Scott Sumner  

Imagine there's no economic inequality

PRINT
Why So High? Economics and th... Unemployment Insurance and Pau...

Now let's see why there would still be enormous income inequality.

1.  Suppose everyone had identical lifetime wage income and inherited no money.  Also assume all investments were risk-free.  Incomes would still vary greatly due to different preferences regarding current vs. future consumption (i.e. different saving preferences.)

2.  Suppose everyone was exactly like me; in the poorest quintile from age 18-26, then the second, then the third, eventually the top, before falling back on retirement.  Also assume these identical people were born in different years.  Again, no economic inequality (lifetime) but large annual income inequality.

3.  Imagine everyone was a farmer with similar land, and there were alternating good years and bad years, which varied by location. When farmers made money in the east they lost money in the west. Over any five year period income averaged out to be roughly identical, but each year farmers made large incomes in some areas, and losses in others.  No economic inequality in a long run sense, but plenty of annual income inequality.

4.  Let's say everyone made an identical unrealized capital gain of $5000 each year, but they differed as to when they actually sold their asset and realized the capital gain.  Again, no economic inequality but lots of measured income inequality, as only realized capital gains go into the income data.

5.  Let's say some people went to school much longer than others.  They earned a compensating differential in income to reward them for the disutility of their extra studying.  Again, no economic inequality in a utility sense but lots of income inequality.

6.  Let's assume some people make more money, but only because they live in an areas with a higher cost of living, perhaps due to higher heating bills in the winter.  Again, no economic inequality but lots of income inequality.

7.  Let's assume that preferences differ, and that some people are less materialistic. They earn less money because they prefer to maintain more spiritual values.  Here I'm thinking of groups like the Amish.

8.  The underground economy.

Is all this nitpicking, or are these distortions important?  The first item suggests that we really ought to be looking at the present value of wage income, or the present value of consumption.  In that case capital income would not count.  I don't think I need to convince anyone that capital income hugely distorts the numbers of the top one percent.

Item two suggests age is an important factor, which might distort our results.  The second poorest town in America is Athens, Ohio, which is full of middle class college students with low incomes. Are they really poor?  That's a judgment call.  But I'd guess that their lifetime incomes are quite respectable.

The first poorest town in America is almost entirely composed of Hasidic Jews, which (according to the NYT) are choosing to live a rather non-materialistic lifestyle.  That's item 7.

And yes, the fact that we measure realized capital gains rather than unrealized cap gains makes income look much more unequal than it is.  Bob Murphy asks me how I can hate income and love NGDP (national income.)  Do capital gains go into NGDP?

Many (liberals) object that this exercise misses the point.  BUT WHAT ABOUT THE BANKSTERS!!??!!  They say even if income data has problems, there is no better alternative, and in any case inequality is clearly getting much worse by any reasonable measure.  I don't accept that view.  We do have a better measure---consumption.  But even consumption is not perfect because of the lifecycle problem I discussed.  It will still overstate economic inequality.

Nonetheless, if we use consumption data then the change in inequality is much less clear. Some studies show increased consumption inequality, some don't.  FWIW, in my view the consumption gap between the middle class and rich has widened over my lifetime, and the consumption gap between the middle class and poor has narrowed. Since I care much more about poverty than the middle class/rich gap, I'm not particularly dismayed by the changes we've seen in recent decades.

Some liberals claim it's about political power, which correlates with income more than consumption. I doubt it.  Public policy is less pro-rich than when Reagan was president (for instance MTRs on the rich have risen sharply since 1987), and yet income is much less equal than when Reagan was President.  I see no evidence that income inequality correlates with more political power for the rich, as compared to consumption inequality.  (That's not to deny that the rich have more political power, they do.)

However I do favor public policies that would lead to greater economic equality (for utilitarian reasons):

1.  Wage subsidies for low wage workers. 2.  Less barriers to entry (less zoning, weaker IP restrictions, no occupational licensing, etc.)

