Wednesday, January 6, 2021

Some Economics of the Middle Class

There are two things that "everyone knows" about the US middle class: it's shrinking in size and the government isn't helping. However, when one digs into the data, the evidence for these claims and some implications of that evidence are considerably more nuanced. 

Here, I draw upon a collection of essays called Securing Our Economic Future, edited by Melissa S. Kearney and Amy Ganz, and published by the Aspen Institute Economic Strategy Group late last year. In h first essay, Bruce Sacerdote asks, "Is the Decline of the Middle Class Greatly Exaggerated?" In the second essay, Adam Looney, Jeff Larrimore, David Splinter look at "Middle-Class Redistribution: Tax and Transfer Policy for Most Americans."

For a flavor of Sacerdote's argument, define the middle class as those with between 75% and 200% of the median income. Then over time, the share of household incomes going to this group does decline. However, a closer look shows that the reason for the decline in the share of household incomes in the "middle class" category is not because the share in the below-75-percent-of-median group has rise, but rather because the share going to the above-200-percent-of-median group has risen.

In an arithmetic sense, this is a decline of the middle class. But it is not a shift to a bimodal or two-humped income distribution with both poor and rich rising. Instead, the middle class still has the largest share of income overall and is declining only because more households are moving up to the higher category.

To think about this shift, imagine a "society" in Scenario A with 100 people: 35 poor people, 51 middle-income people, and 14 rich people. Compare this with Scenario B, which has 35 poor people, 43 middle class people, and 22 rich people. (The numbers here are chosen to match Sacerdote's chart.) In other words, the change here is that eight of middle-income people move up to the "rich" category, and let's hypothesize that no one else is affected negatively.

Is society better off in Scenario A or B? For the purposes of this exercise, it's not fair to invent Scenarios C, D, or E: yes, we might make a case that more broad-based growth, or movement from the poor to the middle-class, would be preferable. But the question here is how to think about the actual shift that happened. In the shift from A to B, the size of the middle class has declined and inequality has risen. However, a standard argument for social welfare comparisons makes the plausible claim that if comparing two scenarios where at least some people are better off, and no one is worse off, then social welfare as a whole has improved

For those who hesitate before accepting this conclusion, consider running this argument in reverse: Say that you start in Scenario B, but then eight people moves from the "rich" to the "middle-class" category in Scenario A. In this situation, the share of those in the middle class has risen, and inequality has diminished. But it would seem perverse to argue that a society where some people have become worse-off (again assuming no effect on others) is a preferable outcome. Or to put it another way, one has to argue that income equality has such a high value that it is worth "levelling down" incomes so that some people are worse-off, even if there is no direct benefit to others from doing so. As Sacerdote writes: "[T]he astounding growth at the top of the distribution need not be making the middle class worse off in absolute terms."

Sacerdote also refers back to the findings of an OECD study in 2019, which argued that "middle class" is associated in people's minds with certain kinds of consumption: in particular, it's associated with a certain level of housing, with relatively easy access to health insurance and health care, and with access to higher education. In the US and around the world, prices for housing, health care, and higher education have risen faster than average incomes. As he points out, one can "ask whether homeownership or college attendance for children in the family has risen or fallen for people in the middle quintiles of the income distribution. I find that since the 1980s, homeownership, square footage of housing consumed, number of automobiles owned, and college attendance have all been rising. The one exception is the modest dip in homeownership that occurred immediately after the financial crisis of 2008."

My sense is that rising inequality has meant that our market-oriented economy will tend to focus more on what it can sell to the rising share of households with higher incomes than on the falling share of househoods with middle-class incomes. But again, the stress of the middle-class looking at this shift, or the stress of those have crossed over into the upper income class only to find that their housing, higher education, and health care expenses still look pretty high, is quite different from arguing that the middle-class are objectively worse off.

For a flavor of the argument from Looney, Larrimore, and Splinter, they look at the "middle class" as representing the middle three-fifths of the income distribution. They write: "The `middle class' has benefitted from government redistribution in recent decades. For individuals in non-elderly households in the middle three income quintiles (the middle class), the share of federal taxes decreased, and the share of transfers increased. Between 1979 and 2016, market income per person increased 39 percent. But when accounting for taxes and transfers income increased 57 percent. Middle-class income support, however, is a recent phenomenon. Before 2000, market income and income after taxes and transfers grew together. Since 2000, middle-class income after taxes and transfers grew three times faster than market income."

Notice that their analysis is focused on the non-elderly, so the results have nothing to do with changes in Social Security or Medicare. Basically, they find that since about 2000, the US government has been able to use a pattern of gradually higher budget deficits along with the ongoing decline in defense spending (as a share of GDP) to finance lower taxes and higher spending for the middle class. Here are a couple of illustrative figures. 

Here's the fall in taxes paid by the middle class. Of course, part of the reason why the top 20% are paying more is because of rising inequality of incomes. But the shift is bigger than what can be accounted for by that factor alone. 

Here's a figure showing the rising share of transfer payments going to the middle three-fifths. To put this another way, many of the expansions of means-tested federal programs over recent decades have been less focused on raising the level of support for the poor, and more focused on expanding the program to the near-poor who would not previously have been covered. 

The authors summarize: 
Over the last several decades, more federal support flowed to the middle class, while the payments they made for federal programs through taxes have declined. Focusing just on amounts for non-elderly households, between 1979 and 2016, the share of means-tested transfers received by middle-class households increased from 27 percent to 49 percent. Their share of federal taxes paid fell from 45 to 31 percent. These changes are partially the result of economic trends, which reduced the share of market income earned by the middle class. However, changes in federal tax policy eliminated income tax liability for more middle-class households and reduced average tax rates on all but the highest-income households. Since 1979, the share of nonelderly adults facing no income tax nearly doubled, to about 40 percent. At the same time, average federal tax rates for non-elderly middle-class households fell about 4 percentage points. Since 1979, the cumulative effect of these policies was to boost the increase in non-elderly middle-class incomes by 18 percentage points. Federal support for middle-class households has clearly improved their economic stability and material well-being.

So if the federal government is doing less to tax and more to pay benefits to the middle class now than a few decades ago, why doesn't it feel that way to so many people? 

One main reason is that many of these benefits do not flow to households directly, but rather go to  health care providers.  For example, the value of excluding employer-provided health insurance from taxation has been rising. But that value doesn't show up in anyone's paycheck. Similarly, the cost of Medicaid has been rising, but this program involves payments from the federal government to health care providers, so the beneficiaries of this program do not see any additional income coming directly to their household. Another reason is that when inequality is rising, the middle-class may be more focused on the gap that is opening up with the rich, rather than on the calculations mentioned here. But the authors write: "Since 2000, non-elderly, middle-class incomes grew three times faster when accounting for transfers and federal taxes."

Looney, Larrimore, and Splinter were writing their before the COVID-related financial rescue packages of 2020 and 2021. However, they were already pointing out that this shift toward rising federal support for the incomes of middle-class households faced some natural limits: for example, defense outlays as a share of GDP rose from about 3% of GDP in the pre-9/11 days of 2000 to above 4.5% of GDP in 2010, but since then has fallen back to the 3% level. Budget deficits were high during the Great Recession, and will be much higher in 2020. Looking ahead, it will be hard for the federal government to use lower defense spending and ever-higher deficits to increase incomes of the middle three-fifths.