'Income Inequality' Claims Ring Hollow When Correctly Examined

'Income Inequality' Claims Ring Hollow When Correctly Examined
May 1, 2007

New York Times columnist David Brooks began a January 14, 2007 piece by saying, "Income inequality is on the rise." No fact or explanation was offered because this is something "everyone knows."

Whenever someone says inequality is rising, however, questions need to be asked about what and when.

Income can be defined narrowly (excluding government transfer payments and taxes) or broadly (including taxable capital gains and a share of corporate profits) at both ends of the scale, and it makes a big difference what definitions one chooses.

We are constantly confronted with dubious estimates of the share of income received by the top 1 percent, as though that could tell us anything about how the other 99 percent are doing.

"If the rich get more," wrote Paul Krugman, "that leaves less for everyone else."

Such zero-sum reasoning defies economists' definition of efficiency ("Pareto optimality"), which occurs whenever someone becomes better off without anyone else becoming worse off. The young founders of Google became billionaires by creating something new and useful, not by "leaving less for everyone else."

The second big question about inequality is about timing. When did the increase in inequality (of what?) supposedly occur? The answer is often given by comparing just two years, such as 1979 and 2004, and then pretending we can assume a continuous trend by drawing an imaginary line between those years.

Unjustified Conclusions

In a highly publicized speech in February, Federal Reserve Chairman Ben Bernanke said, "Rising inequality is not a recent development but has been evident for at least three decades, if not longer."

It would have been more accurate if Bernanke had said rising inequality "is not a recent development," but something that happened long ago. The only study he cited that dealt with income of the entire population claimed inequality "increased between 1968 and the early 1990s," which is not exactly recent.

All the figures Bernanke presented started with 1979 and ended with 2004 or 2005, which tells us nothing about what happened in between. Citing the Congressional Budget Office (CBO), he said, "The share of after-tax income garnered by the households in the top 1 percent of the income distribution increased from 8 percent in 1979 to 14 percent in 2004."

Yet the same data also show the top 1 percent's share fell from 13.2 percent in 1986 to 12.2 percent in 2003. Such two-year comparisons, his or mine, are almost always misleading.

New Definitions

For one thing, the1986 tax reform greatly increased the amount of high incomes reported on individual tax returns, notably by Subchapter S corporations. Much of that income had previously been reported on corporate tax returns.

For another, the CBO now adds 59 percent of all corporate profits to the "incomes" of the top 1 percent, a misestimation of the top 1 percent's share of wealth. As Bernanke noted, the Fed estimates the top 1 percent owns "about 33 percent" of the nation's aggregate household net worth--not 59 percent. Applying the Fed's estimates to CBO data, I calculate the top 1 percent's share of before-tax income as having fallen from 11.8 percent in 1989 to 11.3 percent in 2004.

Getting back to our first question, we also have to ask what Bernanke was referring to when he spoke of "rising inequality" (from 1979 to 1986). His talk generally assumed that differences in income mainly reflect differences in hourly wages. He spoke of the fall in the real minimum wage, and about higher wages for college grads than for high school dropouts.

Additional Factors

Yet the gap between wages of college graduates and high school dropouts could properly be equated with "income inequality" only if work was the only source of income, everyone worked full-time, and the relative numbers of college grads and dropouts did not change.

Wages are indeed a very important source of income among the top fifth, where two salaries are the norm, but transfer payments are most important among the bottom fifth. The number of people who worked full-time all year in 2005 was 16.7 million in the top fifth but only 3.2 million in the poorest fifth.

Bernanke claimed, "The share of income received by households in the top fifth of the income distribution, after taxes have been paid and government transfers have been received, rose from 42 percent in 1979 to 50 percent in 2004, while the share of income received by those in the bottom fifth of the distribution declined from 7 percent to 5 percent."

Unfortunately, those were the wrong figures. They do not exclude taxes and do not include all transfer payments.

Negligible Changes

The top fifth's share of disposable income, "after taxes have been paid and government transfers have been received," rose slightly (from 41.1 percent in 1979 to 44.9 percent in 2004, not 50 percent), while the share received by those in the bottom fifth declined slightly (from 5.3 percent to 4.7 percent).

All of that apparent increase in inequality happened between 1980 and 1986, not recently.

Aside from a meaningless spike to 45.7 percent in 1986, related to that year's tax reform, the income share of the top fifth remained at about 43.5 percent from 1985 to 1992. Then "a change in survey methodology in 1993 led to a sharp rise in measured inequality," as the Economic Policy Institute has explained. Because of that statistical break in the data, the top fifth's share has averaged about 45 percent since 1993.

Similarly, the Gini coefficient for disposable income (higher Gini numbers indicate greater inequality) was close to .39 from 1985 to 1992. It went to 0.40 in 1993, because of the survey change, and remained at 0.40 in 2002-2004.

Consumption Clues

Because income fluctuates and consumption can be financed from transfers, wealth, and credit, relative living standards are best measured by what consumers spend. A study in the April 2005 Monthly Labor Review estimated the Gini coefficient for consumption was 0.283 in 1986 and 0.280 in 2002.

In the 2005 Consumer Expenditure Survey, conducted by the U.S. Bureau of Labor Statistics, the bottom fifth accounted for 8.2 percent of total consumer spending, compared with 39 percent for the top fifth. But there were only 1.7 persons and 0.5 workers per "consumer unit" in the bottom fifth, compared with 3.2 persons and 2.1 workers in the top fifth.

Consumption per-capita or per-worker is much more equal than the consumption shares indicate, and consumption shares are much more equal than income shares (particularly if taxes and transfer payments are excluded).

The next time someone bemoans "rising inequality," ask what they mean by inequality and when they think that rise occurred. There is no evidence of rising inequality of consumption since 1986, nor of disposable income.

Alan Reynolds (areynolds@cato.org), a senior fellow with the Cato Institute and syndicated columnist, is the author of Income and Wealth (Greenwood Press 2006).

For more information ...

"Income Distribution Heresies," by Alan Reynolds, the Cato Institute, http://www.cato-unbound.org/2007/02/07/alan-reynolds/income-distribution-heresies/