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Hot Topic

Income Inequality: What Would You Choose?

Student Reading

Would you rather live in world A where you earn $100,000 while everyone else earns $85,000 or world B where you earn $110,000 while everyone else earns $200,000? Economist, Robert Frank, did just such a survey and found that a majority of Americans would rather live in world A. What does that mean? Even Adam Smith pondered this idea of relative wealth and how the consumption of those around us influences our standards of what is “necessary.”

“By necessaries I understand not only the commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without.” Adam Smith An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

So it’s no surprise that headlines touting that the average CEO makes $5,048 per hour or $100,000 in the first half-week of the year get our attention. Clearly relative wealth matters and it’s no surprise that once again, the debate over income inequality and distribution, or better yet redistribution, has found its way out of the economics classroom and into the mainstream media. With an election always around the next corner, politicians give heed to the opinions of their electorate as they consider which public policies to support.

Understanding based on knowledge and evidence imparts value to opinions. Opinions matter and are of equal value at the ballot box, but on matters of rational deliberation the value of an opinion is determined by the knowledge and evidence on which it is based. Statements of opinion should initiate the quest for economic understanding, not end it. Economic Reasoning Proposition #5- Foundation for Teaching Economics

Sparked by the news of the enormous salaries and bonuses of CEOs amidst an economic downturn, lots of people are weighing in on the issue of income inequality. And opinions matter! But knowledge and evidence give value to opinions. So in an effort to shed some light on this Hot Topic, we’ll examine the opinions making headlines today, in light of the knowledge and evidence they are based on. But first let’s identify how inequality is measured as well as what those measures tell us, or more importantly, do not tell us.

A common way to measure inequality is through household incomes. This is done by dividing a nation’s households into fifths, or quintiles, and then comparing the share of the total income earned by each quintile. Plotting this data on a graph (Lorenz Curve) provides a visual representation of the level of inequality between a nation’s households. In the illustration below, you can see that if income were distributed evenly among households, it would be represented by the 45-degree ray from the origin – the line of equity. Below the line of equity, the Lorenz curve illustrates actual income distribution. The farther bowed out the curve, the less equitable the income distribution. We can also represent the level of inequality mathematically (Gini coefficient) by calculating the area of inequality (A) as a percentage of the total area under the line of equity. So a perfectly equitable distribution, with everyone earning the same, would result in a Gini coefficient of 0, while a perfectly inequitable distribution, with one person earning everything, would result in an Gini coefficient of 1.

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Think you’ve got it? Not so fast. Unfortunately, no one statistic tells the whole story. In the U.S., for example, household income data collected by the Census Bureau is used to measure income inequality, but as Federal Reserve Economist, Thomas Garrett, explains, there’s more to the story. As you read the following selection, identify three deficiencies in the U.S. household income statistics as it relates to measuring inequality.

…One big problem… is that the census statistics provide only a snapshot of income distribution in the U.S., at a single point in time. The statistics do not reflect the reality that income for many households changes over time—i.e., incomes are mobile. For most people, income increases over time as they move from their first, low-paying job in high school to a better-paying job later in their lives. Also, some people lose income over time because of business-cycle contractions, demotions, career changes, retirement, etc. The implication of changing individual incomes is that individual households do not remain in the same income quintiles over time. Thus, comparing different income quintiles over time is like comparing apples to oranges, because it means comparing incomes of different people at different stages in their earnings profile.

The U.S. Treasury released a study in November 2007 that examined income mobility in the U.S. from 1996 to 2005. Using data from individual tax returns, the study documented the movement of households along the distribution of real income over the 10-year period… The study found that nearly 58 percent of the households that were in the lowest income quintile (the lowest 20 percent) in 1996 moved to a higher income quintile by 2005. Similarly… more than 57 percent of the richest 1 percent of households in 1996 fell out of that category by 2005.

…Common reference to “classes” of people (e.g., the lowest 20 percent or the richest 10 percent) is quite misleading because income classes do not contain the same households and people over time.

