Save the Middle Class

Kim Griest, 11 June 2023

Me: The most important thing needed in America today is a huge increase in taxes on the rich.

Intelligent skeptic: I don’t believe that. First, it is not fair; the rich earned their money through hard work and deserve to keep it. And second what does it matter to me if some people have lots of money?

Me: The thing you are missing is that the huge amount of wealth that the rich control comes directly from the middle class; that is, as the rich get richer, you and I get poorer.

Skeptic: Why do you think that? What the rich earn does not affect what I have.

Me: Wrong! Think of all the stuff in America as a pie: all the houses, land, cars, etc. In normal economics, the share of the pie that anyone owns/controls is determined by their share of the wealth.

So, as the share owned by the rich increases, the share owned by the middle class must decrease, and if the middle class wants to increase its share, then the rich’s share must go down.

For the last 40 years, the share of wealth owned by the richest 1% has increased year by year, and the share owned by the middle class (and the entire bottom 90%) has shrunk. Why are those private equity firms buying up all the houses and putting the price of a house out of reach for most middle class people? Why do rents keep rising? Why is homelessness increasing, and why is everything getting more expensive? The amount of stuff is roughly fixed, but if one group has the majority of the money, then they will buy the majority of the stuff, and the rest of us will not be able to afford much.

Here is this story in a little more detail.

In the 1800’s and early 1900’s, the rich in America owned almost everything and there was no middle class; the bottom 90% of Americans owned less than 20% of the total wealth. Then, in the 1930s, FDR enacted the New Deal and raised the top tax rate on the wealthy from 25% to over 90% (and the inheritance tax to around 80% on large fortunes). The share of wealth of the richest 1% immediately started dropping.

Some numbers: The share of wealth owned by top 1% dropped from 44% in 1937 to 28% in 1964. In 1964, the share of wealth owned by the middle class[1] reached 28%, equaling the wealth of the top 1% for the first time in American history. Over time the tax rates on the wealthy were lowered somewhat but never dropped below 70% until the 1980s, and all that time the wealthy continued to lose their share due to high taxes, and the middle class continued to become more wealthy. Finally, in 1984, the top 1% dropped to a wealth share of 24%, and the middle class reached its highest ever wealth percentage of 35%.[2] This is the time many people fondly remember, since the middle class was at its peak, and the average person in America was able to buy a house and live well.

Skeptic: Why does the tax rate on the wealthy effect total wealth of the middle class so much?

It is simple economics. The extremely wealthy make most of their money from investments, and the stock market has risen at around 7% per year over the long run. Ordinary people don’t have substantial investments and so depend on wage increases, which are smaller. Think of the pie; if the top 1% get 7% richer each year, and the middle class get less than 7% richer, then the top 1% wealth fraction increases each year, meaning the middle class fraction decreases.

There are important caveats here, most importantly, the size of the pie can increase. The increase in the size of the pie is roughly measured by the increase of the GDP. If the GDP increases by 5% each year, then the pie gets bigger by around 5%. That means, on average, everyone gets richer by 5%. But if the return on investments is larger than the increase in GDP, then the rich still take a larger share each year. For example, if the top 1% get richer by 7%, then they pull ahead of the middle class by about 7%-5%=2%, and the wealth share of the middle class must shrink (by about 2% per year).

This logic changes due to taxes which reduce the net increase in wealth of everyone. A nice progressive income tax which taxes the wealthy at a much higher rate is what is needed. For example, if, as under Eisenhower, the tax on income over 3 million dollars is 90% (or 70% under Nixon), then the rich do not pull away, and, in fact, the middle class will gain ground.

This is exactly what happened between the 1930s and the 1980s. The high tax rate on the rich reduced the effective income of the top 1% and their fraction of the total wealth dropped by about 1.6% per year, while the middle class fraction of wealth increased by about 1% per year.

Thus, Americans in the early 1980s were the richest middle class in US history. Things changed in the 1980s when the Republicans, under Ronald Reagan, greatly reduced taxes on the wealthy; from 70% to 28%. Immediately, the top 1% started gaining wealth share and the middle class started losing share. Between 1984 and 2014, the top 1% went from owning 24% to owning 36% of the total wealth, and the middle class went from owning 35% to only 26%. That is, since 1984, the top 1% have increased their wealth share by about 1.4% per year, while the middle class share dropped by about 1% per year. America is nearly back to the huge wealth inequality that existed in the 1930s before the New Deal.

The worst news is that this yearly increase in inequality is continuing today and will continue into the future unless taxes on the wealthy are raised. In fact, it is accelerating since Republicans under Trump further reduced taxes on the wealthy.

Skeptic: A drop of wealth share by 1% per year does not seem like much to worry about.

It may not seem like much but if continued over the next 30 years, it means that that the middle class wealth share would shrink to below 20%, back to how it was in the 1920s, while the share of the top 1% would grow to above 50%, thereby bringing us back to the situation before the New Deal. If this happens, then the United States will no longer have a middle class, and the bottom 90% of Americans will basically own nothing.

Thus, if taxes are not greatly increased on the wealthy, we expect much more homelessness, much more inflation, many more poor people, etc. America is on its way to becoming a nation controlled by a small percentage of extremely rich people. It will be more like an old style feudal society run by a king and the nobility, than a democracy where ordinary people have some say in what happens. Even now, 3 extremely rich billionaires have more wealth than the poorest 50% of Americans[3], and due to that wealth, those 3 individuals have more influence on what happens in America than those other 160 million people. This is what is not fair and needs to be fixed.

We can look at poor 3rd world nations run by dictators to see what it will soon be like in America, unless taxes on the wealthy are soon increased to 90% (or at least 70%) as they were in the years between the 1940s and 1980s when the middle class was doing well.

[1] The “middle class” is being defined as the 40% of Americans who earn less than the richest 10% and more than the bottom 50%.

[2] The numbers given in this article can be mostly found in the World Inequality Database: https://wid.world/country/usa/

[3] Wealth here is defined as total assets minus debts.