I frequently argue that income is a meaningless concept, as it includes capital gains (and losses) in asset values. Indeed the problem is even more basic, as income mixes labor income and all investment income, which is like adding apples and oranges. No, it's even worse, like adding strawberries and watermelons, and talking about the number of "fruit".
Because income is a meaningless concept, income inequality is also meaningless. But let's say I'm wrong, and let's assume that capital income actually measures something interesting. What then? In that case, the income of the top quintile would almost certainly be highly cyclical. Consider the following graph, showing the total stock market capitalization in the US:
Notice that stock market capitalization fell by 23.4% of GDP between 2001 and 2002, and by 44.5% of GDP between 2007 and 2009. What happens when stock market capitalization falls by nearly a quarter?
Let's consider the top quintile of the population, which owns the vast majority of stocks. Capital losses of 23% of GDP would sharply cut into their income from other sources. The top quintile earns about 55% of total income, or 43% after taxes and transfers. If the income inequality data were accurate, it should show a huge drop in the share of income earned by the top quintile, any time the stock market crashed. But we don't see that---income shares are pretty stable from year to year.
The problem here is that while income proponents claim to care about capital gains and losses, what they actually measure is realized capital gains and losses, which is meaninglessness on steroids. It takes an already meaningless concept (capital gains) and only counts those amounts that show up on tax returns when people buy and sell stock. Economists agree that there is no functional difference between a realized capital gain and an unrealized gain, indeed realized gains often are not even consumed, rather simply reinvested in another financial asset!
If you really believe that we should be measuring capital gains, and including them in with income, then we ought to include the unrealized gains as well. If we did that, we would observe massive declines in the income of the top 20% in bear markets like 2001-02 and 2007-09. Do you recall Americans basking in the glow of a dramatic improvement in "equality" in 2009? Neither do I. And that's because its consumption inequality that matters, and consumption inequality did not change dramatically during the Great Recession.
A few points on the data:
1. Foreigners own a portion of the American stock market. However, Americans own lots of foreign stocks as well. Since foreign markets crashed at about the same time, I think these are still ballpark estimates of capital losses for Americans from the bear market in stocks.
2. During 2007-09, the top 20% also saw large capital losses in real estate. Thus the data above understates the total capital losses incurred by the elites in 2007-09. It would not surprise me if total income earned by the top 1%, or perhaps the top 0.1%, actually turned negative during 2008. (It did for me.) That is, their capital losses outweighed labor income plus interest and dividends. But obviously it would be silly to include the top 1% in with homeless people in income inequality data. It's consumption that matters.
3. Conversely, huge gains also distort the picture. When I file taxes next year I'll have to report a huge capital gain, as I am selling my house for about a million dollars more than I paid for it. And yet nothing really changed for me this year. I am buying another house of roughly equal value. Nothing has changed in terms of my flow of housing consumption; I occupy the exact same number of square feet as when I bought the house in 1991. It's all just housing inflation, which in coastal areas has outpaced the CPI.
This is not to say that I am not in some sense "rich", or deserve to pay lots of taxes. I could choose to live in a cheaper area, and have lots of money left over. By global standards I'm extremely rich, and even by American standards I'm upper middle class. But the income I report on my tax return next April won't accurately portray my economic circumstances. I'm affluent, but not as affluent as someone who made my combined wage and capital gains income, all in the form of wage income from a single job. There's a reason that 73% of Americans spend at least part of their life in the top quintile--incomes are volatile.
Here's one estimate of income (after taxes) and consumption inequality:
I suspect that inequality in real terms would be less than inequality in nominal terms (shown above), as the affluent tend to live in high cost areas. That's not to deny that there would still be plenty of consumption inequality. There is. And I also suspect that consumption inequality is getting "worse" over time, albeit not at the pace shown in the data---as house prices have risen faster in affluent places like Silicon Valley. (I mean worsening domestically---consumption inequality is actually falling at the global level.)
PS. I always find that some people are confused by the claim that investment income should not be included with wage income. I like to explain this with a thought experiment of two equally well off twin brothers. Assume that both earn identical lifetime wage incomes, and neither inherits money from their parents. Then both are equally well off. If one chose to buy two Hondas and the other chooses to but one BMW, you would not say the guy with two cars is better off. If one chooses to buy a BMW at age 25 and the other saves and buys two BMWs at age 55, you would not say the more patient brother is better off. (Unless you were the US government). Future goods have less value than present goods. Saying that investment income should be included with labor income is essentially saying:
1. The brother who chooses to save is better off, even though that avenue was open to the other brother, who preferred current consumption. After all, the patient brother will have more total "income".
2. A BMW that you have to wait 30 years to get is equally desirable as a BMW today. Is that what you believe? If not, then stop talking about income inequality.
PS. In previous posts I sometimes get people claiming a contradiction when I say that income is meaningless, but at the same time advocate the targeting of "national income". In fact, NGDP does not included capital gains. (And there are other differences as well.)
I do think that it might be better to target total labor compensation rather than NGDP. But not because NGDP inaccurately measures investment income, rather because wage stickiness is the key macro problem that monetary policy needs to address.
PPS. Some commenters claim that income matters more than consumption, because it measures political power. Just the opposite. Suppose Jeff Bezos makes $20 billion in capital gains on Amazon stock in 2017. Does anyone seriously believe that Bezos has more political power than a teachers union representing 400,000 teachers, each earning $50,000/year? Suppose he advocated vouchers for all students in California. Could he beat the teachers union? Consumption is a better index of political power, albeit far from perfect.
In aggregate, 400,000 teachers have far more to lose than Bezos (in terms of foregone consumption) which is why they fight harder for their preferred policies.