Another problem… is that the statistics do not include the noncash resources received by lower-income households… and the tax payments made by wealthier households to fund these transfers. Lower-income households annually receive tens of billions of dollars in subsidies for housing, food and medical care. None of these are considered income by the Census Bureau. Thus the resources available to lower-income households are actually greater than is suggested by the income of those households as reported in the census data.

At the same time, these noncash payments to lower-income households are funded with taxpayer dollars—mostly from wealthier households, since they pay a majority of overall taxes. One research report estimates that the share of total income earned by the lowest income quintile increases roughly 50 percent—whereas the share of total income earned by the highest income quintile drops roughly 7 percent—when transfer payments and taxes are considered.

The census statistics also do not account for the fact that the households in each quintile contain different numbers of people; it is differences in income across people, rather than differences in income by household, that provide a clearer measure of inequality. Lower-income households tend to consist of single people with low earnings, whereas higher-income households tend to include married couples with multiple earners. The fact that lower-income households have fewer people than higher-income households skews the income distribution by person. When considering household size along with transfers received and taxes paid, the income share of the lowest quintile nearly triples and the income share of the highest quintile falls by 25 percent…”U.S. Income Inequality: It’s Not So Bad” by Thomas A. Garrett, Economist, Federal Reserve Band of St. Louis, Inside the Vault, Spring 2010.

Furthermore, alternate measures of inequality tell different stories. For example, if we measured inequality of wealth rather than income, the elderly would move up in the pecking order as they often have greater stores of wealth, but no income. Measuring inequality of consumption paints an even more equitable picture as the poor are able to consume more than their income due to welfare benefits and public services, while the rich consume less than their income.

Another important point to clarify is whether or not the gap between rich and poor is actually growing. And the answer is, of course, it depends! The author of this recent article from the Economist magazine (part of a 14-page special report on the global elite), explains why.

Globally, the gap between the rich and the poor has actually been narrowing, as poorer countries are growing faster. Nor is there a monolithic trend within countries... In Latin America, long home to the world’s most unequal societies, many countries—including the biggest, Brazil—have become a bit more equal, as governments have boosted the incomes of the poor with fast growth and an overhaul of public spending to improve the social safety-net (but not by raising tax rates for the rich).

The gap between rich and poor has risen in other emerging economies (notably China and India) as well as in many rich countries (especially America, but also in places with a reputation for being more egalitarian, such as Germany). But the reasons for this differ. In China inequality has a lot to do with the hukou system of residency permits, which limits internal migration to the towns; by some measures inequality has peaked as rural labour becomes more scarce. In America income inequality began to widen in the 1980s largely because the poor fell behind those in the middle. More recently, the shift has been overwhelmingly due to a rise in the share of income going to the very top—the highest 1% of earners and above—particularly those working in the financial sector. Many Americans are seeing their living standards stagnate, but the gap between most of them has not changed all that much. “The Rich and the Rest,” (The Economist, January 22, 2011)



While the Gini coefficient, used to indicate inequality between the rich and poor, runs from 0 (everyone has the same income) to 1 (one person has all the income), most countries range between 0.25 and 0.6. The excerpt below uses changing Gini coefficients to explain the changing income inequality in and among countries of the world.

Unbottled Gini, (The Economist, January 20, 2011)

...The Gini coefficient has gone up a lot in some rich countries since the 1980s. For American households it climbed from 0.34 in the mid-1980s to 0.38 in the 2000s. In China it went up even more, from under 0.3 to over 0.4. But this was not universal. For decades, Latin America had the world’s worst income inequality. But Brazil’s Gini coefficient has fallen more than five points since 2000, to 0.55. And as poor countries are on average growing faster than rich ones, inequality in the world as a whole is falling. “Unbottled Gini, (“The Economist, January 22, 2011.)

So income equality is falling for the world as a whole, but rising in America.

How Much?

Despite some survey results in which people say they prefer a situation where there is more equal income distribution, even to the point where they’d sacrifice being absolutely better off in order to be relatively better off,” it’s interesting to note that no one seems to be arguing for completely equal income distribution. And, of course, there’s no argument for perfect inequality, so the challenge seems to be finding the right level of inequality for economic health. On NPR recently, Branko Milanovic, author of The Haves and the Have-Nots, compared it to finding the right level of cholesterol for physical health.

