Many scholars have argued that once “basic needs” have been met, higher income is no longer associated with higher in subjective well-being. We assess the validity of this claim in comparisons of both rich and poor countries, and also of rich and poor people within a country. Analyzing multiple datasets, multiple definitions of “basic needs” and multiple questions about well-being, we find no support for this claim. The relationship between well-being and income is roughly linear-log and does not diminish as incomes rise. If there is a satiation point, we are yet to reach it.

Introduction

In 1974 Richard Easterlin famously posited that increasing average income did not raise average well-being, a claim that became known as the Easterlin Paradox. However, in recent years new and more comprehensive data has allowed for greater testing of Easterlin’s claim. Studies by us and others have pointed to a robust positive relationship between well-being and income across countries and over time (Deaton, 2008; Stevenson and Wolfers, 2008; Sacks, Stevenson, and Wolfers, 2013). Yet, some researchers have argued for a modified version of Easterlin’s hypothesis, acknowledging the existence of a link between income and well-being among those whose basic needs have not been met, but claiming that beyond a certain income threshold, further income is unrelated to well-being.

The existence of such a satiation point is claimed widely, although there has been no formal statistical evidence presented to support this view. For example Diener and Seligman (2004, p. 5) state that “there are only small increases in well-being” above some threshold. While Clark, Frijters and Shields (2008, p. 123) state more starkly that “greater economic prosperity at some point ceases to buy more happiness,” a similar claim is made by Di Tella and MacCulloch (2008, p. 17): “once basic needs have been satisfied, there is full adaptation to further economic growth.” The income level beyond which further income no longer yields greater well-being is typically said to be somewhere between $8,000 and $25,000. Layard (2003, p. 17) argues that “once a country has over $15,000 per head, its level of happiness appears to be independent of its income;” while in subsequent work he argued for a $20,000 threshold (Layard, 2005 p. 32-33). Frey and Stutzer (2002, p. 416) claim that “income provides happiness at low levels of development but once a threshold (around $10,000) is reached, the average income level in a country has little effect on average subjective well-being.”

Many of these claims, of a critical level of GDP beyond which happiness and GDP are no longer linked, come from cursorily examining plots of well-being against the level of per capita GDP. Such graphs show clearly that increasing income yields diminishing marginal gains in subjective well-being. However this relationship need not reach a point of nirvana beyond which further gains in well-being are absent. For instance Deaton (2008) and Stevenson and Wolfers (2008) find that the well-being–income relationship is roughly a linear-log relationship, such that, while each additional dollar of income yields a greater increment to measured happiness for the poor than for the rich, there is no satiation point.

In this paper we provide a sustained examination of whether there is a critical income level beyond which the well-being–income relationship is qualitatively different, a claim referred to as the modified-Easterlin hypothesis. As a statistical claim, we shall test two versions of the hypothesis. The first, a stronger version, is that beyond some level of basic needs, income is uncorrelated with subjective well-being; the second, a weaker version, is that the well-being–income link estimated among the poor differs from that found among the rich.

Claims of satiation have been made for comparisons between rich and poor people within a country, comparisons between rich and poor countries, and comparisons of average well-being in countries over time, as they grow. The time series analysis is complicated by the challenges of compiling comparable data over time and thus we focus in this short paper on the cross-sectional relationships seen within and between countries. Recent work by Sacks, Stevenson, and Wolfers (2013) provide evidence on the time series relationship that is consistent with the findings presented here.

To preview, we find no evidence of a satiation point. The income–well-being link that one finds when examining only the poor, is similar to that found when examining only the rich. We show that this finding is robust across a variety of datasets, for various measures of subjective well-being, at various thresholds, and that it holds in roughly equal measure when making cross-national comparisons between rich and poor countries as when making comparisons between rich and poor people within a country.

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Forty years after its initial publication, Equality and Efficiency: The Big Tradeoff remains an influential work from one of the most important macroeconomists over the last century, Arthur M. Okun (1928-1980). Okun’s theory on market economies reminds readers of an engaging dual theme: the market needs a place, and the market needs to be kept in its place. Articulated in a way that remains relevant even during today’s discussions on broadening gaps in income inequality, Okun emphasized that institutions in a capitalist democracy prod us to get ahead of our neighbors economically after telling us to stay in line socially.

On May 4, The Brookings Institution Press re-released Okun’s classic work with a new foreword from Former Treasury Secretary Lawrence H. Summers, in addition to “Further Thoughts on Equality and Efficiency,” a paper published by Okun in 1977. The event included opening remarks from Brookings Senior Fellow George Perry, with a keynote address from Larry Summers. Following these remarks, David Wessel moderated a panel discussion with former Chair of the Council of Economic Advisers Greg Mankiw, Economic Studies’ Melissa Kearney and Justin Wolfers, and Washington Center for Equitable Growth's Heather Boushey regarding the history and impact of Okun’s work.

Download a copy of Lawrence Summers' opening remarks.

Ted Gayer, Vice President and Director of Economic Studies and Joseph Pechman Senior Fellow, reads Lawrence Summers's opening remarks.

David Wessel (right), Director of the Hutchins Center on Fiscal and Monetary Policy, moderates a panel discussion with N. Gregory Mankiw, Melissa Kearney, and Heather Boushey.

Janet Yellen, Chair of the Board of Governors of the Federal Reserve System, listens to the discussion from the audience. To Yellen's right is former Congressional Budget Office director, Doug Elmendorf.

Video

• 40 years later- The relevance of Okun’s "Equality and Efficiency: The Big Tradeoff"

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• 40 years later- The relevance of Okun’s "Equality and Efficiency: The Big Tradeoff"

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• Uncorrected Transcript (.pdf)

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• 20150504_okun_equality_efficiency_transcript
• 050415 Summers Okun Speech

The Brookings Institution today launched the Center for Universal Education, an initiative that will develop and disseminate effective solutions to the challenge of achieving universal quality education. The center becomes part of the Global Economy and Development program and will conduct research and analysis, convene meetings and host policy forums to enhance policy development and understanding on a range of issues relevant to the achievement of universal quality education for the world’s poorest children. Jacques van der Gaag, senior fellow, and Rebecca Winthrop and David Gartner, fellows, will serve as co-directors of the center.

Van der Gaag has been a distinguished visiting fellow in Global Economy and Development at Brookings since 2006 and researched the economics of poverty, the economic consequences of HIV/AIDS and international health care financing. He was most recently a professor of development economics at the Faculty of Economics and Business at the University of Amsterdam. Winthrop, an expert in the field of education in contexts of armed conflict, most recently has been the head of education for the International Rescue Committee and teaching at Columbia University. She will focus on education in contexts of mass displacement, state fragility, and armed conflict and the role of education in long-term solutions for peace and development. Gartner is an expert on global education, global health and international development who recently has been a visiting scholar at Harvard University. His research will focus on global education and the role of international institutions and foreign assistance in global development.

“We are very pleased to welcome these new scholars and the Center for Universal Education to Brookings,” Brookings President Strobe Talbott said. “The center will strengthen and complement our current efforts to contribute to global education and development.”

Established in 2002, the Center for Universal Education (CUE) was previously part of the Council on Foreign Relations and was directed by Gene Sperling. Sperling left the Council on Foreign Relations earlier this year to become senior counselor to U.S. Treasury Secretary Timothy Geithner.

“Jacques, Rebecca and David’s expertise will help CUE develop and disseminate effective solutions to the challenge of achieving universal quality education,” said Kemal Derviş, vice president and director of Global Economy and Development at Brookings. “The center will continue to be a leading forum for shared learning in the global education policy community and will seek to project its own ideas into broader public debates in ways that will strategically support its core mission.”

The new center will focus on the provision of universal quality education among the world's poorest countries. Its affiliated scholars will conduct research and produce policy proposals around the core objective that every child should receive a quality basic education. It will also analyze the challenges and opportunities for the sufficient and effective funding of and programming for universal quality education.

