What do we know about the 1 per cent?

Little, but enough to debunk a few common misconceptions

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Not enough, really.

The surge in the share of total income that goes to the very top earners has been widely documented and much discussed. But without a proper understanding of why it’s happening, there’s not much we can say about what policy measures would solve the problem—or even if there’s a problem to solve. Many of the proposals currently being floated about have a whiff of the Politician’s Syllogism: “We must do something. This is something. Therefore, we must do this.”

So when Mike Veall, an economics professor at McMaster University, took the podium at last June’s meetings of the Canadian Economics Association to give the Presidential Address—entitled “Top income shares in Canada: recent trends and policy implications”—there was a certain amount of anticipation in the auditorium. Mike has been working on this issue for a long time, and has written or co-written some of the most important studies on the topic. If anyone could come up with a convincing explanation for the surge in top-end income in Canada, it would be Mike Veall. His answer:

“I don’t know”

That doesn’t mean we don’t know anything, of course. His talk was recently published in the Canadian Journal of Economics (ungated version available here), and is worth taking the time to read if you’re interested in the topic. Here, I’m going to provide what is essentially a summary of a summary.

One feature of the surge that is perhaps not as well-known as it should be is the way top earners are making their money. In the post-war era, the popular image of high earners being people whose incomes derived from large holdings of capital was largely based in reality. Most of the income that went to the top 0.01 per cent in 1946 came from capital (interest, profits, dividends, etc) and about one-fourth was in the form of wages. In 2009, though, wages accounted for two-thirds of the income in the top 0.01 per cent. So although capital markets and profits attract a lot of attention, the real story of the top income surge is primarily one of labour markets and wages.

Why did wages at the top increase so much? Veall identifies four main theories that have been proposed and that are not without at least partial support in the data:

  1. ‘Globalization’: This is the term Veall uses to describe the internationalization of the market for high-skilled workers. To the extent that high-skilled workers in Canada can credibly threaten to move to (say) the U.S., Canadian employers would be obliged to match the wages being offered there. This theory has a lot going for it, but it simply raises the question of why salaries rose in the U.S. in the first place.
  2. Skill-biased technical change (SBTC): The idea here is that although technical progress increases productivity and wages, it doesn’t always do so uniformly. If new computers and new communications technologies only improve the productivity of those who have the skills to use them, then they will widen the wage gap between skilled and unskilled labour. SBTC may be a contributing factor, but it can’t be the principle explanation. Rapid technological change has been fairly ubiquitous, but only a few countries—most notably those with English-speaking populations—have seen top-end incomes skyrocket.
  3. Executive compensation practices: CEOs and other executives are employees; their bosses are the people who own the company, namely, the shareholders. In principle, executive salaries are negotiated between the executives themselves and people who represent the interests of shareholders, and if shareholders believe that a high salary is justfied by an executive’s contribution to the bottom line, then there’s not much cause for concern. Problems occur if CEOs have undue influence on the people who are supposed to be representing shareholders. This is, again, almost certainly part of the problem, but it’s hard to see how this theory explains the high salaries paid to CEOs hired from outside the firm.
  4. Changes in personal income tax (PIT) rates: There’s an extensive literature documenting the inverse relationship between taxable income and PIT rates: higher tax rates reduce the incentive to work and  increase the incentive to make greater use of mechanisms that allow people to avoid paying taxes. The relationship is even stronger for those with high incomes, so the reductions in PIT rates we’ve seen over the past decades could have been contributing to widening inequality. The problem here is that the PIT rate-tax base relationship estimated from Canadian data explains only a fraction of the increase in top income shares.

In the absence of a “silver bullet” explanation, it’s hard to put together a policy agenda. Even so, here are some ideas Veall thinks we should be looking at:

  1. Tax policy. It turns out that Canadian PIT rates are already pretty close to available estimates for the rate that produces maximum revenue, and the rise in top incomes doesn’t change those estimates. Veall is pessimistic about the prospects for generating significantly higher revenues with higher rates. However, closer inspection of the myriad of tax deductions, exemptions and credits may produce measures that remove tax preferences that exacerbate inequality.
  2. Corporate governance: Veall notes that “it has been estimated that Canada has a relatively high prevalence of insider trading and it has not been immune to practices such as backdating options.” To the extent that this suggests the existence of an “insider culture” in Canada, initiatives to reinforce shareholder oversight are something to be looked at more closely.
  3. Social mobility: As Veall puts it, “many would argue that one of the most negative aspects of inequality is intergenerational immobility. If a high ability child born to lower socioeconomic status has little chance to advance and use her or his talents, or if someone of low ability takes home a large salary as the CEO of the family-controlled firm, it may be widely seen as unfair but it will also lead to a less dynamic and productive economy.” Canada actually does relatively well as far as international measures of social mobility go—due largely to access to public health care and education—but that doesn’t mean it always will, or that it can’t do better.

We would all like to know more about why the top-income surge is happening and what we should do about it. But all we have to go on for now are partial answers.