“Inequality is like cholesterol. I mean, you have good inequality, that would be an inequality which would lead people to take risks, to actually work harder, to study more in order to make more money. But there is also bad inequality, that’s an inequality which actually cements the acquired position, which doesn’t let poor people acquire education if they don’t have money and so on.” “Why income inequality isn’t always a bad thing.” National Public Radio, Market Place, January 11, 2011.

Recent surveys in the United States tell us that even though people may not know the actual distribution of income, they still think it should be more equal.

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Historical evidence suggests, however, that we might want to be careful what we wish for. Countries that have attempted to equalize income have instead destroyed incentives for production and innovation (think the Soviet Union, Cuba under Castro, North Korea today), leaving their populations mired in poverty.

An excessively equal income distribution can be bad for economic efficiency. Take, for example, the experience of socialist countries, where deliberately low inequality (with no private profits and minimal differences in wages and salaries) deprived people of the incentives needed for . . . diligent work and vigorous entrepreneurship. Among the consequences of socialist equalization of incomes were poor discipline and low initiative among workers, poor quality and limited selection of goods and services, slow technical progress, and eventually, slower economic growth leading to more poverty.

In many high-income countries relatively low inequality of incomes is achieved with the help of considerable transfer payments from the government budget. However, economists often argue that mitigating inequality by increasing the burden of government taxes tends to discourage investment, slow economic growth, and undermine a country’s international competitiveness.

On the other hand, excessive inequality adversely affects people’s quality of life, leading to a higher incidence of poverty, impeding progress in health and education, and contributing to crime. “Income Inequality,” Beyond Economic Growth - Student Book, World Bank – Development Education Program, 2004.

And what about happiness? While the perceptions may be that people are happier when income distribution is more equitable, or in this case, less happy as income distribution becomes more inequitable, the reality is we are just as happy today as we were in 1970. The General Social Survey has been tracking the opinions of Americans for four decades. In 1972, 30 percent of the population said that they were “very happy” with their lives; in 1982, 31 percent; in 1993, 32 percent; and in 2006, 32 percent. So, even while income inequality has been on the rise, there has been no significant change in happiness

Public Policy

While it would be good if more people understood the dynamics of income inequality, income mobility, Lorenz Curves and Gini Coefficients, educating them is unlikely to eliminate disagreement over how much inequality is too much. If we want more equal income distribution, politicians will respond and propose policies designed to change it – and that brings up another important question. Should policies target the outcomes of human choice and behavior, the inequality itself, or the institutions that influence human choice and behavior? Often, proponents of change focus on outcomes, changing inequality through higher taxes on the rich and redistribution to the poor. An understanding of economic reasoning and how incentives shape human behavior suggests that focusing on the institutions, while admittedly difficult, is more likely to produce lasting changes.

…The right way to combat inequality and increase mobility is clear. First, governments need to keep their focus on pushing up the bottom and middle rather than dragging down the top: investing in (and removing barriers to) education, abolishing rules that prevent the able from getting ahead and refocusing government spending on those that need it most. Oddly, the urgency of these kinds of reform is greatest in rich countries, where prospects for the less-skilled are stagnant or falling. Second, governments should get rid of rigged rules and subsidies that favour specific industries or insiders. . . In the emerging world there should be a far more vigorous assault on monopolies and a renewed commitment to reducing global trade barriers—for nothing boosts competition and loosens social barriers better than freer commerce.

Such reforms would not narrow all income disparities: in a freer world skill and intellect would still be rewarded, in some cases magnificently well. But the reforms would strike at the most pernicious, unfair sorts of income disparity and allow more people to move upwards. They would also boost growth and leave the world economy more stable. “The Rich and the Rest,” The Economist, January 22, 2011.

