surprised if increased inequality is one of the side effects.
Scott Sumner is professor of economics at Bentley University and director of the program on monetary policy at the Mercatus Center. He writes TheMoneyIllusion.com blog. Kevin Erdmann is a private investor and the author of the blog IdiosyncraticWhisk.blogspot.com.