Normally when inequality widens it should be self-correcting.  The relatively poor will see a bigger gap, and work harder to boost their standing in society.  Thus if the gap between the consumption bundle of college grads and non-college grads gets wider, then more people will get college degrees. This may not work for two reasons:

1.  Barriers to entry.

2.  Talent gaps.

You may have noticed that one of my policy suggestions addresses barriers to entry, and the other addresses talent gaps.  And here's the final irony.  A wage subsidy that reduces economic inequality actually raises income inequality, at least if you measure income net of the subsidy (which is how we do it.)  If you are convinced that I am wrong and want to hold on to the income inequality data, then you ought to oppose my wage subsidy proposal---it will make inequality "worse."

PS. Josh Barro has an excellent post on a supply-side agenda for the 21st century. The emphasis is on lots of deregulation and cuts in implicit marginal tax rates. However I found this remark unfortunate:


We're going to need a new supply side economics that encourages people to work, invest and innovate.


That doesn't mean conservatives' agenda of tax cuts and federal deregulation, which aims at problems that were addressed in the 1970s or never existed at all.


Barro will find very little support for his agenda among politicians of either party. However he will find lots of support among both liberal and conservative intellectuals.

PPS. Whenever I do posts like this I get commenters saying "Sumner's trying to deny America has lots of inequality," or "Sumner's saying the typical poor person in America is Hasidic Jew." I'm used to it by now.


Comments and Sharing


CATEGORIES: Income Distribution



COMMENTS (25 to date)
Arthur_500 writes:

I don't have a problem with income inequality any more than I have a problem with NFL team inequality. Anyone with a competitive streak will work to improve their situation.

We are not equal. We will never be equal. It is not in our best interest to be equal.

I don't quite understand the Wage subsidy thing. Do you mean something like the Earned Income Tax Credit? or would you prefer the gubment subsidize a minimum wage?

My problem is that subsidies create a false floor. If my landlord knows that I will garner at least $1,000 per month he can set the rent at $800 and leave me some for food. However, if everyone is competing then the landlord needs to either lower the rent to what I can pay or improve the property to get a higher paying tenant.

Richard Besserer writes:

Heck, I don't think a complete absence of income inequality would even make sense in the classless society imagined by Marx et al. "To each according to his needs" doesn't mean "to each exactly the same amount." Needs will vary just over one's lifetime; families with children would need a bigger food ration or housing unit than single people, say.

Of course, if anything, income inequality was far worse in actually existing socialist economies than in market economies, when at all honestly measured, but that's another story.

Elwailly writes:

I think you miss the point when you discuss income inequality between the top and other quintiles. The statistics are much more revealing when looking at the top 0.1% or even the top 1%.

The changes in relative income in this case are so much more important because of their effects on politics and social priorities. When the top 0.1% has enough surplus money to contribute the bulk (and an increasing share) of the money flowing to politicians and political causes it results in a profound distortion of the fabric of rules that maintained and sustained the middle class in this country after WWII.

It's this loss of middle class influence on the political process that is so distressing to liberals talking about rising income inequality.

This phenomenon is real and arguments about how income inequality within the lower 99.9% is natural is a distraction.

Scott Sumner writes:

Arthur, Ideally the wage subsidy would be on an hourly basis. There is a perception that it helps employers, but I think it makes more sense to view emplotyers as part of the group that will be paying the extra taxes to finance these wage subsidies. Like any tax or subsidy, it distorts the market. But in this case there are many policies that distort the labor market towards too little working. A wage subsidy pushes back in the other direction. I believe the Germans (who have no minimum wage and low unemployment) have had some success with this idea.

Elwailly, I'm skeptical of the political argument, as policy toward the rich was more favorable in the 1980s when they had a lower share of income. In any case much of the income of the top 1% is capital income, and it makes no sense to mix that in with labor income---apples and oranges.

joe writes:

"I see no evidence that income inequality correlates with more political power for the rich, as compared to consumption inequality"

One word: SuperPac.

"Public policy is less pro-rich than when Reagan was president (for instance MTRs on the rich have risen sharply since 1987), and yet income is much less equal than when Reagan was President"

This statement isn't true if you go back one more more year to 1986. Cherry picking years here to support your assertion. Nice in-depth analysis.

Stick to NGDPLT posts, Dr.