ABSTRACT

This study analyzes the willingness to pay for health insurance and hence the potential market for new low-cost health insurance product in Namibia, using the double bounded contingent valuation (DBCV) method. The findings suggest that 87 percent of the uninsured respondents are willing to join the proposed health insurance scheme and on average are willing to insure 3.2 individuals (around 90 percent of the average family size). On average respondents are willing to pay NAD 48 per capita per month and respondents in the poorest income quintile are willing to pay up to 11.4 percent of their income. This implies that private voluntary health insurance schemes, in addition to the potential for protecting the poor against the negative financial shock of illness, may be able to serve as a reliable income flow for health care providers in this setting.

Read the full paper on ScienceDirect »

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Student enrollment and expenditures per student have been on the rise in sub-Saharan Africa over the past decade. Yet, financing gaps still exist for achieving universal quality education throughout the region, especially in countries with strong demographic pressures. Many African countries are facing a dilemma of how best to balance scarce resources and the growing demands to improve education quality for their children and youth.

On April 27, the Center for Universal Education and the Africa Growth Initiative at Brookings hosted a discussion of the state of education financing in sub-Saharan Africa. Albert Motivans of UNESCO’s Institute for Statistics presented the main findings of a new report "Financing Education in sub-Saharan Africa," which focuses on the new challenges related to expanding access, equity and quality education. Shantayanan Devarajan of the World Bank and Brookings Senior Fellow Jacques van der Gaag provided commentary, and Senior Fellow Mwangi Kimenyi, director of the Africa Growth Initiative, moderated the discussion.

After the discussion, the panelists took audience questions.

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• Africa’s Education Financing Challenge

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• Transcript (.pdf)
• Motivans UNESCO presentation (.pdf)
• Financing Education in Sub-Saharan Africa (.pdf)

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• event_transcript_africa_education
• Motivans PPT_FINAL
• Finance_Education_Africa

The Chinese government has recently made early childhood development a national priority, recognizing the social and economic dividends that quality early learning opportunities reap for its human capital in the long term. As the country with the largest population in the world, 100 million children under the age of six in China stand to benefit from increased access to high quality early childhood education.

The quality of education in a country is indicative of its overall development prospects. Over the past two decades – building on the momentum generated by the Education for All and Millennium Development Goals – there have been significant increases in the number of children enrolled in school. Now, with discussions heating up around what the next set of development goals will look like in 2015, it is critical that learning across the education spectrum – from early childhood through adolescence and beyond – is included as a global priority. Starting early helps children enter primary school prepared to learn. High-quality early childhood development opportunities can have long-term impacts on a child’s later success in school.

Last month, the Chinese Ministry of Education, in partnership with the United Nations Children’s Fund, launched its first national early childhood advocacy month to promote early learning for all children. The campaign, which includes national television public service announcements on the benefits of investing early in education, builds on a commitment made by the government in 2010 to increase funding for early childhood education over the next decade. The Chinese government pledged to build new preschool facilities, enhance and scale up teacher training, provide subsidies for rural families for access to early learning opportunities, and increase support for private early childhood education centers.

A new policy guide by the Center for Universal Education outlines recommendations that education stakeholders, including national governments, can take to ensure that all children are in school and learning. These steps include establishing equity-based learning targets for all children, systematically collecting data for tracking progress against these targets, and allocating sufficient resources to education beginning in early childhood. The policy guide, based on a report calling for a Global Compact on Learning, is available in Mandarin, as well as Spanish, Portuguese, French and, soon, Arabic.

The success of China’s productivity and growth over the last few decades is attributable in part to its commitment to building a robust education system. As international attention mounts around the post-2015 education and development agendas, the priorities of national governments must be a central organizing principle. When national governments take bold steps to prioritize early childhood development, the global community should take its cue and integrate early childhood development into the broader push toward access plus learning. There is an opportunity for the global education community to push toward reaching the Education for All and Millennium Development Goals while ensuring that the post-2015 agendas include a focus on the quality of education, learning and skills development, beginning with the youngest citizens.

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Five years have passed since the self-immolation of Mohamed Bouazizi in Tunisia sparked revolts around the Arab world and the beginning of the Arab Spring. Despite high hopes that the Arab world was entering a new era of freedom, economic growth, and social justice, the transition turned out to be long and difficult, with the Arab world now in turmoil with revolutions, counter revolutions, wars, civil strife, and the worst refugee crisis of our times. The response to the Arab Spring and its aftermath has focused almost exclusively on political and security issues, and on the very divisive questions of national identity and political regimes. Economic and social questions have been put on the back burner.

On January 15, Global Economy and Development at Brookings hosted a discussion on a new book, "The Arab Spring Five Years Later," which explores the critical economic and social issues driving the Arab Spring agenda and the real economic grievances that must be addressed in order to achieve peace, stability, and successful political transitions as well as provides an approach to addressing those grievances.

Hafez Ghanem and Shinchi Yamanaka presented the key findings of the book, followed by a panel discussion. 

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• The Arab Spring Five Years Later: Toward greater inclusiveness

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• Uncorrected Transcript (.pdf)

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• 20160115_arab_spring_transcript

“When I go to meetings today, I see more women, and I see many more younger women coming into the field.  But what’s really struck me, as I’ve been thinking about this issue of women in foreign policy in the last couple years, is the difference between presence and voice.  There are many more women working in foreign policy today, but you don’t see the same proportion of women prominent in foreign policy speaking in the media, in senior positions, or even when you’re all in the room together sitting at the table and speaking as the lead speaker at a conference.  It’s that distinction between presence and voice and what accounts for that gap.  That’s what I find both fascinating and frustrating.”—Tamara Wittes

Show Notes

The Absence of Women from Middle East Policy Debates: An Update

Women still overlooked in vital peacekeeping process, study finds

An All-Women Symposium: The Missing XX-Factor

Foreign Policy Interrupted

Women Are Underrepresented In Cable News Segments On Foreign Affairs, National Security 

With thanks to audio engineer and producer Zack Kulzer, Mark Hoelscher, Carisa Nietsche, Sara Abdel-Rahim,  Eric Abalahin, Fred Dews and Richard Fawal.

Subscribe to the Intersections on iTunes, and send feedback email to intersections@brookings.edu.

On October 17, the Brookings Institution’s Project on International Order and Strategy hosted two of the most prominent thinkers on American grand strategy to discuss whether Washington should remain forward-leaning in its posture, or if it should adopt a more restrained approach to global engagement.

The event was moderated by Brookings Foreign Policy Fellow Jeremy Shapiro, and featured a debate between Brookings Foreign Policy Senior Fellow Robert Kagan and Barry Posen, Ford International Professor at Massachusetts Institute of Technology.

Kagan argued that the United States has an enduring responsibility and capacity to shape the world order and must remain actively engaged abroad to prevent the international order from collapse. Posen, on the other hand, warned against American overreach in foreign policy and urged Washington to embrace restraint, focusing on its own national security interests and limiting engagement – particularly military - abroad.

In their discussion of the Middle East, both scholars sought to define American regional interests with greater precision. Posen argued that “affective” relationships, such as those with Israel, do not explain the U.S. defense budget dedicated to the region or contingency plans for the region. Posen also disputed the view that oil is the primary driver of U.S. regional policy, suggesting that threats to major suppliers could be managed with a less robust regional security commitment than Washington has traditionally maintained.

Kagan argued that President Obama is more intellectually inclined toward Posen’s strategy of restraint than most of his predecessors, and yet he too has been drawn into the Middle East. “It can’t just be pure stupidity that has had the United States involved in the Middle East as consistently as it has been for almost 70 years now, taking the place of the previous powers that had been involved in the Middle East,” he said.

Posen discussed U.S. efforts against the Islamic State group (also called ISIS or ISIL). He noted that President Obama’s rhetoric on ISIS has gone beyond what is prudent, describing the strategy as one of “containment that’s augmented by the promise of future counter-offensives and destruction.” Washington’s current strategy, Posen argued, has demobilized allies by enabling them to skirt responsibility for the crisis.

Posen and Kagan differed in their interpretations of the track record of American interventions in the region. Posen criticized American understanding of the causes and effects of intervention, saying that it is easier to oust a government than to generate internal consensus or transform a country into a stable democracy. By contrast, Kagan argued that the U.S. has never invaded a Middle Eastern country with the purpose of rearranging domestic politics.

