If Middle Class Is Falling Behind, Solution Lies in Higher Productivity

“The economy is in a stall, the public has malaise, the middle class has been hurt and the President is doing nothing.”

Statements similar to this fill the airwaves and newspapers. There is no escape. Each new report of a slow recovery--yes, recovery--seems to set off a new round of hand-wringing and more calls for some quick economic fix.

As a nation, we are truly in trouble if we mistake the current slow recovery for a deep recession or the start of another Great Depression, as many commentators do. Even worse, we are in deep trouble if we expect the government to solve our problem. Its business is politics, not production, and its specialty is regulation and redistribution, not growth and progress.

One cause for alarm is that standard measures of income inequality show that family or household income has become less equally distributed. The trend began as far back as 1969. The middle 60% of all households received 53% of household income in 1969, 52% in 1979 but only 49% in 1989. Middle-class losses in income share coincided with increases in the share received by 20% of the households with the highest incomes.

The usual explanation is that the greedy grabbed from the needy. The alleged mechanism was the Reagan tax cuts, a gross mistake in the eyes of the critics.

This argument is almost certainly wrong. If before-tax income of the highest group increased relative to others, it must be because they reported more income. Either they worked more and earned more, or they took less income as non-taxable benefits and perquisites. None of these would hurt the middle class. All would benefit society.

In fact, middle-class income rose from 1979 to 1989, according to the most commonly used measures. The rate of increase slowed, however. One reason is the deep recession of 1981-’82. It took until 1986 for a family with middle-class income to get back to the real income level of 1979. After 1986, middle-class income rose at a slightly better rate than in the 1970s.

There are many reasons for changes in income shares other than tax policy or recessions. Changing family structure, single-parent families and more aged and retired in the population have had important effects in recent decades.

Suppose, however, that the perceptions and allegations are correct and that the middle class is falling behind absolutely as well as relatively. Can we solve the problem by reducing middle-class taxes in one way or another, as some in Congress propose?

The answer is either no or not much. Some proposals are for temporary reductions. These would be used mainly for debt reduction or other forms of saving and would have little effect on spending. Some are permanent reductions paid for by higher taxes on upper-income groups. The net effect of these changes on total spending will probably be small, and it is uncertain whether it would raise or lower spending.

More important, the proposals for tax reductions misperceive the problem. If growth of middle-class incomes is lagging, it is because productivity is lagging. Tax cuts that get the middle class to spend more may give them some temporary good feeling. Increased sales and purchases would encourage some increases in investment, thereby improving tools and equipment and increasing productivity. The problem is that these effects would be small. Part of the increased spending would be on imported goods. And part of the increased investment would be spent to equip plants abroad.

The more direct way to raise incomes for the middle class, and everyone else, is to raise the productivity growth rate. There is no magic pill or quick fix to do that. Productivity growth in the aggregate depends on investment in physical capital and in education. People with better tools and equipment produce more. People with better education think of ways of improving either the tools or the way they are used.

One of the main reasons for the faster growth of incomes in the highest income groups is that education is not only pleasant for many, it is also profitable. The highest-income groups include professionals, managers and others who have invested in their own education.

Middle-income groups include many who never went beyond high school. As my colleague Marvin Kosters has shown, investment in higher education became more profitable for individuals in the 1980s. Middle-income groups who want to raise their children’s incomes should be demanding more and better education, more homework, more hours of school, better teaching of more relevant materials. To raise their own incomes, they should seek out adult education programs and other programs to improve their skills.

The other way to increase productivity is to increase investment. To get more investment as a society, we have to increase the after-tax, risk-adjusted real return to investment. Government could help by replacing taxes on income or output with taxes on spending. That would encourage saving and finance productive investment. The short-term effect on the economy during the adjustment could be negative, but the long-term effect would be positive as productivity increased. Substitution of spending taxes for income taxes would leave the budget deficit unchanged. Over time, higher productivity growth would produce more tax revenue.

An alternative would be to encourage investment by allowing corporations to take all investment spending as a deduction from income or by giving a permanent investment credit. This rapid writeoff of costs would help rebuild some of our industries and encourage development of new capital-intensive industries. As productivity rose, incomes would rise. These proposals would reduce the present bias in the tax system against investment.

None of these proposals would give the economy a quick fix. That isn’t our problem. For more than 100 years, mild recessions have typically been followed by gradual recoveries. We have had a mild recession, and we are having a gradual recovery. When the recovery is complete, we will still have slow productivity growth in the economy as a whole. President Bush--and Congress--should go for the long-term solution, not the quick fix.