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Whatever happened to middle class income gains?

Editor’s note: This post originally appeared 
in Real Clear Markets on July 2, 2015.

This year’s Economic Report of the President has an interesting analysis of the sources of the slowdown in income gains among the middle class. Given all the attention given to the issue of growing inequality, especially between those at the top and the other 90 percent you might think that was the major economic problem facing the nation. But no, it turns out that the biggest source of the slowdown is the poor performance of productivity since 1995 compared to the earlier postwar period.  

The question the President’s Council of Economic Advisers (CEA) asks is what if productivity growth from 1973 to 2013 had continued at the rate of the previous 25 years from 1948-1973? The answer is that the typical household would have had an additional $30,000 in income. (CEA report, p. 33)

The CEA goes on to ask parallel “what if” questions about income inequality and female labor force participation. How much better off would the typical middle class household be if income gains had been broadly shared after 1973 and female labor force participation had not levelled off after 1995?  These changes produce smaller effects on middle class incomes of $9,000 and $3,000 respectively. However, all three factors combined can explain a whopping $50,000 in income foregone by our typical family.  In other words, these families would have almost twice as much income if it hadn’t been for the decline in productivity growth, the rise in income inequality, and the levelling off of female participation rates. 

The very large role of slower productivity growth is surprising. After all, we have seen an explosion in technology fed by the increasing power of computers. Smart phones, driverless cars, computer-assisted design and manufacturing, robots, drones, and the innovations they have made possible should have boosted productivity smartly. But as Nobel-prize winning economist Robert Solow once quipped, ” You can see the computer age everywhere but in the productivity statistics.” So what’s going on here? 

According to the CEA, starting in 1973, labor productivity growth slowed dramatically to only 1.4 percent annually from its earlier pace of 2.8 percent from 1948-1973. (It has recovered somewhat over the last two decades but has not matched its earlier high levels.) They cite the exhaustion of pent-up innovations from World War II, reduced public investment, dislocations associated with a new international monetary system, and the oil shocks of the 1970s.  

Other experts might add other factors to the list. Economist Robert Gordon believes that the technological breakthroughs of the late twentieth century cannot match earlier innovations such as those represented by electricity, cars, the telephone, and radio. It’s also possible that we have not yet seen the full effects of the computer revolution. My colleague, Barry Bosworth, has shown that a lot of productivity gains are occurring in the service sector and that it isn’t just capital deepening that is producing these gains.  It is everything from better management to human capital investment and organizational innovation – all the things we cannot measure very well but which show up in the data as an unexplained residual.        

In the meantime, the new technologies are contributing to growing income inequality. Because these technologies are replacing unskilled and even some medium-skilled jobs, we are left with the worst of both worlds – disappointing increases in productivity and declining opportunities for those without the education and skills to benefit from the new technologies. 

The solution cannot be to slow down the pace of technology. It must be to encourage innovation, retrain workers, invest in the next generation, and help those dislocated by the changes. Yet we are not investing in research, in education, and in infrastructure in the same way we did in earlier decades. Taxes need to be reformed to provide greater simplicity, fairness, and growth.  Policies such as paid leave, child care, and more flexible work places would encourage more second earners to join the labor force. Most innovation, to be sure, occurs in the private sector, but it has little incentive to invest as long as overall demand is constrained by policies that fail to mitigate financial instability or that are focused on short-term spending cuts in public investments combined with a longer-term explosion of consumption-oriented spending on the big entitlement programs. Until elected officials act to recreate these underpinnings of growth, any permanent improvements in middle class incomes are unlikely to be realized.


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