There was little discussion of terrorism and nuclear proliferation, though Posen identifies these two threats as major items on which the U.S. should remain engaged. More information about Posen’s arguments can be found in his new book, Restraint: A New Foundation for U.S. Grand Strategy (Cornell University Press, 2014). Kagan’s argument for continued pre-eminence and engagement in grand strategy can be found in his influential May 2014 New Republic essay “Superpowers Don’t Get to Retire.”

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John Quincy Adams famously said that America “goes not abroad in search of monsters to destroy.” A diplomat, secretary of state, as well as the sixth president, Adams is often described as a “realist,” and as the founder of American foreign policy realism. But did his own policy choices square with that doctrine of restraint? Recently, President Obama has described his own views in explicitly realist terms; Hillary Clinton is widely viewed as a more ardent believer in the active use of American power; and the Republican candidates seem more eager to build walls than to engage the outside world.

On April 11, the Brookings Project on International Order and Strategy (IOS) hosted a discussion between Brookings Senior Fellow Robert Kagan and James Traub, columnist and contributor at foreignpolicy.com, lecturer of foreign policy at New York University, and now the author of the new book, “John Quincy Adams: Militant Spirit” (Basic Books, 2016). Kagan and Traub debated whether Adams was a foreign policy realist and whether his approach to foreign policy can still inform the policy choices facing the United States today. Brookings Fellow Thomas Wright, director of IOS, moderated the discussion.

Audio

• Was John Quincy Adams a realist? A debate

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• Transcript (.pdf)

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• 20160411_john_quincy_adams_transcript

A Q&A with Dennis Lower, president and CEO, Cortex Innovation Community

As leaders scan the landscape for strong examples of innovation districts, their tour is hardly complete without learning of the Cortex Innovation Community—an innovation district in the heart of St. Louis. We sat down with Dennis Lower, president and CEO of the Cortex Innovation Community to learn what kinds of interventions and instruments are driving their success.

What is the Cortex Innovation Community?

Cortex is the region’s largest innovation hub, generating 3,800 tech-related jobs and over $500 million in investment in the last 14 years. It’s located close to downtown and built on the intellectual assets and resources of St. Louis’ leading universities, a premier health care provider, and the Missouri Botanical Garden. The focal point is the 200 acres of old industrial land that one time separated these institutions but that now stitches them together. At full build-out, Cortex will likely generate $2 billion of development and create 13,000 jobs.

What sets Cortex apart from other innovation districts?

Of course, every district is distinctive and unique, building off its local character, culture, and assets. What sets Cortex apart, I would argue, is that we literally have billions of dollars of academic, cultural, and recreational assets in the neighborhoods that surround the district, which other places simply do not have.

We are bookended by two universities—Washington University and St. Louis University—each a magnet for international students and each with a reputation for research and academic excellence. Washington University, for example, was one of five consortium members funded by the National Institutes of Health to map the human genome. These universities, together with the University of Missouri-St. Louis, are the academic bedrock of our local innovation ecosystem.

Recent demographic analysis tells us we are now the most diverse employment environment in the region no matter how you slice it, including by age, ethnicity, and educational attainment.

Another Cortex advantage is the neighborhood that surrounds us. In addition to historic housing, the Grand Center arts district is to the east, to the west is Forest Park, which contains the St. Louis Zoo, fine arts and history museums, two golf courses, the St. Louis Science Center, abundant walking and biking trails, and the internationally renowned Botanical Garden. Restaurant corridors are to the north and south. I tell you all this to say that Cortex is where innovation, tech, culture, and community collide—and people are hungry for this mix.

Cortex Innovation Community is also a tax-exempt 501(c)3 that oversees the design and development of the innovation district. What makes your nonprofit unique in managing this district?

Cortex has been designated the master developer to transform an old industrial district into a center for innovation and commercialization. We are in a particularly advantageous position because the state and the city have granted the 501(c)3 powers of eminent domain, the power to abate taxes, and the power to approve or reject building plans. From a traditional economic development perspective, these powers have been critical in overcoming obstacles that land speculators sometimes put in our way. We have not had to use this power very often, fortunately. Only a handful of properties were acquired under the threat of eminent domain, and we reached an impasse only twice, sending us to court to purchase those properties. We take this responsibility seriously and only use eminent domain powers sparingly. We have a good reputation with the public as a result.

Can you describe one accomplishment you are particularly proud of?

We knew that to jump-start an innovation district it was essential to build entrepreneurial density. We developed an unorthodox strategy of sorts in that we built a concentration of innovation assets all within a block of each other. Today, we have six innovation centers, each with its own community and programming: the Center for Emerging Technologies, a traditional technical assistance incubator for information technology, bioscience, and consumer/manufacturing products; the BioGenerator, an accelerator with shared wet lab space and $3 million of shared core lab equipment; TechShop, a premier maker work space for prototyping and creating; the Cambridge Innovation Center–St. Louis, a co-working office and lab startup space); Venture Café–St. Louis, a shared public space for the startup community to meet weekly with 8 to 12 unconventional breakout educational sessions; and IdeaLabs/MedLaunch, a unique university graduate/undergraduate incubator that develops new technology to solve clinical problems. This strategy is working beyond our wildest expectations. It’s the “secret sauce” for supercharging our district’s innovation ecosystem. 

Venture Café: one of the six innovation centers that weekly draws together over 500 entrepreneurs from all technology sectors.

Can you highlight one particularly interesting innovation or invention coming out of Cortex? 

Let me highlight two. We have over 200 companies in Cortex—there’s too much innovation happening here to highlight only one!

First, we have a medical device company that is changing the way infectious diseases are diagnosed. Its products can rapidly detect bacterial infections, determine if the infection is resistant to a range of antibiotics, and provide clinicians with patient-specific guidance to treat infections quickly and accurately. Their first product can diagnose urinary tract infections in just three hours.

And then we have a company tackling the biggest challenge in agriculture today—preventing insects, diseases, and weeds from destroying food crops. This company is developing a cost-effective technology to produce and topically deliver RNAi for agricultural crops. Put simply, this technology helps plants develop desired genetic traits without the use of genetically modified organisms, or GMOs. This could be transformative.

Many people have asked us how innovation districts are supporting inclusive growth. There is a concern that innovation districts are focusing on innovation to the exclusion of employment of city residents, who may not possess the skills or education the district’s businesses are seeking.

We look at inclusion as an integral part of our work and mission at Cortex. We currently have six inclusion initiatives and will soon introduce two more. One of those is the development of a magnet high school in the St. Louis Public School District, the Collegiate School for Medicine and Biosciences. Working closely with the school district’s superintendent and an important group of institutional and civic leaders, we have been developing an urban high school centered on one of the major strengths of our Cortex sponsors—bioscience. We recruited our first class in 2013, providing instruction in a small, temporary school, and in 2015 moved to a permanent location that can support 400 students.

The students come from all across the region, representing the largest spread of zip codes of any regional public school. Currently, 53 percent of the students are African American, 23 percent are Asian, and 22 percent are white, representing a great mix. Last year’s proficiency testing in math and English revealed that we ranked first across the entire public school system. I find this particularly gratifying because a number of incoming freshmen were not performing at grade level. What this tells us is given the opportunity, creative teaching approaches, and a supportive structure, these kids will excel quickly. With our incoming 9th grade class this August, we will have a full complement of freshmen to seniors, graduating our first class in 2017.

Perhaps one of these students will find the next cure for cancer. To me, this illustrates an important part of our district’s DNA—to grow and cultivate innovation talent for the future.

Editor’s note: The following remarks were prepared and delivered by Gary Burtless at a roundtable sponsored by the American Tax Policy Institute on January 7, 2016. Video of Burtless’ remarks are also available on the Institute’s website. Download the related slides at the right. 

To eliminate suspense from the start: Nothing I am about to say undermines the popular narrative about recent inequality trends.  For the past 35 years, U.S. inequality has increased.  Inequality has increased noticeably, no matter what income definition you care to use.  A couple of things you read in the newspaper are untrue under some income definitions. For example, under a comprehensive income definition it is false to claim that all the income gains of the past 2 or 3 decades have gone to the top 1 percent, or the top 5 percent, or the top 10 percent of income recipients.  Middle- and low-income Americans have managed to achieve income gains, too, as we shall see.

Tax policy certainly affects overall inequality, but I shall leave it for Scott, David, and Tracy to take that up. Let me turn to my main job, which is to distinguish between different reasonable income measures.