No Easy Answers

So,what do you or ‘we’ want? More income inequality or less? More income mobility? More or less redistribution? As the debate continues, keep in mind two things: First, the value of an opinion is determined by the knowledge and evidence on which it is based, and second, institutions, or the “rules of the game,” influence choices. Understanding the mechanics and measurement of income inequality isn’t going to determine whether you would support more or less income equality, but it should help to clarify the trade-offs you’re accepting with either choice.

Questions for Discussion:

1. Does your answer to the survey question differ from the survey results? How do you explain the similarities or differences? Do you think the results of the survey are important to policy makers in our government? Why or why not?

2. List 3 problems with using the Census Bureau’s household income data to measure income inequality in the U.S.

3. What is happening to income distribution at the global level? Is the same true for individual countries?

4. What are the fundamental arguments against too much income inequality?

5. What are the fundamental arguments against too much income equality?

Teacher Guide

1. To start the lesson, and before distributing the student reading, conduct the following survey:

Would you rather live in World A or World B?

• World A: You earn $100,000 and everyone else earns $85,000.

• World B: You earn $110,000 and everyone else earns $200,000.

Tabulate the results, and conduct a brief discussion, allowing students to give reasons for their choices.

2. Present (or review the FTE’s Economic Reasoning Propositions #4 and 5”

Economic Reasoning Proposition #4:

Institutions are the “rules of the game” that influence choices.

Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions controlling behavior set out and establish the incentive structure and the basic design of the economic system.

Economic Reasoning Proposition #5:

Understanding based on knowledge and evidence imparts value to opinions.

Opinions matter and are of equal value at the ballot box, but on matters of rational deliberation the value of an opinion is determined by the knowledge and evidence on which it is based. Statements of opinion should initiate the quest for economic understanding, not end it.

3. Distribute the student reading

4. Divide students into small groups to complete the discussion questions or assign for homework

5. Conduct a class discussion to debrief

6. Extension Activity:

Listen to the EconTalk podcast with Robert Frank on Inequality. November 15, 2010.

Answer Guide to Discussion Questions:

1. Does your answer to the survey question differ from the survey results? How do you explain the similarities or differences? Do you think the results of the survey are important to policy makers in our government? Why or why not? Answers will vary, but this gives students an opportunity to lay out their thinking. For example, were they thinking of having those options within the United States or in a country where that distribution would always be their lot?

2. List 3 problems with using the Census Bureau’s household income data to measure income inequality in the U.S.

a. The statistics don’t reflect that incomes are mobile and that people change quintiles at different stages in their lives. The Census statistics compare incomes of different people who are at different stages of their lives… so of course they’ll be different. Likewise, the idea of “classes” that is inferred from the 5 quintiles is misleading because, once again, the quintiles do not contain the same people and households over time.

b. The statistics don’t include transfer payments to the poor (subsidies for housing, food, medical care, etc) as income. Nor do they subtract out the higher taxes of the rich that are used to fund the transfers.

c. The statistics don’t account for the fact that households are different sizes. They overstate the problem because lower-income households have, on average, fewer people while higher income households have more.

3. What is happening to income distribution at the global level? Is the same true for individual countries? At the global level, income inequality is falling. In some countries income inequality is falling (Brazil), and in others it is rising (China, India, America, Germany)

4. What are the fundamental arguments against too much income inequality? Lower quality of life, which may lead to more poverty, impede progress in health and education, and contribute to crime. May lead to less income mobility.

5. What are the fundamental arguments against too much income equality? It deprives people of incentives that encourage people to work diligently and pursue entrepreneurial activities. The redistribution efforts to make income distribution more equal can discourage investment, slow economic growth and even undermine a country’s international competitiveness.

6. How would you answer the Rawls thought-experiment question at the end of the article? Consider whether or not your answer is consistent with your original survey choice of World A or World B, and comment on the connection. Accept a variety of answers. Encourage students to identify the context in which they answered the survey? For example, were they considering that there is a trade-off between the degree of income inequality and general level of income? Would they be willing to trade-off being the richest if they could be wealthier overall? What if a third choice was to be in World A as a young person and World B as an older person?

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