December 16, 1997

Pulling Apart:
A State-by-State Analysis of Income Trends - Chapter Four
by Kathryn Larin and Elizabeth McNichol


IV. States Can Choose a Different Course

Both government policies and economic trends have contributed to the increase in income inequality over the past two decades in most states. Economic developments are the major force driving increases in inequality, but federal and state policies have, in many cases, accelerated rather than moderated this trend.

State policy decisions in recent years affecting both benefit programs and tax systems have tended to widen the already growing gaps in the distribution of income. If they so choose, however, states can chart a different course. States can enact policies such as minimum wages and unemployment insurance reform that improve the distribution of income. In addition, states can pursue tax policies that can, in part, offset the growing inequality of pre-tax incomes.

A detailed analysis of the factors contributing to the widening of income gaps over the past two decades is beyond the scope of this paper. Following is a brief overview of the factors that have been identified by researchers as underlying the growing income disparities and some suggestions of state policies that could mitigate this trend.


Economic Trends

There are two major economic trends that have contributed to a widening of the income gaps among the wealthy and the poor and the middle class. The first is a widening of the wage gap and the second is a substantial increase in investment income.

Wages at the bottom and middle of the wage scale have been stagnant in real terms for many years. The wages of the highest paid employees, however, have grown significantly. This trend does not signify an increase in work effort among the highest-paid employees relative to middle- and lower-wage employees. Rather, it reflects a shift in the relative pay levels of workers. The trend also reflects an increase in the proportion of workers who are paid very low wages. This is a sharp reversal from the trends of previous decades when the proportion of workers earning very low wages was falling. Several fundamental changes in the United States economy have contributed to the increasing disparities in the wages paid to low- and middle-income workers relative to highly-skilled, highly-paid workers.

Increasing international trade has led to a movement of in certain low-skilled manufacturing jobs overseas and a loss of low-skilled manufacturing jobs in the United States. It has become cheaper to manufacture labor-intensive goods overseas where labor costs are lower, and import the goods rather than manufacturing them domestically. Several studies have estimated the degree to which increased international trade affects income inequality, and most have found that trade has contributed between 10 and 30 percent to the growth in wage inequality over the past 15 years.(1)


Income Mobility:
Do Low-Income Families Move Quickly Up the Economic Ladder?

As shown in this analysis, income inequality has increased substantially in the vast majority of states over the past two business cycles. In most states, the average income of the poorest fifth of families with children is lower now than in the late 1970s.

Some families, however, have low incomes for only a few years, quickly moving into the middle class. For example, the parents of a young child may be working part-time while finishing college. The family's income might be very low for a few years, but after both parents graduate from college and obtain well-paying jobs, the family's income could increase substantially.

While some families with children do see their incomes increase over time, studies of income mobility have shown that the majority of low-income families have low incomes for many years. A recent study of earnings mobility showed that mobility among workers in the bottom fifth of the income distribution is significantly lower than mobility among workers in the middle three fifths of the distribution.(2)1 In the late 1980s, over 80 percent of workers in the bottom fifth of the distribution were still in the bottom fifth a year later and over 60 percent were still in the bottom fifth five years later. By contrast, approximately 60 percent of workers in the second fifth of the income distribution were still in the second fifth of the distribution a year later and close to 45 percent of workers were still in the second fifth of the distribution five years later. (The incomes of some of the workers that moved to another income fifth increased, but some experienced a drop in income.)

Not only is income mobility lower for low-income workers, but mobility has not increased over time. Some observers have speculated that while the average income of the poorest fifth of workers has fallen, this decrease in income may have been offset by increased mobility. In other words, if poor workers have lower earnings initially but they move more quickly into the middle class than they did in the past, the increases in income disparities would not necessarily signal a decrease in families' "wellbeing." The data, however, do not support this theory. In fact, income mobility has remained virtually unchanged since the 1970s.2 There is no evidence that the increases in inequality of recent years have been offset by increases in mobility.
1Richard V. Burkhauser, Amy D. Creuz, Mary C. Daly, and Steven P. Jenkins. Income Mobility and the Middle Class. American Enterprise Institute Studies of Understanding Income Inequality. (Washington, D.C.: American Enterprise Institute Press) 1996.