The crucial thing to know is that contradictory statements can be made about some income trends because of differences in the definition of income.  In general, the most pessimistic statements about trends rely on an income definition that is restrictive in some way.  The definition may exclude important income items, items, for example, that tend to equalize or boost family incomes.  The definition may leave out adjustments to income … adjustments that tend to boost the rate of income gain for low- or middle-income recipients, but not for top-income recipients.

The narrowest income definition commonly used to evaluate income trends is Definition #1 in my slide, “pretax private, cash income.”  Columnists and news reporters are unknowingly using this income definition when they make pronouncements about the income share of the “top 1 percent.”  The data about income under this definition are almost always based on IRS income tax returns, supplemented with a bit of information from the Commerce Department’s National Income and Product Account (NIPA) data file.

The single most common income definition used to assess income trends and inequality is the Census Bureau’s “money income” definition, Definition #2 on the slide.  It is just the same as the first definition I mentioned, except this income concept also includes government cash transfer payments – Social Security, unemployment insurance, cash public assistance, Veterans’ benefits, etc.

A slightly more expansive definition (#3) also adds food stamp (or SNAP) benefits plus other government benefits that are straightforward to evaluate. Items of this kind include the implicit rent subsidy low-income families receive in publicly-subsidized housing, school lunch subsides, and means-tested home heating subsidies.

Now we come to subtractions from income. These typically reflect families’ tax obligations.  The Census Bureau makes estimates of state and federal income tax liabilities as well as payroll taxes owed by workers (though not by their employers).  Since income and payroll taxes subtract from the income available to pay for other stuff families want to buy, it seems logical to also subtract them from countable income. This is done under income Definition #4.  Some tax obligations – notably the Earned Income Credit (EIC) – are in fact subtractions from taxes owed, which would not be a problem in the case of families that still owe positive taxes to the government.  However, the EIC is refundable to taxpayers, meaning that some families have negative tax liabilities:  The government owes them money.  In this case, if you do not take taxes into account you understate low-income families’ incomes, even as you’re overstating the net incomes available to middle- and high-income families.

Now let’s get a bit more complicated.  Forget what I said about taxes, because our next income definition (#5) also ignores them.  It is an even-more-comprehensive definition of gross or pretax income.  In addition to all those cash and near-cash items I mentioned in Definition #3, Definition #5 includes imputed income items, such as: 

• The value of your employer’s premium contribution to your employee health plan;
• The value of the government’s subsidy to your public health plan – Medicare, Medicaid, state CHIP plans, etc.
• Realized taxable gains from the sale of assets; and
• Corporate income that is earned by companies in which you own a share even though it is not income that is paid directly to you.

This is the most comprehensive income definition of which I am aware that refers to gross or pre-tax income.

Finally we have Definition #6, which subtracts your direct and indirect tax payments.  The only agency that uses this income definition is principally interested in the Federal budget, so the subtractions are limited to Federal income and payroll taxes, Federal corporate income taxes, and excise taxes.

Before we go into why you should care about any of these definitions, let me mention a somewhat less important issue, namely, how we define the income-sharing group over which we estimate inequality.  The most common assessment unit for income included under Definition #1 (“Pre-tax private cash income”) is the Federal income tax filing unit.  Sometimes this unit has one person; sometimes 2 (a married couple); and sometimes more than 2, including dependents.

The Census Bureau (and, consequently, most users of Census-published statistics) mainly uses “households” as reference units, without any adjustment for variations in the size of different households.  The Bureau’s median income estimate, for example, is estimated using the annual “money income” of households, some of which contain 1 person, some contain 2, some contain 3, and so on.

Many economists and sociologists find this unsatisfactory because they think a $20,000 annual income goes a lot farther if it is supporting just one person rather than 12.  Therefore, a number of organizations—notably, the Luxembourg Income Study (LIS), the Organisation of Economic Cooperation and Development (OECD), and the Congressional Budget Office (CBO)—assume household income is equally shared within each household, but that household “needs” increase with the square root of the number of people in the household.  That is, a household containing 9 members is assumed to require 1½ times as much income to enjoy the same standard of living as a family containing 4 members.  After an adjustment is made to account for the impact of household size, these organizations then calculate inequality among persons rather than among households.

How are these alternative income definitions estimated?  Who uses them?  What do the estimates show?  I’ll only consider a two or three basic cases.

First, pretax, private, cash income. By far the most famous users of this definition are Professors Thomas Piketty and Emmanuel Saez.  Their most celebrated product is an annual estimate of the share of total U.S. income (under this restricted definition) that is received by the top 1 percent of tax filing units.

Here is their most famous chart, showing the income share of the top 1 percent going back to 1913. (I use the Piketty-Saez estimates that exclude realized capital gains in the calculation of taxpayers’ incomes.) The notable feature of the chart is the huge rise in the top income share between 1970—when it was 8 percent of all pretax private cash income—and last year—when the comparable share was 18 percent.  

I have circled one part of the line—between 1986 and 1988—to show you how sensitive their income definition is to changes in the income tax code.  In 1986 Congress passed the Tax Reform Act of 1986 (TRA86). By 1988 the reform was fully implemented.  Wealthy taxpayers noticed that TRA86 sharply reduced the payoff to holding corporate earnings inside a separately taxed corporate entity. Rich business owners or shareholders could increase their after-tax income by arranging things so their business income was taxed only once, at the individual level.  The result was that a lot of income, once earned by and held within corporations, was now passed through to the tax returns of rich individual taxpayers. These taxpayers appeared to enjoy a sudden surge in their taxable incomes between 1986 and 1988.  No one seriously believes rich people failed to get the benefits of this income before 1987.  Before 1987 the same income simply showed up on corporate rather than on individual income tax returns.

A final point:  The chart displayed in SLIDE #6 is the source of the widely believed claim that U.S. inequality is nowadays about the same as it was at the end of the Roaring 1920s, before the Great Depression.  That is close to being true – under this income definition.

Census “money income”: This income definition is very similar to the one just discussed, except that it includes cash government transfer payments.  The producer of the series is the Census Bureau, and its most famous uses are to measure trends in real median household income and the official U.S. poverty rate. Furthermore, the Census Bureau uses the income definition to compile estimates of the Gini coefficient of household income inequality and the income shares received by each one-fifth of households, ranked from lowest to highest income, and received by the top 5 percent of households.

Here is a famous graph based on the Bureau’s “median household income” series.  I have normalized the historical series using the 1999 real median income level (1999 and 2000 were the peak income years according to Census data).  Since 1999 and 2000, median income has fallen about 10 percent.  If we accept this estimate without qualification, it certainly represents bad news for living standards of the nation’s middle class. The conclusion is contradicted by other government income statistics that use a broader, more inclusive income definition, however.

And here is the Bureau’s most widely cited distributional statistic (after its “official poverty rate” estimate).  Since 1979, the Gini coefficient has increased 17 percent under this income definition. (It is worth noting, however, that the portion of the increase that occurred between 1992 and 1993 is mainly the result of methodological changes in the way the Census Bureau ascertained incomes in its 1994 income survey.)

When you hear U.S. inequality compared with that in other rich countries, the numbers are most likely based on calculations of the LIS or OECD.  Their income definition is basically “Cash and Near-cash Public and Private income minus Income and Payroll taxes owed by households.”  Under this income definition, the U.S. looks relatively very unequal and America appears to have an exceptionally high poverty rate.  U.S. inequality has been rising under this income definition, as indeed has also been the case in most other rich countries. The increase in the United States has been above average, however, helping us to retain our leadership position, both in income inequality and in relative poverty.

We turn last to the most expansive income definition:  CBO’s measure of net after-tax income.  I will use CBO’s tabulations using this income definition to shed light on some of the inequality and living standard trends implied by the narrower income definitions discussed above.

Let’s consider some potential limitations of a couple of those definitions.  The limitations do not necessarily make them flawed or uninteresting.  They do mean the narrower income measures cannot tell us some of the things that users claim they tell us.

An obvious shortcoming of the “cash pretax private income” definition is that it excludes virtually everything the government does to equalize Americans’ incomes.  Believe it or not, the Federal tax system is mildly progressive.  It claims a bigger percentage of the (declared) incomes of the rich than it does of middle-income families’ and especially the poor.  Any pretax income measure will miss that redistribution.

