Income Inequality in the United States

ECON PROJET IMAGE 2Income inequality in the United States is at historic heights (Pew Research, 2013). Unless the underlying structural drivers of income inequality are addressed, an increasingly restive populace could fundamentally undermine the efficacy of the institutions that promote peace, prosperity and progress in American society. For instance, (1) increasing disillusionment with the political establishment could compromise the delicate balance of power between despotism and anarchy through the rise of authoritarian or populist forces (Hamilton, 1781), (2) associating the pursuit of knowledge as an exploitative attribute of the economic elite could result in a skepticism for education that stymies the nation’s economic potential (Lyngar, 2015), (3) directing the frustration compounded by inequality towards hard-working and productive immigrants could result in the compromise of humanitarian values and the nation’s human capital (Dustmann, 2004).  In short, the growing resentment with the economic and political elite as a consequence of increasing income inequality could result in the adoption of measures that exacerbate various negative social and economic trends. There is thereby a pressing need to understand and address the structural drivers of income inequality. Unfortunately, rather than proactively address the key structural drivers of income inequality, policy makers tend to reactively appease the public subject to the negative effects of income inequality. This paper specifically analyzes one such significant case of appeasement in the recent past where policy makers increased access to housing as a response to voters on the wrong side of the rising income inequality trend (Rajan, 2010).

This paper asserts that increasing the ease of educational attainment should be the central priority of policy makers. In specific terms, policy makers need to reduce funding for policies of appeasement such as the aggressive promotion of housing credit, and increase funding for policies that promote educational attainment (such as Pell grants and technical training). The evolution of the American labor market has resulted in increasing demand for high skilled jobs and lowering demand for low skilled jobs. The difficulty of educational attainment in an economy where high skills are in demand is a key structural driver of income inequality.

ECON PROJET IMAGE 6To start understanding the current inequality crisis one must appreciate how dramatic technological progress in the last century has triggered an evolution in the American labor market where high-skilled workers are in increasing demand and low-skilled workers are in lowering demand (Goldin & Katz, 2008). The increasingly central role of technology in determining economic output has caused economists to consider the human capital capable of leveraging the technological developments as a key input to the production function of the American economy (see Appendix 1).   The difference in pay between college graduates and those who didn’t graduate college is a key indicator of this trend. The New York Times reported that Americans with college degrees earned 98 percent more than their peers with no college education in 2013. This number is part of a growing trend, as the advantage of college graduates was 89 percent in 2008, 85 percent in 2013 and 64 percent in the early 1980’s (Leonhardt, 2014).  One can thereby infer that educational attainment is the key determinant of skill based income inequality.  
ECON PROJET IMAGE 7The next step to understanding the inequality crisis would naturally be to analyze the trend in the real cost of educational attainment in the past few decades. The data is unambiguous. The cost of educational attainment has increased dramatically in the past few decades. The cost of college is currently twelve times over the 1978 Consumer Price Index (Li, 2013).  The dramatically high college costs prevent people from easily acquiring the skills that are in demand in the labor market. Another direct consequence of the high college costs has been sky-rocketing levels of student loan debt. The total student loan debt is currently around 1.2 trillion USD. This debt burden reduces the flexibility of the labor market by impeding the acquisition of new, relevant skills by members of the labor force. Another consequence of the increasing importance of college and the high college costs is that there are lower labor force participation rates (Gandel, 2015).There is an urgent need for policy measures to increase the ease of educational attainment to address income inequality.

ECON PROJET IMAGE 8Unfortunately, policy makers have tended to respond to increasing income inequality with reactive policies of appeasement as opposed to proactive policies of structural reform. We specifically analyze federal funding for housing and education in the United States. In 2014, the Federal Government spent close to 130 billion USD to increase access to housing ECON PROJET IMAGE 10through the tax code (CBO, 2014).  In contrast, the total 2014 Presidential discretionary spending budget for the Department of Education was just 71 billion USD. Federal Pell grants which increase the ease of access to college cost the taxpayer close to 30 billion USD in 2014 (US Dept of Education, 2015). The data from the past three decades clearly indicates that policy makers aggressively prioritized increasing the ease of access to housing as a response to growing income inequality (Rajan, 2010). This policy does not address the key structural driver of skill based income inequality and according to Dr. Raghuram Rajan, played a key role in causing the 2007 financial crisis. Policy makers thereby need to aggressively prioritize increasing the ease of access to education (rather than housing).
ECON PROJET IMAGE 9It should thereby be evident that aggressively prioritizing increasing the ease of educational attainment would be a proactive and effective policy of structural reform to address income inequality. Increasing federal spending on education to increase the Human capital in the American economy will negate the increasing income inequality trend (see Appendix 1). Note that as human capital in an economy increases, there are diminishing returns to skilled workers and the marginal product of unskilled labor rises. The wage-differential between skilled and unskilled workers decreases resulting in a more egalitarian society. There is thereby a compelling economic argument to increase federal spending on education.
Appendix 1

Consider the following Cobb-Douglas Production Function with three inputs. K is capital (the number of machines), L is Labor (the number of workers), and H is human capital (the number of college degrees among the workers).

The production function: Y = K^⅓*L^⅓*H^⅓ .

An unskilled worker earns the marginal product of labor (MPL), whereas a skilled worker earns the marginal product of labor plus the marginal product of human capital (MPH).

              MPL = 1/3 * K1/3 * H1/3  * L-2/3  

              MPH =  1/3 * K1/3 * H-2/3  * L1/3

Observe that increase in human capital raises MPL and lowers MPH.

Let S be the earning of a skilled worker and U be the earning of an unskilled worker.

S / U = (MPH + MPL) / MPL = MPH/MPL + 1 = 1 + L/ H

Increase in the amount of human capital decreases the ratio of the skilled worker wage to the unskilled worker wage. This happens because there are diminishing returns to skilled workers as its amount increases. Along with this, there occurs an increasing return to unskilled workers.

Note: This model assumes that capital, labor and human capital have equal share of the national income. This model is a hypothetical and simplified representation of the US economy designed to highlight the theoretical argument of this paper.
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