Widening Income Gap Holding Back Recovery: S&P

The noisy public debate over whether the income gap between the wealthiest Americans and the rest of us is getting wider is no longer a debate, according to ratings and research firm Standard & Poor’s.

S&P released a report on Wednesday that says the widening income gap in the U.S. contributed to a boom and bust cycle that led to the 2008 financial crisis, and that the growing gap has served as an obstacle to ongoing economic recovery.

“At extreme levels, income inequality can harm sustained economic growth over long periods. The U.S. is approaching that threshold,” S&P said in the report.

S&P said “extreme income inequality” serves as a drag on long-run economic growth. Consequently, S&P has reduced its 10-year U.S. growth forecast to a 2.5% rate, down from 2.8% five years ago.

S&P’s research included a 2011 Congressional Budget Office report that showed that while real net average U.S. household income grew 62% from 1979-2007, household income growth was “much more rapid” at the higher end of the income scale than at the middle and lower end.

A second CBO report in 2013 showed that after-tax average income soared 15.1% for the top 1% from 2009 to 2010, but grew by less than 1% for the bottom 90% over the same time period, and fell for many income groups.

S&P cautioned against “extreme policy measures” to ease the gap, instead recommending that Americans seek to improve their educations. Specifically, obtaining college degrees.

“With wages of a college graduate double that of a high school graduate, increasing educational attainment is an effective way to bring income inequality back to healthy levels,” the report states.

More Americans achieving a higher level of education would also benefit the economy. S&P said that if more Americans completed one more year of school over the next five years, the additional productivity gains would add about $525 billion, or 2.4%, to the level of GDP.

Higher levels of income inequality increase political pressures, discouraging trade, investment, and hiring, according to the report. And when the imbalances reach their peak, the U.S. falls into a boom and bust cycle similar to the one that resulted in the 2008 financial crisis and Great Recession.

Moreover, broad income imbalances “tend to dampen social mobility and produce a less-educated workforce that can't compete in a changing global economy. This diminishes future income prospects and potential long-term growth, becoming entrenched as political repercussions extend the problems,” S&P warned.

The report holds a mirror up to Washington, D.C., where the question of a growing income disparity has fueled a heated national debate over the impact of such a gap and how or if it should be addressed.

President Barack Obama and many other Democrats say the wealthiest Americans should pay higher taxes to offset the gap, while Republicans argue that raising taxes would prove more harmful to the economic recovery than a growing income disparity.

S&P doesn’t offer specific policy measures to address the issue, but argues that reducing the gap would benefit the economy.

“In addition to strengthening the quality of economic expansions, bringing levels of income inequality under control would improve U.S. economic resilience in the face of potential risks to growth,” the report states.

Boosting the income of middle and lower-earning Americans would add to their purchasing power, which would increase demand for goods and lift the entire economy. And wealthy Americans would benefit by not being left vulnerable to boom and bust cycles perpetuated by a widening income gap.

“Policymakers should take care, however, to avoid policies and practices that are either too heavy handed or foster an unchecked widening of the wealth gap. Extreme approaches on either side would stunt GDP growth and lead to shorter, more fragile expansionary periods,” S&P said.