More seriously, it excludes all government transfer payments.  You may think the rich get a bigger percentage of their income from government handouts compared with middle class and poorer households.  That is simply wrong.  The rich get a lot less.  And the percentage of total personal income that Americans derive from government transfer payments has gone way up over the years.  In the Roaring 1920s, Americans received almost nothing in the form of government transfers. Less than 1 percent of Americans’ incomes were received as transfer payments.  By 1970—near the low point of inequality according to the Piketty-Saez measure—8.3 percent of Americans’ personal income was derived from government transfers.  Last year, the share was 17 percent. None of the increase in government transfers is reflected in Piketty and Saez’s estimates of the trend in inequality.  Inequality is nowadays lower than it was in the late 1920s, mainly because the government does more redistribution through taxes and transfers.

Both the Piketty-Saez and the Census “money income” statistics are affected by the exclusion of government- and employer-provided health benefits from the income definition. This slide contains numbers, starting in 1960, that show the share of total U.S. personal consumption consisting of personal health care consumption.  I have divided the total into two parts. The first is the share that is paid for out of our own cash incomes (the blue part at the bottom).  This includes our out-of-pocket spending for doctors’ charges, hospital fees, pharmaceutical purchases, and other provider charges as well as our out-of-pocket spending on health insurance premiums. The second is the share of our personal health consumption that is paid out of government subsidies to Medicare, Medicaid, CHIP, etc., or out of employer subsidies to employee health plans (the red part). 

As everyone knows, the share of total consumption that consists of health consumption has gone way up.  What few people recognize is that the share that is directly paid by consumers—through payments to doctors, hospitals, and household health insurance premium payments—has remained unchanged.  All of the increase in the health consumption share since 1960 has been financed through government and employer subsidies to health insurance plans. None of those government or employer contributions is counted as “income” under the Piketty-Saez and Census “money income” definitions.  You would have to be quite a cynic to claim the subsidies have brought households no living standard improvements since 1960, yet that is how they are counted under the Piketty-Saez and Census “money income” definitions.

Final slide: How much has inequality gone up under income definitions that count all income sources and subtract the Federal income, payroll, corporation, and excise taxes we pay?  CBO gives us the numbers, though unfortunately its numbers end in 2011.

Here are CBO’s estimates of real income gains between 1979 and 2011.  These numbers show that real net incomes increased in every income category, from the very bottom to the very top.  They also show that real incomes per person have increased much faster at the top—over on the right—than in the middle or at the bottom—over on the left.  Still, contrary to a common complaint that all the income gains in recent years have been received by folks at the top, the CBO numbers suggest net income gains have been nontrivial among the poor and middle class as well as among top income recipients.

Suppose we look at trends in the more recent past, say, between 2000 and 2011.  That lower panel in this slide presents a very different picture from the one implied by the Census Bureau’s “money income” statistics.  Unlike the “money income numbers” [SLIDE #9], these show that inequality has declined since 2000.  Unlike the “money income numbers” [SLIDE #8], these show that incomes of middle-income families have improved since 2000.  There are a variety of explanations for the marked contrast between the Census Bureau and CBO numbers.  But a big one is the differing income definitions the two conclusions are based on.  The more inclusive measure of income shows faster real income gains among middle-income and poorer households, and it suggests a somewhat different trend in inequality.

Gary Burtless, a senior fellow in Economic Studies, explains new research on the growing longevity gap between high-income and low-income Americans, especially among the aged.

“Life expectancy difference of low income workers, middle income workers, and high income workers has been increasing over time,” Burtless says. “For people born in 1920 their life expectancy was not as long typically as the life expectancy of people who were born in 1940. But those gains between those two birth years were very unequally distributed if we compare people with low mid-career earnings and people with high mid-career earnings.” Burtless also discusses retirement trends among the educated and non-educated, income inequality among different age groups, and how these trends affect early or late retirement rates.

Also stay tuned for our regular economic update with David Wessel, who also looks at the new research and offers his thoughts on what it means for Social Security.

Show Notes

Later retirement, inequality and old age, and the growing gap in longevity between rich and poor

Disparity in Life Spans of the Rich and the Poor Is Growing

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Researchers have long known that the rich live longer than the poor. Evidence now suggests that the life expectancy gap is increasing, at least here the United States, which raises troubling questions about the fairness of current efforts to protect Social Security.

There's nothing particularly mysterious about the life expectancy gap. People in ill health, who are at risk of dying relatively young, face limits on the kind and amount of work they can do. By contrast, the rich can afford to live in better and safer neighborhoods, can eat more nutritious diets and can obtain access to first-rate healthcare. People who have higher incomes, moreover, tend to have more schooling, which means they may also have better information about the benefits of exercise and good diet.

Although none of the above should come as a surprise, it's still disturbing that, just as income inequality is growing, so is life-span inequality. Over the last three decades, Americans with a high perch in the income distribution have enjoyed outsized gains.

Using two large-scale surveys, my Brookings colleagues and I calculated the average mid-career earnings of each interviewed family; then we estimated the statistical relationship between respondents' age at death and their incomes when they were in their 40s. We found a startling spreading out of mortality differences between older people at the top and bottom of the income distribution.

For example, we estimated that a woman who turned 50 in 1970 and whose mid-career income placed her in the bottom one-tenth of earners had a life expectancy of about 80.4. A woman born in the same year but with income in the top tenth of earners had a life expectancy of 84.1. The gap in life expectancy was about 3½ years. For women who reached age 50 two decades later, in 1990, we found no improvement at all in the life expectancy of low earners. Among women in the top tenth of earners, however, life expectancy rose 6.4 years, from 84.1 to 90.5. In those two decades, the gap in life expectancy between women in the bottom tenth and the top tenth of earners increased from a little over 3½ years to more than 10 years.

Our findings for men were similar. The gap in life expectancy between men in the bottom tenth and top tenth of the income distribution increased from 5 years to 12 years over the same two decades.

Rising longevity inequality has important implications for reforming Social Security. Currently, the program takes in too little money to pay for all benefits promised after 2030. A common proposal to eliminate the funding shortfall is to increase the full retirement age, currently 66. Increasing the age for full benefits by one year has the effect of lowering workers' monthly checks by 6% to 7.5%, depending on the age when a worker first claims a pension.

For affluent workers, any benefit cut will be partially offset by gains in life expectancy. Additional years of life after age 65 increase the number years these workers collect pensions. Workers at the bottom of the wage distribution, however, are not living much longer, so the percentage cut in their lifetime pensions will be about the same as the percentage reduction in their monthly benefit check.

Our results and other researchers' findings suggest that low-income workers have not shared in the improvements in life expectancy that have contributed to Social Security's funding problem.

It therefore seems unfair to preserve Social Security by cutting future benefits across the board. Any reform in the program to keep it affordable should make special provision to protect the benefits of low-wage workers.

Editor's note: This piece originally appeared in The Los Angeles Times. 

Alert voters everywhere realize the economy is neither as strong as claimed by the party in power nor the disaster described by the opposition. The election season will bring many passionate but dubious claims about economic trends. People running for office know that voters rank the economy near the top of their concerns. Of course, perceptions of the economy differ from one voter to the next. A few of us are soaring, more are treading water, and too many are struggling just to stay afloat.

Since reaching a low point in 2009, total U.S. output—as measured by real GDP—has climbed 15 percent, or about 2.1 percent a year. The recovery has been long-lived and steady, a tribute to the stewardship of the Administration and Federal Reserve. The economic rebound has also been disappointingly slow in view of the depth of the recession. GOP office seekers will mention this fact a number of times before November.

Compared with the worst months of the Great Recession, the unemployment rate has dropped by half. It now stands at a respectable 4.9 percent, almost 3 points lower than the rate when President Obama took office and far below the rate in fall 2009 when it reached 10 percent. Payroll employment has increased for 77 consecutive months. Since hitting a low in January 2010, the number of workers on employer payrolls has surged 14.6 million, or about 190,000 a month. While the job gains are encouraging, they have not been fast enough to bring the employment-to-population ratio back to its pre-recession level. June’s job numbers showed that slightly less than 80 percent of adults between 25 and 54 were employed. That’s almost 2 percentage points below the employment-to-population rate on the eve of the Great Recession.

