Income Inequality

It seems like as long as America has existed, equality has been a key virtue.  Thomas Jefferson opined in the Declaration of Independence that “all men are created equal“, and I believe that value has stuck in American society as a whole.  Lately, there has been much discussion of the topic of income inequality, namely how income inequality is at an all time high, and also how incomes of the richest people in America are growing substantially faster than poorer people.  However, I believe that much of the discussion of this issue is misguided and misinformed, either by asking the wrong questions or misusing the data.

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Those most opposed to income inequality often point to the fact that the richer someone is, the richer they are getting.  You have probably seen graphic likes the GIF to the right (click to make it work).  The graphic shows how the incomes of the top 1% are skyrocketing compared to the bottom 99%.  However, this GIF is a typical overstatement of the probably for income inequality.  The researcher behind this study, defines income as “pre-tax cash market income — wages and salaries; dividends, interest, rent and other returns on invested capital; business profits; and realized capital gains”.  This is to say, no tax payments are incorporated into the GIF.  However, considering that the top 1% pay a higher tax rate than the the bottom 99%, this graph overstates the problem with income inequality.

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While it is true that wage growth for that top income earners is far higher than for low wage workers, the more important question to ask is whether low wage workers are better or worse off.  The chart of the left illustrates that while top earners have seen a much larger increase in wage over a 28 year-period, real income growth for the lowest quintile was about 25%.  Is the fact that top incomes increase more rapidly a problem?  Clearly wage increases are not a zero-sum game; the top earners are not necessarily benefitting at the expense of the poor.

Another measure that is used for income inequality is the Gini coefficient, which attempts to fix into one number how wages in a country are distributed, on a scale from 0 to 1, where 0 is perfect equality, and 1 is perfect inequality.  The following chart show 2000’s Gini coefficients:

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The before-tax Gini coefficient of the United States is actually fairly close to places typically well known for high equality, like Sweden, Finland, and Norway.  However, the U.S.’s post-tax Gini coefficient is the highest of any of these nations.  This suggests that through taxes, all these other countries do a better job of redistributing income.  Critics equate this to mean that the U.S. doesn’t have a progressive enough tax system.  However, a 2008 study by the OECD indicated that the U.S. actually has the most progressive income tax system out of the OECD-24 nations, which includes all of the richest European nations (With the recent increase on taxes to the highest income bracket in the U.S., our system can only be more progressive now than previously).  How does this all make sense, one might ask?  Although I’m not entirely sure, one solution is that higher overall taxes, on all people, would create such an effect.  By the government taking, and redistributing a higher percentage of the income of the nation overall, the Gini coefficient will be lower, but could also lead to a less progressive tax system.

However, the most important issue with income inequality is “Is it necessarily bad?”  For a long time, many economists theorized that inequality was good for growth (because inequality might boost investment).  I think such a theory has some truth to it; I believe that an economy with perfect income equality would stagnate quickly because incentive to work would plummet.  In it’s recent revision of the long-term effects of the ACA, the CBO essentially admitted that an increase in the marginal tax rate makes people want to work less.  Recently, many economists have started to believe that perhaps income inequality hinders growth, but have had difficultly proving this empirically.

I think that much of the ire directed towards income inequality is actually misdirected.  For example, the problem of poverty is not the same thing as income inequality.    As I explained earlier, real incomes can rise both for the poor and the rich, even if income inequality is increasing. If the total amount of income in the economy was fixed, then income inequality would “cause” poverty, but this is not the case.  Income inequality does not cause poverty; low wages, not enough jobs, and many other factors cause poverty.