Ni Zhang writes:

I agree with you that wage subsidies is a good way to let people earn more and because of the wage subsidies, the employers would like to hire more people, because it cost them less people with the wage subsidies.

And in terms of make less barriers to entry, the government can creat more tech school for those unstilled labors who are willing to do some job that need strong skill. And trying to make the school term short and make it affortable for people to enroll.

Andrew_FL writes:

Policy was "more favorable" meaning in fact, *less punitive*.

But I think you are overstating that point a bit. To be sure, in *aggregate* we have a situation where we demand more from the rich in taxes, but does that really mean that policy is less favorable to the rich-all the rich? I don't think so, actually. I think policy is very much more favorable to someone like Warren Buffet, say, than it was then. I don't think that is because he has more political power from having a greater gap between his income and a middle class person's, I think it is because there has been a shift in ideas that favors a more corporatist policy, which benefits some wealthy people like Buffet over others, including other wealthy or high income people.

For example, the blocking of the Keystone Pipeline has been very favorable toward his railroad company.

I don't think I need to convince anyone that capital income hugely distorts the numbers of the top one percent.

It also distorts the numbers of the bottom 20%. As Robert Fogel pointed out in one of his books, the bottom income quintile has a disproportionate number of self-employed. Their incomes are much more likely to vary from year to year, even if just because of accounting treatments of investment.

Hazel Meade writes:

I kind of think any attempt at rational argument on this subject is doomed to fail.

Why? Because the driving motivations behind it are two factors:
1. Economic self interest. Everyone believes that THEY should make more money. Regardless of whether inequality is increasing or decreasing, complaining about inequality is a social acceptable substitute for saying you're not doing as well as you'd like, and you want more. A lot of people want more right now.

2. Social signalling. Complaints about "inequality" appear to demonstrate a concern for other people's well-being, the kind of stuff that signals that you're a good cooperator and a nice person and so forth.

Those two factors dovetail nicely in a way that is ultimately self-serving, for both the politicians that expound them, and the people that consume them. It allows people to feel that they are being public spirited, instead of being envious and greedy.

And of course, the worst confounding aspect of this is that a lot of people are genuinely worse off today, and they are looking for someone to blame. When people's standard of living declines they are bound to feel that they deserve more than what they have.


LD Bottorff writes:

"The changes in relative income in this case are so much more important because of their effects on politics and social priorities."

Right. Very few of the middle class people I know really wanted gay marriage, federally mandated coverage of birth control, morning after pills available to teens, or even a housing policy that encouraged zero-down mortgages.

Many middle class folks were concerned about the folks who didn't have health insurance and the fact that they might lose their own. But many of them liked their insurance and they thought they could keep it.
When the income inequality puritans actually propose something, I guess they'll tell us "if you like your income, and make less than 250K, you can keep it."

And maybe some people will believe them.

Mike Rulle writes:

The politics if income inequality is, of course, a scam. You name a variety of issues which muddles up any rational discussion of the term.

Life cycle models of annual per capita increases in net worth (liquid and illiquid) seem like the best place to start serious discussions; certainly better than the preferred static categorical household income approach that is de rigeur in most commentaries on the subject. From life cycle models, many more sophisticated adjustments can be made, many which you have mentioned.

The irony of the current politically motivated "household income" approach is that it is designed to encourage the transfer of income to those who are in the lower categories at any point in time. Which has in fact happened! So the "scam" if you will, has succeeded. But that can't be admitted, hence it is left out of the numbers. To include them is to admit society has addressed these concerns, however poorly conceived. So we must keep pounding the drum.

Let's face it, politics is a process of transferring money around for political gain----not entirely, but largely. I am, oddly, okay with that---as long as the amounts stay within some historical norm. Obsessing over some perfect order is a waste of time. But it still needs to be severely checked. One way to do so is to change the language. The left won that war long ago. We all speak like Marxists now. Even when we oppose it.

So, when it comes to income inequality, let's change how it's discussed. Scott has made a great start. Perhaps he can get a simple framework, like he did with NGDP, so the language and politics of income inequality can become a bit more rational, i.e., truthful.