Technological innovations also have changed the labor market. Manufacturing has become more automated than in the past, so the demand for high-skilled jobs has increased while the demand for low-skilled manufacturing jobs has fallen. Most new low-wage, low-skilled jobs created today are in the service sector. These service-sector jobs tend to be lower-paid than the comparable manufacturing jobs. For example, over the past 26 years, 22 percent of all new service-sector jobs were in retail trade. Average hourly wages in retail trade are just 64 percent of those in manufacturing.(3)

The continuing decline in the percentage of workers who are union members has also led to increased income inequality. Unions have historically been successful in raising wages and benefits by standardizing compensation across competing employers. Unions also reduce the turnover of employees, enhance the accumulation of skills, and improve health and safety on the job.(4) Non-unionized workers typically are paid lower wages, have less job security, fewer benefits, and are more likely to work part time. In 1975, 20.7 percent of the labor force was unionized. By 1996, the percentage of workers belonging to unions had dropped to 14.5 percent.

Social factors have also had an impact. During the 1970s and 1980s, families often made up for the decline in the wages of a worker by increasing the number of hours family members were employed. Increasing numbers of women entered the workforce, helping to stem the decline in family incomes that resulted from the fall in average male earnings. More recently, as the deterioration in male wages has accelerated, families have been unable to offset the lost wages through increased earnings by wives. The increase in the number and percentage of single-parent households has also put downward pressure on family incomes.

After wages, the second largest source of income for middle- and upper-income families is investment income. Over the past two decades, the distribution of investment income has become increasingly unequal. This was particularly true in the period of recession of the early 1990s.

This report captures only some of the effects of these investment income trends. The income measure used in this report includes only a portion of investment earnings. It does not include income from capital gains. The rapid growth since the 1970s of income derived from capital — such as rent, dividends, interest payments and capital gains — rather than labor has disproportionately benefited the highest-income families. Some 80 percent of all capital gains income is realized by families in the top fifth of the income distribution. The average amount of capital income — capital gains plus other investment income — received by the richest of these families — the top 5 percent — increased by 56 percent between 1979 and 1994. The average household in the top 5 percent received more than $51,000 in capital income in 1996.(5)

Minimum Wage

One way that policymakers could help reverse or moderate the decline in wages for workers at the bottom of the pay scale would be to enact a higher minimum wage. The federal minimum wage is now $5.15 an hour. At this level, the value of the minimum wage is still lower than it was any year between 1961 and 1984, after adjusting for inflation. The purchasing power of the minimum wage is about 18 percent below its average value during the late 1970s.

Because prospects for an additional increase in the federal minimum wage are uncertain, increases in state minimum wages should be considered. Since 1981, a number of states have raised their minimum wages to offset the decline in the value of the federal minimum wage. The minimum wage in six states — Alaska, California, Connecticut, Hawaii, Massachusetts, and Oregon — is now higher than the federal level.

A higher minimum wage could serve to reduce income inequality significantly. Each 25 cent increase in the minimum wage would boost the earnings of a full-time minimum wage worker by $520 per year.(6)

Unemployment Insurance

The incomes of many workers over the course of a year are often reduced because they experience a spell of unemployment. Poverty resulting from unemployment is especially serious during periods of weak economic growth, when many workers are laid off and face limited prospects of finding new employment. Intermittent unemployment is also likely to be a significant cause of workers falling into poverty in states that have a high level of seasonal unemployment, such as in agriculture or tourism.

The unemployment insurance system, administered jointly by the federal and state governments, is an important part of the safety net designed to prevent such poverty. Unemployment insurance helps workers who lose their jobs by replacing a portion of their former earnings while they are looking for new jobs or waiting to be called back to their old jobs, frequently preventing the unemployed from falling into poverty or from needing to rely on welfare.

Unemployment insurance has become less effective in maintaining income than in the past, however, because a smaller share of unemployed workers now receive unemployment insurance. In 1995, just one in three unemployed workers — 35 percent — received unemployment insurance. By contrast, the share of unemployed workers receiving unemployment compensation virtually always exceeded 40 percent prior to 1980.

The decline in unemployment insurance receipt reflects both economic trends, such as the decline in manufacturing jobs in the United States, and changes in federal and state policies. The federal government and a number of state governments have enacted changes that have made the unemployment insurance program more difficult to access. When benefit costs rose due to a lengthy period of high unemployment in the early 1980s, a number of states reacted by making eligibility rules more restrictive.

Efforts to strengthen the unemployment insurance system — both at the national level and in many states — are warranted in order to broaden the receipt of unemployment insurance among unemployed workers. There are a number of options for modifying state rules that govern unemployment insurance that would expand coverage among low-wage workers.

Income Support Programs

Changes in programs that provide assistance to low-income families also have contributed to the increase in income inequality and will likely continue to exacerbate the trend toward increasing inequality in the coming years.

Among these changes are reforms in the cash assistance programs serving needy families with children. Over the period between the late-1970s and the mid-1990s, benefits provided under the Aid for Families with Dependent Children program fell in the majority of states. In the typical state, benefits for a family of three with no other income fell 40 percent between 1975 and 1996, after adjusting for inflation.

