Income inequality: Does wider gap between rich and poor threaten capitalism?

Income inequality seems an unlikely focus for Bill Gross, the most powerful bond manager of his generation and co-head of a $2 trillion investment management firm.

But he rankled a few of his peers and clients in the fall when he joined a growing chorus that is raising caution flags about America's widening disparities in income and wealth – as well as the current state of the capitalist system producing them.

As he surveys the past 30 years of the system that made him one of the world's richest people – and the 55th most powerful person on the planet, according to Forbes – the glaring income gaps are approaching a breaking point, he says.

"We're not just experiencing a new Gilded Age, but a Bitcoin Age," says Mr. Gross, referring to the digital currency. "Artificial money, corporate K Street, and Wall Street interests are producing one world for the rich and an entirely different world for the working class," says the founder and co-chief investment officer of PIMCO in Newport Beach, Calif.

"It can't go on like this, either from the standpoint of the health of the capitalist system itself or the health of individuals and the family," he adds.

Such a standpoint may be rare for a so-called 1 percenter, but the subject of income inequality and the health of the American financial system has burst into the larger national conversation in a new way over the past two months. A widespread and robust national debate has brought difficult questions to the fore, with a host of economists and political writers joining the fray.

At issue are a number of short- and long-term trends that are starting to startle a number of observers, even beyond the progressive activists who have been focusing on such things for years.

For many economists, a shrinking middle class, as well as low employment, has profound implications. A majority of economists polled by The Associated Press in mid-December said they worry that with most stock market gains flowing upward to the top 10 percent of Americans, the consumer spending base has become too narrow. They also said that a middle class with more cash to spend would be able to stimulate a broad-based climate of economic growth and job creation better than a smaller, über-rich base could.

"For the past 10, 20, 30 years, capital has moved away from labor and towards corporations and investors," Gross says. "I'm not sure capitalism can thrive in a system in which ... [labor] has a declining interest, in terms of percentage of the pie. Then ultimately the pie itself can't grow, because consumption can't be supported."

95 percent of income gains go to top 1 percent

Indeed, Wall Street has been on a record-smashing binge. The Dow has been setting all-time highs since March 2013, closing with its 52nd on New Year's Eve, with a 26 percent gain for the year. The S&P 500 set its 45th record, also on New Year's Eve, with a yearly profit of nearly 30 percent – its largest increase in 16 years. And the Nasdaq has outperformed both, with a 38 percent gain in 2013.

Corporate profits, fueled by the easy cash flowing into Wall Street, have been setting all-time records as well. In the third quarter of 2013, profits after taxes accounted for more than 11 percent of US gross domestic product, the sum of all goods and services. That's the highest such percentage of GDP ever recorded, although record highs have been set in each of the past three years.

As a result, since the official end of the Great Recession in mid-2009, 95 percent of all income gains have flowed up to America's top 1 percent, who also now accrue 20 percent of the nation's total pretax income, doubling their 10 percent share from the 1970s.

Main Street, too, has been setting records – albeit of a different kind. Only a little more than half of Americans own stock today, continuing the record lows since the start of the recession. Income from wages and salaries, the essence of middle- and working-class wealth, has shrunk from more than 50 percent of the GDP pie in 1970 to 42.6 percent in 2012 – the smallest piece ever measured.

And job gains have been decidedly tepid for the past three years. Many of the jobs are low-wage, low-skill work in retail and personal service, and many are part time. Moreover, only 63 percent of adults are participating in the job market – the lowest percentage since 1978.

"If people are dropping out of the labor force without a gainful use of their time, I worry about the social problems that come from that," says Douglas Holtz-Eakin, former chief economist of the president's Council of Economic Advisers under George W. Bush, and now president of American Action Forum, a conservative policy institute in Washington. "That'll become a cohesion issue over time."

When Gross highlighted many of these trends and others in an investment outlook piece posted on his company's website in late October, he told his peers that maybe they should be willing to pay higher taxes. More provocatively, he challenged the orthodoxy on capital gains taxes, saying they should be taxed at rates as high as that for income.

"The feedback wasn't so good. Some clients got [irritated], and we may have lost a few, but that's the breaks," Gross says. "I've always felt that being honest, to the extent that one knows one's being honest – it's the right thing to do from a personal and business standpoint."

Josh Strauss, a portfolio manager for the Appleseed Fund at Pekin Singer Strauss Asset Management in Chicago, voices similar views. "Tax policies over the last 30 years have exacerbated the preexisting disparity between ... the rich and the poor and middle class," he says. "Low capital gains taxes disproportionately benefit people who have assets."

Mr. Strauss points to the striking disparities that appear when the stock performance of high-end luxury stores is compared with that of other retailers. Since March 2009, the height of the recession, the stock value for Tiffany & Co. has jumped more than 425 percent. Estée Lauder's has jumped more than 600 percent, and the luxury sporting goods store Lululemon Athletica has gained more than 2,500 percent.

By contrast, Wal-Mart's stock has gained 61 percent, Kohl's has gained 64 percent, and JCPenney has lost more than 36 percent of its value during the same period.

Much of the current debate over income inequality sprang from a speech President Obama delivered in early December. He identified "a dangerous and growing inequality and lack of upward mobility that has jeopardized middle-class America's basic bargain – that if you work hard, you have a chance to get ahead."

It's "the defining challenge of our time," he said at the Town Hall Education Arts Recreation Campus, a community center in Washington.

Even so, there's a sense that these issues are nothing new. Indeed, almost exactly two years earlier, Mr. Obama gave another major speech on income inequality, saying in Osawatomie, Kan., that it was "the defining issue of our time." And for years, it has been one of the most passionate issues galvanizing progressive activists.

