But how did that democratic society come into being?
Simon Kuznets, a Russian immigrant to the United States who won the Nobel Prize in Economics in 1971, more or less invented modern economic statistics. During the 1930s he created America’s National Income Accounts, the system of numbers—including gross domestic product—that lets us keep track of the nation’s income. By the 1950s Kuznets had turned his attention from the overall size of national income to its distribution. And in spite of the limitations of the data, he was able to show that the distribution of income in postwar America was much more equal than it had been before the Great Depression. But was this change the result of politics or of impersonal market forces?
In general economists, schooled in the importance of the invisible hand, tend to be skeptical about the ability of governments to shape the economy. As a result economists tend to look, in the first instance, to market forces as the cause of large changes in the distribution of income. And Kuznets’s name is often associated (rather unfairly) with the view that there is a natural cycle of inequality driven by market forces. This natural cycle has come to be known as the “Kuznets curve.”
Here’s how the Kuznets curve is supposed to work: In the early stages of development, the story goes, investment opportunities for those who have money multiply, while wages are held down by an influx of cheap rural labor to the cities. The result is that as a country industrializes, inequality rises: An elite of wealthy industrialists emerges, while ordinary workers remain mired in poverty. In other words a period of vast inequality, like America’s Long Gilded Age, is the natural product of development.
But eventually capital becomes more abundant, the flow of workers from the farms dries up, wages begin to rise, and profits level off or fall. Prosperity becomes widespread, and the economy becomes broadly middle class.
Until the 1980s most American economists, to the extent that they thought about the issue at all, believed that this was America’s story over the course of the ninteenth and twentieth centuries. The Long Gilded Age, they thought, was a stage through which the country had to pass; the middle-class society that followed, they believed, was the natural, inevitable happy end state of the process of economic development.
But by the mid-1980s it became clear that the story wasn’t over, that inequality was rising again. While many economists believe that this, too, is the inexorable result of market forces, such as technological changes that place a growing premium on skill, new concerns about inequality led to a look back at the equalization that took place during an earlier generation. And guess what: The more carefully one looks at that equalization, the less it looks like a gradual response to impersonal market forces, and the more it looks like a sudden change, brought on in large part by a change in the political balance of power.
The easiest place to see both the suddenness of the change and the probable importance of political factors is to look at the incomes of the wealthy—the top 1 percent or less of the income distribution.
We know more about the historical incomes of the wealthy than we know about the rest of the population, because the wealthy have been paying income taxes—and, in the process, providing the federal government with information about their financial status—since 1913. What tax data suggest is that there was no trend toward declining inequality until the mid-1930s or even later: When FDR delivered his second inaugural address in 1937, the one that spoke of one-third of a nation still in poverty, there was little evidence that the rich had any less dominant an economic position than they had had before World War I. But a mere decade later the rich had clearly been demoted: The sharp decline in incomes at the top, which we have documented for the 1950s, had already happened by 1946 or 1947. The relative impoverishment of the economic elite didn’t happen gradually—it happened quite suddenly,
This sudden decline in the fortunes of the wealthy can be explained in large part with just one word: taxes.
Here’s how to think about what happened. In prewar America the sources of high incomes were different from what they are now. Where today’s wealthy receive much of their income from employment (think of CEOs and their stock-option grants), in the twenties matters were simpler: The rich were rich because of the returns on the capital they owned. And since most income from capital went to a small fraction of the population—in 1929, 70 percent of stock dividends went to only 1 percent of Americans—the division of income between the rich and everyone else was largely determined by the division of national income between wages and returns to capital.
So you might think that the sharp fall in the share of the wealthy in American national income must have reflected a big shift in the distribution of income away from capital and toward labor. But it turns out that this didn’t happen. In 1955 labor received 69 percent of the pretax income earned in the corporate sector, versus 31 percent for capital; this was barely different from the 67–33 split in 1929.
But while the division of pretax income between capital and labor barely changed between the twenties and the fifties, the division of after-tax income between those who derived their income mainly from capital and those who mainly relied on wages changed radically.
In the twenties, taxes had been a minor factor for the rich. The top income tax rate was only 24 percent, and because the inheritence tax on even the largest estates was only 20 percent, wealthy dynasties had little difficulty maintaining themselves. But with the coming of the New Deal, the rich started to face taxes that were not only vastly higher than those of the twenties, but high by today’s standards. The top income tax rate (currently only 35 percent) rose to 63 percent during the first Roosevelt administration, and 79 percent in the second. By the mid-fifties, as the United States faced the expenses of the Cold War, it had risen to 91 percent.
Moreover, these higher personal taxes came on capital income that had been significantly reduced not by a fall in the profits corporations earned but in the profits they were allowed to keep: The average federal tax on corporate profits rose from less than 14 percent in 1929 to more than 45 percent in 1955.
And one more thing: Not only did those who depended on income from capital find much of that income taxed away, they found it increasingly difficult to pass their wealth on to their children. The top estate tax rate rose from 20 percent to 45, then 60, then 70, and finally 77 percent. Partly as a result the ownership of wealth became significantly less concentrated: The richest 0.1 percent of Americans owned more than 20 percent of the nation’s wealth in 1929, but only around 10 percent in the mid-1950s.
So what happened to the rich? Basically the New Deal taxed away much, perhaps most, of their income. No wonder FDR was viewed as a traitor to his class.