These cuts were especially severe in states that began operating their AFDC programs under federal waivers. In some of these states, needy families had their benefits reduced if they did not or could not comply with a variety of new requirements, and participants may have been discouraged from applying for assistance.

The Personal Responsibility and Work Opportunities Act of 1996, better known as the welfare reform law, will likely have a significant effect on the incomes of low-income single parent families with children when the law is fully implemented. The law allows states to eliminate benefits to families that do not conform to strict training and work requirements and sets a time limit on benefits. Although the harshest provisions of the law have not yet taken effect, participation in what was once known as Aid for Families of Dependent Children and is now known as Temporary Assistance to Needy Families has dropped precipitously over the past year. It is not known whether the majority of those families no longer receiving assistance have gotten jobs or found other sources of income, or whether their incomes have dropped.

States have broad latitude in designing programs that comply with the new welfare law. Some states have adopted very strict work requirements and shorter time limits than are required under the federal law. While it is uncertain what the long-term effect of these changes will be on the incomes of families with children, it is likely that when the economy goes into another recession, the consequences for these families could be dire. Families that have relied on public assistance are often headed by adults with few job skills who are likely to be among the first to lose their jobs if there is a recession.

The welfare reform bill also replaced the eligibility criteria for the Supplemental Security Income program for the elderly and disabled poor with far stricter standards. These new standards have resulted in thousands of low-income disabled children being disqualified from the program. This will likely further reduce the incomes of low-income families with children.

Many states operate a general assistance program for individuals and families that do not qualify for federal assistance under SSI or TANF. However, in recent years, many states have either eliminated or substantially cut funding from general assistance programs. This also will likely increase the income inequality in those states.

There are a host of options state policymakers can consider to strengthen their social safety nets including expanded earnings disregards for persons just entering the workforce or restoration of SSI and Food Stamp benefits for immigrants and children with disabilities excluded from these programs by federal changes. States that emphasize job placement, training, and the provision of supportive services such as transportation and child care in their implementation of the TANF program may be less likely to see a deterioration in the well-being of poor families than states that emphasize harsh sanctions and very short time limits.

State Tax Policies

Virtually all state tax systems collect a larger share of the incomes of poor families than of high-income families. This serves to widen the after-tax income gap, exacerbating the trends in pre-tax income detailed in this report. Further, many states have been making their tax systems less progressive throughout the 1990s. When states raised taxes over the past decade to meet recession-induced shortfalls, they predominantly raised those taxes that fall most heavily on low- and moderate- income households. When a stronger economy has allowed taxes to be reduced, however, much of the benefit has been targeted on higher-income families. As a result, state taxes appear to have become relatively more burdensome to low- and moderate-income families than they were in the late 1980s.(8)

State Tax Reform

As long as current economic trends continue, states are likely to maintain healthy fiscal conditions. State revenue collections are growing because of a combination of low unemployment and strong returns on financial investments; the increased personal income and associated consumption translate into rising revenue for many states. Moreover, strong economies temporarily reduce the demand and the need for some social safety net programs. An additional — although short-lived — boost to state revenue may come from the 1997 reduction in the federal capital gains tax rate. To the extent the federal capital gains tax rate reduction persuades investors to cash in additional accumulated capital gains, a temporary rise in state capital gains tax revenue may occur over the next year or two.

These additional revenues and reduced expenditures are likely to spur continued discussion of tax cuts in many states. The specific taxes that states choose to cut and the form of those cuts will determine whether these cuts increase or decrease after-tax income inequality in the states. In order to narrow the gap between high- and low-income families, states can institute tax reforms — and if they choose to cut taxes, can fashion tax reductions — that are progressive in nature and improve the after-tax distribution of income.

There are many ways to accomplish this. One is to increase the state's reliance on income taxes rather than sales taxes by, for example, cutting sales tax rates rather than income tax rates. States can also make their income tax systems more progressive by enacting tax credits targeted to low-income tax-payers or by raising personal exemptions or standard deductions. In 1997, for example, two additional states enacted state earned income tax credits (see below) targeted to the working poor. Another way to lessen the negative impact of state tax systems on the poor while cutting taxes is to exempt food from the sales tax base. Georgia is phasing out its sales tax on food and Missouri and North Carolina have both reduced the rate at which food is taxed under their sales taxes.

Establishing a State Earned Income Tax Credit

One direct way that states can use tax policies to raise income from work for their poorest residents is to enact a state earned income tax credit. In recent years, several states have created earned income tax credits to build on the strengths of the federal Earned Income Tax Credit. The federal EITC is a tax credit for low- and moderate-income working people that is designed to offset the sizable burden of the Social Security payroll tax on low-wage workers, supplement the earnings of low- and moderate-income families, and complement efforts to help families make the transition from welfare to work.