Dale writes:

"Since I care much more about poverty than the middle class/rich gap, I'm not particularly dismayed by the changes we've seen in recent decades."

I would suggest that liberals would tend to say that the middle class/rich gap widening is the same issue of the poor/middle class gap and that its the overall distribution which matters most.

After all if the middle class are as poor off as the poor are they really middle class? That isn't to say that we want a large gap between them, but to say that simply a small gap does not indicate that things are necessarily good.

That being said: I don't understand why consumption is a better metric than income. While its true that consumption measures economic wellbeing* best for the current time by that measure income is quite literally the change in consumption over the entire lifetime since you must save or spend in aggregate.

I am not sure I agree with the strength of consumption smoothing enough to support a view that looks at consumption rather than income.

Additionally I am not particularly comfortable with a view that people who are monetarily poor are choosing to invest less (rather than simply being financially limited in being able to do so). If we get the net present value for incomes of people who have more freedom to do as they please may actually understate inequality rather than overstate.

All of that being said: Cost of living adjustments should not be a part of the calculations. If you live in a high cost of living area either one of two things is happening 1) You're choosing to live in an area where everyone wants to live, implying an increased use of limited real resources [land]. This implies an actual higher income.
2) You're choosing to live in an area where it requires more real resources in order to live [coal/heating/oil]. Thus meaning you're actually spending more real resources which means you have more income.

3) You don't choose to live there but you're in a trap where you can't afford to leave. I am skeptical of this happening to large numbers of people who live in "high cost of living areas"

Randomize writes:

The trouble is that capital income is *real* income in the sense that those who receive it can consume a larger share of our resources. If that capital income were received only as a result of investing, that would be one thing, but those who receive this lifetime of privilege for them and their grandchildren only by inheriting such power have done nothing to earn it.

If we're going to keep the income tax system, let's at least acknowledge that wealth begets more wealth and that, ceteris paribus, the poor may very well remain poor no matter how hard they work as long as the owner class continues to gain compounding amounts of income and resources, outpacing any amount of wages. This is the very nature of capitalism and is thus a necessary evil but we can start addressing this problem by taxing inheritances as regular income; the people will cry all the way to the bank.

Philo writes:

@ Randomize

”[W]ealth begets more wealth” only if it’s saved; it might, instead, be consumed. If you want to tax consumption (and isn’t that better than taxing “income”?) you’re agreeing with Scott.

You complain about inheritance, as “unearned,” but you seem willing to allow an earner to enjoy the fruits of his labor. Then what if the earner wants to *give some of what he has earned to someone else*? Would you disallow this, requiring the earner to consume his earnings *himself*; would you enforce selfishness? You should instead allow the earner to give to his spouse, his children, people he likes, people he feels sorry for, etc.--but none of them will have *earned* what he is giving them. And once gifts are allowed it is inconsistent to disallow bequests.

Your focus on *earning* is misplaced. Which of us 21st-century Americans has earned everything he enjoys? Most people now and in the past have had much harder lives than we enjoy, and we have not earned this advantage. We did not even earn our very existence: many fetuses have, through no fault of their own, failed to make it to birth. The principle that people may enjoy only what they have earned is quite unworkable.

Jason Harner writes:

Scott, I think you've put together a lucid and intellectually honest piece on the many problems with income inequality figures. However, I believe it will be used to confirm people's mistaken priors regarding inequality of opportunity in this country.

You fail to discuss the very real educational attainment gaps present across the US. Yes, an expansive earned income tax credit in lieu of the minimum wage and other social programs that severely distort the job market is a good idea. But without addressing the severe structural problems in our education system it's unlikely to stop the cycle of poverty occurring in much of the country.

Trevor Vossberg writes:

I have seen critiques of welfare/anti-poverty programs like this one and David Henderson's on the minimum wage that are correct but answer the wrong question.

They seem argue:

1. Welfare program X is not perfectly set up to accomplish some goals. (Explicit)
2. Welfare program X shouldn't be enacted. (Implicit)

They ignore the real question, a question not considered often enough:
Is this policy an improvement or not?

If we really care about consumption, which I agree with, then why is capital income different? It still gives the rich a greater amount of wealth and thus consumption.