Just over two years ago, growing inequality was the rallying cry of the "Occupy" movement. Its "we are the 99 percent" slogan has since become part of the cultural lexicon, and many of its members have moved on to fast-food strikes and protests calling for a higher minimum wage.

After something of a lull, the pace for such activists has appeared to pick up. Fourteen states are raising their minimum-wage requirements this year, and 11 states have tied future increases to inflation – the heart of a Democratic proposal also before Congress. But the battle to raise the federal minimum wage is likely to stall, as Republicans appear to instead be homing in on "Obamacare" for the 2014 midterm elections.

In addition, last year New York City elected, in a stunning 73.3 percent landslide, the Occupy-friendly and unabashed liberal Bill de Blasio, who ran on a tax-the-rich platform with the suggestive slogan, "A tale of two cities."

"We've seen a new vibrancy among labor, community organizing, and clergy," says Deborah Axt, co-executive director of Make the Road New York, a community organizing group in Brooklyn. "Other folks are engaged in the streets, in protest politics and organizing, and simultaneously in electoral work as well, to really reshape what our government looks like for us."

Even Pope Francis jumped in. Delivering his first lengthy apostolic exhortation in late November, he targeted "trickle-down theories." These express, he wrote, "a crude and naive trust in the goodness of those wielding economic power and in the sacralized workings of the prevailing economic system. Meanwhile, the excluded are still waiting."

Polls say Washington favors the rich

The public has been taking notice. Almost two-thirds of Americans say federal policies currently favor the wealthy, and 57 percent say the government should try to reduce the gap between the wealthy and those less well-off, according to an ABC News/Washington Post poll in December.

This includes almost half of Republicans. And 4 out of 10 conservatives think the government should do something about it – not insignificant in today's hyperpartisan era. Support for government action among Democrats is overwhelming, of course, with more than 8 out of 10 Democrats believing federal policies favor the wealthy and 3 out of 4 supporting efforts to reduce the income gap.

For many of those concerned about income inequality, a deeper worry is its effect on social mobility – the long-held promise of America, believed by liberals and conservatives alike, that hard work, industry, and talent can breed economic success, no matter one's social class.

"Whatever you may believe about the facts, it has been the belief of a vast majority of Americans for a long time that they had a chance to get ahead – and that belief is a piece of the glue that holds our society together," says Mr. Holtz-Eakin, who has also served as director of the nonpartisan Congressional Budget Office.

Yet today, four years after the recession ended, 64 percent of Americans no longer believe the country offers everyone an equal chance to succeed, compared with 33 percent who do, according to a Dec. 11 Bloomberg poll. And for those making $50,000 or less, 73 percent see the economy stacked against them.

This feels all too real for Cynthia Turay, who 10 years ago was a classic illustration of the American dream. An immigrant entrepreneur and mother of five, she opened God's Time Beauty Supply, a store specializing in wigs in Brooklyn.

Ms. Turay had been a middle school teacher in Nigeria, but she fled a violent coup in 1991, eventually coming to the United States after living with her brother in Stockholm for a while.

It wasn't easy. She worked three jobs – as a medical billing specialist at both a hospital and a retirement home and as a cashier at a local Pathmark – all while her new American husband worked as a facilities handyman with an investment firm in Manhattan.

In 2001, they had saved enough to buy a three-bedroom home. Two years later, she had finally saved enough to open the store, whose name is rooted in her Christian faith that God would supply her needs in His due time.

The business was a modest success, taking in more than $100,000 the first few years and providing a small profit.

"I moved here to be an American dream," Turay says. "That's the reason I worked so hard, so this house, we can live in together, to have a marriage and my store."

In 2006, however, she and her husband took out a home-improvement loan to do some renovations. It was an adjustable rate, subprime mortgage starting at $1,700 a month.

Little did Turay and her husband know that the housing bubble – fueled by the bundling and selling of high-risk mortgage-backed securities – was about to burst.

In 2008, Turay's monthly mortgage payment ballooned to $2,648. In a matter of months, everything in her life collapsed.

Trying to pick up the pieces

The investment company where her husband worked closed shop, and he lost his job. The house soon went into foreclosure. Most devastating, Turay had to close God's Time. Beset by stress and frustration, her husband left.

The banks that had bundled the toxic loans were bailed out by the Troubled Asset Relief Program (TARP), and for years the Federal Reserve has stimulated the markets by buying billions of bonds in a program of "quantitative easing."

Turay, meanwhile, looked for her own help. She was referred to South Brooklyn Legal Services, a beneficiary of The Children's Aid Society. The community group helped her negotiate a payment plan, reducing her monthly mortgage payments to $1,852. She even got a grant to cover the following two months of the mortgage – which allowed her to reopen the store.

But her struggles continued, and business was never the same, especially after superstorm Sandy. She had fewer customers last year, and in June she closed her business – this time, she says, for good.

"The perverse effect of this recession, of course, was that it was not caused by the poor or the working class," says Richard Buery, president and chief executive officer of The Children's Aid Society. "But as the wealthy have recovered and the wealthy's share of national income has skyrocketed, one perverse effect of that is, it's actually led to fewer investments for those at the bottom."

Now Turay's making just over the minimum wage, serving as a home aide for the elderly at Atria Senior Living in Brooklyn. But even with some help from her daughter, she can no longer afford to pay her mortgage.

"That dream that I dream of – the marriage, the house, the business – is shaking," Turay says. "That is the trouble I'm still in now.... I'm confused: I don't know what to do, to push it more or go back to Sweden. I'm very disappointed and don't know if I am still seeing that dream that I was dreaming to come here. It's very, very painful."

[Editor's Note: The original version of this article misstated Bill Gross's title at PIMCO. He is co-chief investment officer, not co-chief information officer.]