There is an important role for state EITCs. Many families with working parents remain poor even when their federal EITC benefits are considered. In addition, low-income families pay a substantial share of their incomes in state and local taxes, particularly regressive sales and excise taxes. Partly as a result of these factors, nine states have established their own EITCs — Iowa, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Wisconsin. State EITCs can boost the incomes of a state's poorest working families and reduce the gap between the state's poorest and state's richest residents.

Better Information on the Impact of State Tax Changes

In most states, tax reductions or increases are considered without much information or debate over the extent to which various income groups would benefit or be harmed by the proposed tax changes. Only a few states have the capacity in either their executive budget offices or legislative fiscal offices to analyze routinely and disseminate in a timely way during the legislative process information on the distribution of the benefits that would result from a tax proposal. Even states that have such a capacity do not necessarily produce and disseminate analyses throughout the session, when negotiations become intense, compromises are hammered out, and legislation can undergo substantial change. Nor is it common for states to prepare analyses of the distribution of tax changes that have been enacted over a period of years. Policymakers in most states do not have access to analytic information describing the impact on families at different income levels of decisions they have made or might make.

In order for state policymakers to fashion tax reforms which reduce after-tax inequality, they must have access to consistent, timely information about the distributional impact of their taxes. Minnesota has routinely produced such information. Texas is moving in the direction of providing comprehensive information on the impact of its tax system and proposed tax changes. The availability of this type of information can help the public participate in debates over the type of tax changes that are desirable for the state and can help policymakers make informed decisions.


V. Conclusion

Over the course of the two decades since the late 1970s, few states have experienced broadly-shared growth. While overall the economy of the United States has grown over the period, most of the benefits of that growth have accrued to families at the top of the income distribution. Middle- and lower-income families have seen their incomes fall in real terms in the vast majority of states while incomes at the top of the distribution have increased substantially, thereby widening the gap in income between the richest and the poorest families with children.

Even the robust growth of the early to mid-1990s has not reversed this long-term trend. In two-thirds of states, families at the bottom and the middle of the income distribution have failed to keep pace with the gains made by the richest fifth of families over the past decade, and consequently, in those states, the gaps between high-income families and the middle class and between high-income families and the poor have continued to widen.

The increase in income inequality has resulted from a number of factors, including both economic trends and changes in policy. Both federal and state policies have contributed to the increasing gap in income, and both federal and state policies can be used to help mitigate or even reverse this trend in the future.

End Notes for Chapter Four

1. See Dale Belman and Thea Lee. "International Trade and the Performance of U.S. Labor Markets." in Robert Blecker, ed, U.S. Trade Policy and Global Growth: New Directions in the International Economy (Armonk, NY: M.E. Sharp) 1996. And Gary Burtless "International Trade and the Rise in Earnings Inequality." Journal of Economic Literature, Vol. 33, June 1995.

2. Richard V. Burkhauser, Amy D. Creuz, Mary C. Daly, and Steven P. Jenkins. Income Mobility and the Middle Class. American Enterprise Institute Studies of Understanding Income Inequality. (Washington, D.C.: American Enterprise Institute Press) 1996.

3. Lester Thurow, "Wages and the Service Sector," in Restoring Broadly Shared Prosperity (Washington, DC: The Economic Policy Institute) 1997.

4. Richard Freeman, " Is Declining Unionization of the U.S. Good, Bad, or Irrelevant?" in Unions and Economic Competitiveness (Armonk, NY: Economic Policy Institute Series) 1992.

5. State of Working America, 1996-1997, Economic Policy Institute, 1996.

6. For someone working 40 hours per week and 52 weeks per year at the minimum wage, a 25 cent increase would yield a gross annual wage increase of $0.25 times 2,080, or $520. After payroll taxes of 7.65 percent are deducted, the net gain is $480.

7. These states are Arkansas, Colorado, Delaware, Indiana, Maine, Massachusetts, Michigan, Minnesota. Mississippi, North Carolina, Ohio, Pennsylvania, South Dakota, West Virginia, and Wisconsin.

8. In the last four years, states have lowered personal income taxes, which are the major taxes paid by upper-income families, by $9.9 billion. This is approximately equivalent to the $8.2 billion income taxes were raised in the early 1990s if inflation is taken into account. But states have not reversed the increases in sales and excise taxes that took place in the earlier years. While sales and excise taxes — the most burdensome taxes for lower-income families — were increased $12.0 billion in the early 1990s, there has been a net reduction of only $0.1 billion in sales and excise taxes in the 1994-97 period.