One of the most disappointing numbers from the recovery has been the growth rate of wages. In the first 5 years of the recovery, hourly wages edged up just 2 percent a year. After factoring in the effect of consumer price inflation, this translates into a gain of exactly 0 percent. The pace of wage gain has recently improved. Workers saw their real hourly pay climb 1.7 percent a year in the two years ending in June.

The economic bottom line for most of us is the rate of improvement in our family income after accounting for changes in consumer prices. No matter how household income is measured, income gains have been slower since 2007 than they were in earlier decades. The main reason is that incomes produced in the market—in the form of wages, self-employment income, interest, dividends, rental income, and realized capital gains—fell sharply in the Great Recession and have recovered very slowly since then. That a steep recession would cause a big drop in income is hardly a surprise. Employment, company profits, interest rates, and rents plunged in 2008 and 2009, pushing down the incomes Americans earn in the market. The bigger surprise has been the slow recovery of market income once the recession was behind us.

Some critics of the recovery argue that the income gains in the recovery have been highly skewed, with a disproportionate share obtained by Americans at the top of the income ladder. Economist Emmanuel Saez tabulates U.S. income tax statistics to track market income gains at the top of the distribution. His latest estimates show that between 2009 and 2015 income recipients in the top 1 percent enjoyed real income gains of 24 percent. Among Americans in the bottom nine-tenths of the income distribution, average market incomes climbed only 4 percent.

However, Saez’s estimates also show that top income recipients experienced much bigger income losses in the Great Recession. Between 2007 and 2009 they saw their inflation-adjusted incomes drop 36 percent (see Chart 1). In comparison, the average market income of Americans in the bottom nine-tenths of the distribution fell just 12 percent. These numbers mean that top income recipients have not yet recovered the income losses they suffered in the Great Recession. In 2015 their average market income was still 13 percent below its pre-recession level. For families in the bottom nine-tenths of the distribution, market income was “only” 8 percent below its level in 2007.

Only about half of households rely solely on market income to support themselves. The other half receives income from government transfers. What is more, this fraction tends to increase in bad times. Many retirees rely mainly on Social Security to pay their bills; they depend on Medicare or Medicaid to pay for health care. Low-income Americans often have little income from the market, and they may rely heavily on public assistance, food stamps, or government-provided health insurance. When joblessness soars the percentage of families receiving government benefits rises, largely because of increases in the number of workers who collect unemployment insurance.

Government benefits, which are not counted in Saez’s calculations, replace part of the market income losses families experience in a weak economy. As a result, the net income losses of most families are much smaller than their market income losses. The Congressional Budget Office (CBO) recently published statistics on market income and before-tax and after-tax income that shed light on the size and distribution of household income losses in the Great Recession and ensuing recovery. The tabulations show that, except for households at the top of the distribution, net income losses were far smaller than the losses indicated in Saez’s income tax data.

For example, among households in the middle fifth of the before-tax income distribution, average market income fell more than 10 percent in the Great Recession (see Chart 2). If we include government transfers in the income definition, average income fell 4.4 percent. If we account for the federal taxes families pay, average net income fell just 1 percent. In contrast, among households in the top 1 percent of the distribution, average market income fell 36 percent, average income including government transfers fell 36 percent, and average income net of federal taxes fell 37 percent. Government transfers provided little if any protection to top-income households.

The CBO income statistics end in 2013, so they do not tell us how net income gains have been distributed in the last couple of years. Nonetheless, based on Saez’s income tax tabulations it is very unlikely top income recipients have recovered the net income losses they experienced in the Great Recession. All the available statistics show household income gains since 2007 have been negligible or small, and this is true across the income distribution.

It is popular to say slow income gains in the middle and at the bottom of the distribution are due to outsize income gains among families at the top. While this story is at least partly true for the three decades ending in 2007, it does not fit the facts for the years since 2007. CBO’s latest net income tabulations show that inequality was almost 5 percent lower in 2013 than it was in 2007. The Great Recession hurt the incomes of Americans up and down the income distribution, but the biggest proportional income losses were at the very top. To be sure, income gains in the recovery after 2009 have been concentrated among top income recipients. Even so, their income losses over the recession and recovery have been proportionately bigger than the losses suffered by middle- and low-income families.

Editor's note: This piece originally appeared in Real Clear Markets.

Washington is again paralyzed and pulling back on clean energy economic development. Deficit politics and partisanship are firmly entrenched and the raft of federal financial supports made available through the 2009 stimulus law and elsewhere is starting to expire.

No wonder it’s hard to imagine—especially if you’re sitting in the nation’s capital—how the next phase of American clean energy industry growth will be financed or its next generation of technologies and firms supported.

And yet, one source of action lies hidden in plain sight. With federal clean energy activities largely on hold, a new paper we are releasing today as part of the Brookings-Rockefeller Project on State and Metropolitan Innovation argues that U.S. states hold out tremendous promise for the continued design and implementation of smart clean energy finance solutions and economic development.

Specifically, we contend that the nearly two dozen clean energy funds (CEFs) now running in a variety of mostly northern states stand as one of the most important clean energy forces at work in the nation and offer at least one partial response to the failure of Washington to deliver a sensible clean energy development approach.

To date, over 20 states have created a varied array of these public investment vehicles to invest in clean energy pursuits with revenues often derived from small public-benefit surcharges on electric utility bills. Over the last decade, state CEFs have invested over $2.7 billion in state dollars to support renewable energy markets, counting very conservatively.  Meanwhile, they have leveraged another $9.7 billion in additional federal and private sector investment, with the resulting $12 billion flowing to the deployment of over 72,000 projects in the United States ranging from solar installations on homes and businesses to wind turbines in communities to large wind farms, hydrokinetic projects in rivers, and biomass generation plants on farms. 

In so doing, the funds stand well positioned—along with state economic development and other officials—to build on a pragmatic success and take up the challenge left by the current federal abdication of a role on clean energy economic development.

Yet here is the rub: For all the good the funds have achieved, project-only financing—as needed as it is—will not be sufficient to drive the growth of large and innovative new companies or to create the broader economic development taxpayers demand from public investments.  Also needed will be a greater focus on the deeper-going economic development work that can help spawn whole new industries. 

All of which points to the new brand of fund activity that our paper celebrates and calls for more of. 

In recent years, increasingly ambitious efforts in a number of states have featured engagement on at least three major fronts somewhat different from the initial fund focus: (1) cleantech innovation support through research, development, and demonstration (RD&D) funding; (2) financial support for early-stage cleantech companies and emerging technologies, including working capital for companies; and (3) industry development support through business incubator programs, regional cluster promotion, manufacturing and export promotion, supply chain analysis and enhancement, and workforce training programs.

These new economic development efforts—on display in California, Massachusetts, New York, and elsewhere—show the next era of state clean energy fund leadership coming into focus. States are now poised to jumpstart a new, creative period of expanded clean energy economic development and industry creation, to complement and build upon individualistic project financing. 

Such work could not be more timely at this moment of federal gridlock and market uncertainty.

Along these lines, then, our paper advances several recommendations for moving states more aggressively into this new period of clean energy economic development. We suggest that:

• States should reorient a significant portion (at least 10 percent of the total portfolio) of state CEF money to clean energy-related economic development

• States, as they reorient portions of their CEFS to economic development, should better understand the market dynamics in their metropolitan regions.  They need to lead by making available quality data on the number of jobs in their regions, the fastest-growing companies, the critical industry clusters, gaps in the supply chain for those industries, their export potential, and a whole range of economic development and market indicators

• States also should better link their clean energy funds with economic development entities, community development finance institutions (CDFIs), development finance organizations and other stakeholders who could be ideal partners to develop decentralized funding and effective economic development programs

In addition, we think that Washington needs to recognize the strength and utility of the CEFs and actively partner with them:

• The federal government should consider redirecting a portion of federal funds (for instance, from federal technology support programs administered by the Department of Energy and other programs meant for federal-state cooperation) to provide joint funding of cluster development, export programs, workforce training, and other economic development programs  through matching dollars to state funds that now have active economic development programs, and to provide incentives to states without such programs to create them

• The federal government should create joint technology partnerships with states to advance each state’s targeted clean energy technology industries, by matching federal deployment funding with state funding.