Scott Sumner writes:

Andrew, Plenty of wealthy people were hurt by the blocking of Keystone. If it had been approved the left would have complained about the political power of big oil.

Dale, You asked:

"After all if the middle class are as poor off as the poor are they really middle class?"

No, but of course they aren't as bad off as the poor.

You said;

"2) You're choosing to live in an area where it requires more real resources in order to live [coal/heating/oil]. Thus meaning you're actually spending more real resources which means you have more income."

That's true, but what's the point? The point is that income doesn't measure utility.

Randomize, So you are proposing a cut in the inheritance tax rate? It is currently higher than income taxes, isn't it?

I see no reason to tax selfish rich guys who spend it all on themselves at a lower rate than generous rich guys who give a lot to their children and live a thrifty lifestyle. Why not tax them at the same rate?

Jason, I'm all for reforming our educational system but there is very little evidence that it would make much difference.

Trevor, Capital income doesn't give them more wealth, it just means they choose to consume it later in life, and hence have more consumption.

David writes:

I don't believe wage subsidies should be the burden of the employer. Social issues like barriers to entry and talent gaps should be the responsibility of the society. A minimum income payed for by income taxes would create better incentives. Tax payers would pay more attention to factors that affect lower income people. Would a minimum income have a smaller affect on the labor market?

Glen Smith writes:

The intuition underlying the thought of those with an issue over income equality is that people should be paid according to how hard they work. While I've worked more when my work was well compensated, I have never experienced a situation where my compensation was based on how hard I work and I've never met anybody who has been compensated based on how hard they work.

Jesse K writes:

Scott,

You lost me here,

A wage subsidy that reduces economic inequality actually raises income inequality, at least if you measure income net of the subsidy (which is how we do it.)

I think I'm missing a step in reaching this conclusion from what precedes. Do you have a back link that elaborates?

TallDave writes:

Discussions of income inequality suffer the same problem as discussions of phlogistons -- the concept is not a useful model in the real world.

Fun exercise: consider the wealth that existed circa 1950 vs 2014. Now consider all the wealth consumed or otherwise lost between 1950 and 2014. Whence all that new and consumed wealth?

In the modern positive-sum, value-added economy the provenance of wealth explains its distribution. The preference for free market economies results from the efficient allocation of resources to activities people find useful.

Brian writes:

"So, when it comes to income inequality, let's change how it's discussed."

Mike,

Yes, the use of the terms income or wealth "inequality" are biased to be negative. "Inequality" is always used in a negative context. One of the problems is that people never get beyond the words, and so take for granted that the income gap is bad.

For more neutral terminology, I propose income or wealth diversity. It has the advantage of having a strong positive connotation of the left and forces them to think about why such a thing is bad, or might be good. It has the advantage of giving everyone pause when they talk about it. After all, unlike inequality, diversity has both positive and negative characteristics.

John Hayes writes:

Elwailly,

The top 1% and top 0.1% are not groups that are persistent year to year. I would bet the majority of people in the group one year are not there the next.

Unless the group membership is persistent over a long period of time, there won't be much scope for accumulation of political influence. Politicians are forward looking, no point in favoring someone who can't reliably make donations in the future. That's why lobbyists are much more influential that individuals.

Andrew_FL writes:

@Scott Sumner- I don't disagree. I think you are right to say that greater "inequality" has not lead to greater political power for the rich in general, I was merely noting that I believe there has been an unrelated ideological shift, that has been favorable to some wealthy people, relative to others. I believe this gives many people the impression that "the rich" are more powerful. It would be more accurate to say that some have benefited from a change in the ideology of the government and others have been harmed by it.

Matt writes:

Scott,

You and Tyler Cowen are both very rational and well-informed individuals, but his stagnation book seems to squarely reject your line of reasoning here. In light of the theorems about how there can't be rational disagreement, what explains the disconnect? I know you hedge a little about the state of the middle class relative to the one percent, but my understanding is that Cowen takes as essentially accurate the income-based metrics that reflect median stagnation which you find unconvincing.

Comments for this entry have been closed
Return to top