• The states and the federal government, more generally, should look to “decentralize” financing decisions to local entities with street knowledge of their industries, relying on more “development finance” authorities that have financed traditional infrastructure and now could finance new clean energy projects and programs

In sum, our new paper proposes a much greater focus in U.S. clean energy finance on “bottom up,” decentralized clean initiatives that rely on the states to catalyze regional economic development in regions. Such an approach—which reflects the emergence of an emerging “pragmatic caucus” in U.S. economic life—is currently demanded by federal inaction. However, it might also be the smartest, most durable way to develop the clean energy industries of the future without the partisan rancor and obtuseness that has stymied federal energy policy. State clean energy funds—having funded thousands of individual projects—bring significant knowledge to bear as they focus now on building whole industries. For that reason, the funds’ transition from project development to industry creation should be nurtured and supported.

State and local bond finance represents a powerful but underutilized tool for future clean energy investment.

For 100 years, the nation’s state and local infrastructure finance agencies have issued trillions of dollars’ worth of public finance bonds to fund the construction of the nation’s roads, bridges, hospitals, and other infrastructure—and literally built America. Now, as clean energy subsidies from Washington dwindle, these agencies are increasingly willing to finance clean energy projects, if only the clean energy community will embrace them.

So far, these authorities are only experimenting. However, the bond finance community has accumulated significant experience in getting to scale and knows how to raise large amounts for important purposes by selling bonds to Wall Street. The challenge is therefore to create new models for clean energy bond finance in states and regions, and so to establish a new clean energy asset class that can easily be traded in capital markets. To that end, this brief argues that state and local bonding authorities and other partners should do the following:

• Establish mutually useful partnerships between development finance experts and clean energy officials at the state and local government levels
• Expand and scale up bond-financed clean energy projects using credit enhancement and other emerging tools to mitigate risk and through demonstration projects
• Improve the availability of data and develop standardized documentation so that the risks and rewards of clean energy investments can be better understood
• Create a pipeline of rated and private placement deals, in effect a new clean energy asset class, to meet the demand by institutional investors for fixed-income clean energy securities

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The financial sector has undergone major changes in response to the Great Recession and post-crisis regulatory reform, as a result of the Dodd-Frank Act and Basel III. These changes have created serious questions about the sector’s role in supporting economic growth and how it affects financial and overall economic stability.

On June 8, the Initiative on Business and Public Policy at Brookings explored the intersection of the financial system and economic growth with the goal of informing the public policy debate. The event featured a keynote address by Richard Berner, director of the Office of Financial Research and other participants with a wide range of views from a variety of backgrounds. Among other issues, the experts considered the changing landscape of the financial sector; growth-promoting allocation and investment decisions; credit availability for low- and moderate-income households; the ideal balance between growth and stability; and the impact of the 2014 midterm elections on regulatory reform.

 Follow the conversation at @BrookingsEcon or #Finance.

Video

• Keynote remarks by Richard Berner
• The financial sector: How has it changed?
• The view from the trenches
• The future of the U.S. financial sector

Audio

• Can the financial sector promote growth and stability?

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• Aaron Kleins presentation
• 20150608 BAER slides
• 20150608 MEHTA slides
• 20150608_financial_sector_stability_transcript

Introduction

I would like to thank the Department for giving me the opportunity to testify on this important issue. The document I submitted to you is more general than most of the comments you have received, talking about the issues facing retirement savers and policymakers, rather than engaging in a point-by-point discussion of the detailed DOL proposal¹.

Issues around Retirement Saving

1. Most workers in the bottom third of the income distribution will rely on Social Security to support them in retirement and will save little. Hence it is vital that we support Social Security in roughly its present form and make sure it remains funded, either by raising revenues or by scaling back benefits for higher income retirees, or both.

2. Those in the middle and upper middle income levels must now rely on 401k and IRA funds to provide income support in retirement. Many and perhaps most households lack a good understanding of the amount they need to save and how to allocate their savings. This is true even of many savers with high levels of education and capabilities.

3. The most important mistakes made are: not saving enough; withdrawing savings prior to retirement; taking Social Security benefits too early² ; not managing tax liabilities effectively; and failing to adequately manage risk in investment choices. This last category includes those who are too risk averse and choose low-return investments as well as those that overestimate their own ability to pick stocks and time market movements. These points are discussed in the paper I submitted to DoL in July. They indicate that retirement savers can benefit substantially from good advice.

4. The market for investment advice is one where there is asymmetric information and such markets are prone to inefficiency. It is very hard to get incentives correctly aligned. Professional standards are often used as a way of dealing with such markets but these are only partially successful. Advisers may be compensated through fees paid by the investment funds they recommend, either a load fee or a wrap fee. This arrangement can create an incentive for advisers to recommend high fee plans.

5. At the same time, advisers who encourage increased saving, help savers select products with good returns and adequate diversification, and follow a strategy of holding assets until retirement provide benefits to their clients.

Implications for the DoL’s proposed conflicted interest rule

1. Disclosure. There should be a standardized and simple disclosure form provided to all households receiving investment advice, detailing the fees they will be paying based on the choices they make. Different investment choices offered to clients should be accompanied by a statement describing how the fees received by the adviser would be impacted by the alternative recommendations made to the client.

2. Implications for small-scale savers. The proposed rule will bring with it increased compliance costs. These costs, combined with a reluctance to assume more risk and a fear of litigation, may make some advisers less likely to offer retirement advice to households with modest savings. These households are the ones most in need of direction and education, but because their accounts will not turn profits for advisors, they may be abandoned. According to the Employee Benefits Security Administration (EBSA), the proposed rule will save families with IRAs more than $40 billion over the next decade. However, this benefit must be weighed against the attendant costs of implementing the rule. It is possible that the rule will leave low- and medium-income households without professional guidance, further widening the retirement savings gap. The DoL should consider ways to minimize or manage these costs. Options include incentivizing advisors to continue guiding small-scale savers, perhaps through the tax code, and promoting increased financial literacy training for households with modest savings. Streamlining and simplifying the rules would also help.

3. Need for Research on Online Solutions. The Administration has argued that online advice may be the solution for these savers, and for some fraction of this group that may be a good alternative. Relying on online sites to solve the problem seems a stretch, however. Maybe at some time in the future that will be a viable option but at present there are many people, especially in the older generation, who lack sufficient knowledge and experience to rely on web solutions. The web offers dangers as well as solutions, with the potential for sub-optimal or fraudulent advice. I urge the DoL to commission independent research to determine how well a typical saver does when looking for investment advice online. Do they receive good advice? Do they act on that advice? What classes of savers do well or badly with online advice? Can web advice be made safer? To what extent do persons receiving online advice avoid the mistakes described earlier?

4. Pitfalls of MyRA. Another suggestion by the Administration is that small savers use MyRA as a guide to their decisions and this option is low cost and safe, but the returns are very low and will not provide much of a cushion in retirement unless households set aside a much larger share of their income than has been the case historically.

5. Clarifications about education versus advice. The proposed rule distinguished education from advisement. An advisor can share general information on best practices in retirement planning, including making age-appropriate asset allocations and determining the ideal age at which to retire, without triggering fiduciary responsibility. This is certainly a useful distinction. However, some advisors could frame this general information in a way that encourages clients to make decisions that are not in their own best interest. The DoL ought to think carefully about the line between education and advice, and how to discourage advisors from sharing information in a way that leads to future conflicts of interest. One option may be standardizing the general information that may be provided without triggering fiduciary responsibility.

6. Implications for risk management. Under the proposed rule advisors may be reluctant to assume additional risk and worry about litigation. In addition to pushing small-scale savers out of the market, the rule may encourage excessive risk aversion in some advisors. General wisdom suggests that young savers should have relatively high-risk portfolios, de-risking as they age, and ending with a relatively low-risk portfolio at the end of the accumulation period. The proposed rule could cause advisors to discourage clients from taking on risk, even when the risk is generally appropriate and the investor has healthy expectations. Extreme risk aversion could decrease both market returns for investors and the “value-add” of professional advisors. The DoL should think carefully about how it can discourage conflicted advice without encouraging overzealous risk reductions.

The proposed rule is an important effort to increase consumer protection and retirement security. However, in its current form, it may open the door to some undesirable or problematic outcomes. With some thoughtful revisions, I believe the rule can provide a net benefit to the country.

^{1. Baily’s work has been assisted by Sarah E. Holmes. He is a Senior Fellow at the Brookings Institution and a Director of The Phoenix Companies, but the views expressed are his alone.}

^{2. As you know, postponing Social Security benefits yields an 8 percent real rate of return, far higher than most people earn on their investments. For most of those that can manage to do so, postponing the receipt of benefits is the best decision.}

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Executive Summary ¹

The regional banks play an important role in the economy providing funding to consumers and small- and medium-sized businesses. Their model is simpler than that of the large Wall Street banks, with their business concentrated in the U.S.; they are less involved in trading and investment banking, and they are more reliant on deposits for their funding. We examined the balance sheets of 15 regional banks that had assets between $50 billion and $250 billion in 2003 and that remained in operation through 2014.

The regionals have undergone important changes in their financial structure as a result of the financial crisis and the subsequent regulatory changes:

• Total assets held by the regionals grew strongly since 2010. Their share of total bank assets has risen since 2010.

• Loans and leases make up by far the largest component of their assets. Since the crisis, however, they have substantially increased their holdings of securities and interest bearing balances, including government securities and reserves.

• The liabilities of the regionals were heavily concentrated in domestic deposits, a pattern that has intensified since the crisis. Deposits were 70 percent of liabilities in 2003, a number that fell through 2007 as they diversified their funding sources, but by 2014 deposits made up 82 percent of the total.

• Regulators are requiring large banks to increase their holdings of long term subordinated debt as a cushion against stress or failure. The regionals, as of 2014, had not increased their share of such liabilities.

• Like the largest banks, the regionals increased their loans and leases in line with their deposits prior to the crisis. And like the largest banks, this relation broke down after 2007, with loans growing much more slowly than deposits. Unlike the largest banks, the regionals have increased loans strongly since 2010, but there remains a significant gap between deposits and loans.

• The regional banks’ share of their net income from traditional sources (mostly loans) has been slowly declining over the period.

• The return on assets of the regionals was between 1.5 and 2.0 percent prior to the crisis. This turned sharply negative in the crisis before recovering after 2009. Between 2012 and 2014 return on assets for these banks was around 1.0 percent, well below the pre-crisis level.

As we saw with the largest banks, the structure and returns of the regional banks has changed as a result of the crisis and new regulation. Perhaps the most troubling change is that the volume of loans lags well behind the volume of deposits, a potential problem for economic growth. The asset and liability structure of the banks has also changed, but these banks have a simpler business model where deposits and loans still predominate.

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The White House Council of Economic Advisers (CEA) was created by Congress in 1946 to advise the president on ways “to foster and promote free competitive enterprise” and “to promote maximum employment, production and purchasing power.” President Truman, who signed the Employment Act of 1946 into law, was unenthusiastic about the Council and didn’t nominate members for nearly six months. Yet the CEA, comprised of three individuals whom Congress says are to be “exceptionally qualified,” has not only survived but also prospered for 70 years and remains an important part of the president’s economic policy decisionmaking.

On February 11, the Hutchins Center on Fiscal and Monetary Policy at Brookings marked this anniversary by examining the ways the CEA and other economists succeed and fail when they set out to advise elected politicians and tap the expertise of some of the “exceptionally qualified” economists who have chaired the Council over the past four decades.

You can join the conversation and tweet questions for the panelists at #CEAat70.

Video

• Panel 1: The CEA in Moments of Crisis
• Panel 2: The CEA and Policymaking
• Panel 3: Current Economic Policy Issues

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• The Council of Economic Advisers: 70 years of advising the president

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• Uncorrected Transcript (.pdf)

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• 20160211_economic_advisers_transcript

A major oil spill will result in cleanup spending that boosts GDP, but no one thinks oil spills are good. Oil spills and other forms of pollution are examples of negative externalities — harm caused to others by the economic activity of a firm or industry. These externalities represent a failure of the market, and unless there is corrective action, their presence means that there is too much production of something that causes negative spillovers.

That criticism can be applied to the financial services industry. Many say that it grew too large, triggered a financial crisis and damaged the rest of the economy. Is that still the case, and is financialization spoiling the economy? Despite the alarmist rhetoric around today’s finance sector, the answer is generally “no” because of changes made to financial regulation.

First, a check on the facts: How large is the industry and how much has it grown? The broad definition of the financial sector includes finance, insurance and real estate, known by the acronym “FIRE.” It was 17.5 percent of gross domestic product in 1990 and rose to 20.0 percent in 2014, but that figure is misleading as it includes office and apartment rents and leases — stuff that has little to do with Wall Street.

Finance and insurance separately peaked well before the financial crisis at 7.7 percent of GDP, which was up from 5.8 percent in 1990. In 2014, it was 7.0 percent of GDP. Employment in finance and insurance has been on a downtrend since 2003 and is currently 4.25 percent of total nonfarm payrolls. Most of those jobs are in offices and bank branches around the country. (The output data given here are drawn from the Bureau of Economic Analysis, GDP by Industry data. The employment data are from the Bureau of Labor Statistics, Payroll Employment data. Author’s calculations.)

Still, salaries and bonuses at the top are extremely attractive, so perhaps the externality plays out by drawing the best and brightest away from other more productive activities. The Harvard Crimson reported that in 2007, 23 percent of graduating Harvard seniors said they planned to enter finance. That is an impressive number, but things turned around sharply, with the 23 percent figure falling to 11.5 percent in 2009 after the financial crisis. At this point, the financial industry really isn’t large enough to crowd out other parts of the economy.

Meanwhile, the insurance industry serves an important social purpose providing life, property, and casualty insurance. AIG got into trouble in the crisis because it strayed into providing very risky financial services, not because of its main insurance business. Likewise, the core value of banks is financial intermediation between savers and investors, giving savers relatively secure and liquid assets while also funding investment.

There are critics of how well our banking industry serves this core purpose, a quality that is hard to determine. My judgment is that it does the job pretty well compared to most other countries. As the IMF reported in September 2015, the non-performing loan problem among European banks remains severe, whereas most U.S. banks now have strong balance sheets. Good financial intermediation means that most of the savings dollars are transferred to investors and are not lost through inefficient bank operations. A 2002 study that I participated in found bank productivity higher in the United States than in France or Germany.

The parts of the financial sector that give rise to the most concern are market-making, deal-making and the creation and trading of derivatives on Wall Street. The volume of market trading has increased exponentially because of the increased speed of computers and communications. Up to a certain point, the increased volume is helpful because it adds to the liquidity of markets, but the advent of high-frequency trading has taken us over the top. As Michael Lewis describes in his book Flash Boys, the high speed traders are finding ways to shave milliseconds off the time needed to make trades. That is thoroughly wasteful. As for deal-making, it has been going on for a long time — indeed the go-go years for deals were in the 1980s — so it is hard to blame the recent slowing of economic growth on this activity.

Still, the explosion of derivatives and other overly-complex instruments was problematic, and it is crystal clear that the mortgage market became too opaque and removed accountability from the system. The layering of complex derivatives on top of lousy mortgages (and other shaky assets) distorted the economy, resulted in the overbuilding of houses, and caused the financial crisis. There are plenty of people at fault besides the bankers, but the smart people on Wall Street were driving the process, and they should have known better. The excessive financialization obscured the reality of loans that depended upon ever-rising home prices and thus were never going to be paid back. There was an externality because the private calculations of potential profit ignored the risks being imposed on society.

Is that still the situation today? No. Things have changed. Banks and other financial institutions that create risks for the whole economy are now required to hold sufficient capital to cover losses even in periods of economic and financial stress, plus a liquidity buffer (they must pass “stress tests” administered by the Federal Reserve). The screws have been turned pretty tight, and the owners of large financial institutions will bear the costs of future failures — not taxpayers. This brings private incentives in line with the public interest, getting rid of the externality that gave us too much financialization in the first place. But to keep the future safe, we’ll have to make sure no one forgets what happened in the last crisis, and ensure that new risks are not created in other, less-regulated parts of the industry.

Editor's note: This piece originally appeared in the Washington Post.