CHAPTER THIRTY-TWO



chapter Thirty-two

income inequality, poverty, and discrimination

I. Income inequality facts

A. In 2006, almost 36.5 million Americans—12.3 percent of the population—lived in poverty, 500,000 were estimated to be homeless, the richest fifth of American households received about 50.5 percent of total income, the poorest fifth 3.4 percent.

B. The distribution of Household Income for 2006 is shown in Table 20.1 and Figure 20.1.

1. Average family income in 2006 was $66,570.

2. Over 25.2 percent of the households had annual incomes of less than $25,000, 19.1 percent had annual incomes of $100,000 or more.

3. The top 20 percent of the households received half (50.5 percent) of all income, more than ten times as much as the lowest 20 percent of households.

C. The Lorenz curve depicts income distribution graphically.

1. If income were distributed perfectly equally, the Lorenz curve would be the straight-line diagonal line.

2. The extent to which the actual income distribution varies from the line of perfect equality is the measure of inequality; the greater the distance of the curve from the line of equality, the more unequal the distribution of income.

3. The extreme would be a line that follows the horizontal axis to the right until it meets the right vertical axis and then turns upward along that axis.

4. The Lorenz curve can be used to compare changes in the curve over time or to compare income distributions across countries.

D. The Gini ratio measures the distribution numerically.

1. The Gini ratio is measured as the ratio of the area between the Lorenz curve and diagonal to the total area below the diagonal.

2. Higher numbers signify greater income inequality; lower numbers imply a more equal distribution. The Gini ratio is bounded between zero and one.

3. Wealthier, more industrialized nations tend to have lower Gini ratios, while poorer, less developed nations have higher ratios.

E. Income Mobility: The Time Dimension

1. The income accounting period of a year is too short to be meaningful in judging income inequality. Over a period of time—several years, a decade, or a lifetime—earnings might be more equal.

2. If Brad earns $1,000 in year 1 and $100,000 in year 2, while Jenny earns $100,000 in year 1 and $1000 in year 2, income distribution looks unequal in a single year, but appears equal over the two-year period.

3. There is considerable “churning around” in the distribution of income over time. Movement between quintiles is called income mobility.

4. Most income receivers start at a low level, peak during middle age, and then decline. As a result, considerable income inequality will exist in any specific year because of age differences.

F. Effect of Government on Redistribution

1. The income data in Table 20.1 and Figure 20.1 show before-tax, cash income, including earnings (wages, salaries, dividends, interest) and cash transfers (social security, unemployment compensation, welfare payments).

2. The figures do not take into account outlays for personal income taxes and payroll (social security) taxes. Nor do they include in-kind (noncash) transfers such as Medicare, Medicaid, food stamps or housing subsidies.

3. Government significantly redistributes income from higher to lower income households through taxes and transfers. (Figure 20.2)

a. Without government redistribution, the lowest 20 percent of households would have received only 1.5 percent of total income. With redistribution they receive 4.4 percent.

b. Because the American tax system is only modestly progressive, transfer payments are the most important method of redistribution. They account for more than 75 percent of the income of the lowest quintile.

4. Most income receivers start at a low level, peak during middle age, and then decline. As a result, considerable income inequality will exist in any specific year because of age differences.

5. Individuals and households will move up to higher quintile groups or move down to lower quintile groups. This is called income mobility.

II. Income Inequality: Causes

A. Ability differences lead to differences in earnings.

B. Education and training correlate closely with differences in earnings: in general, the more education, the higher the income.

C. Discrimination in education, hiring, training, and promotions contributes to income inequality.

1. If women and minorities are restricted to certain occupations, there will be an oversupply of workers relative to demand and wages and incomes will be low.

2. If women and minorities are restricted from entering white-male occupations, there will be an undersupply of workers relative to demand and wages and incomes will be high.

D. Differences in tastes and risk preferences lead to different incomes.

1. Workers who are willing to work long hours at arduous jobs will tend to earn more.

2. Those that are willing to assume risk, e.g., entrepreneurs, are likely to earn more income.

E. Unequal distribution of wealth:

1. Wealth is a “stock,” reflecting at a particular moment the financial and real assets an individual has accumulated over time. A retired person may have little income but vast amounts of accumulated wealth.

2. Ownership of wealth in the United States is more unequal than the distribution of income. (See Last Word)

3. This inequality of wealth leads to inequality in rent, interest and dividends, which contributes to income inequality.

F. Market power: the ability to “rig the market” on one’s own behalf, resulting in higher income or profits.

G. Luck, connections, and misfortune are other forces explaining income differences.

H. Inequality is not unique to the United States. Global Perspective 20.1 compares income inequality across several nations.

III. Trends in inequality

A. Absolute incomes have risen over time, while the relative distribution by quintile has been changing.

B. Table 20.2 examines the relative income distribution by quintiles for selected years: 1970, 1975, 1980, 1985, 1990, 1995, 2000, and 2006. Income inequality has steadily increased since 1970, as revealed by the following data:

1. Shares for the bottom 80 percent have declined, including the share going to the lowest 20 percent eroding from 4.1 percent to 3.4 percent of household income.

2. The income share going to the top 20 percent has risen from 43.4 percent to 50.5 percent, from 16.6 percent to 22.3 percent for the top 5 percent of households.

C. Causes of growing inequality.

1. Firms have increased their demand for highly skilled and well-educated workers. Because the demand for these workers continues to exceed the supply, wages have been bid up. Between 1980 and 2003, the wage difference between college graduates and high school graduates increased. The growth of income to business, athletic, and entertainment “superstars” has increased income inequality.

2. In terms of demographics, large numbers of less-experienced and less-skilled “baby boomers” entered the labor force during the 1970s and 1980s, thus contributing to greater inequality during those decades. An increase in the number of households headed by single women has lead to greater inequality.

3. More international competition has reduced the demand for less-skilled, high-paid and often union workers in manufacturing industries in the U.S. There has been an upsurge in immigration of unskilled workers.

4. Two cautions: First, all quintiles have grown in terms of absolute income, but growth was fastest in the top quintile. Second, increased income inequality is not unique to the U.S. (Global Perspective 20.1)

D. CONSIDER THIS … Laughing at Shrek

Comparing income inequality and consumption inequality

IV. Equality vs. Efficiency

A. The case for equality is based on the idea that more equal distribution will maximize utility. If income is subject to diminishing marginal utility, then people at the high end of the income scale receive less utility per dollar of income than people at the low end. The argument is that utility would be raised if low-income people were given more by taking it from the high-income groups. The high-income earners would lose less utility than the low-income groups would gain. This idea is illustrated in Figure 20.3, which assumes that money incomes are subject to diminishing marginal utility (Chapter 7). If this is true, utility would be maximized when each has the same amount of income dollars.

B. The case for inequality is that inequality is an important determinant of the amount of income produced and available for distribution overall. In other words, inequality provides an incentive for people to work harder and more efficiently.

C. CONSIDER THIS … Slicing the Pizza

If everyone receives a slice of a size relative to his or her contribution, the total pizza is larger. If everyone receives the same size slice regardless of contribution, some will lose the incentive to work and the pizza will shrink. Society must decide how much smaller of a pizza it is willing to tolerate in order for everyone to have an adequate slice.

V. LAST WORD: Some Facts on U.S. Family Wealth and Its Distribution

A. In 2006, the Federal Reserve reported that household wealth (net worth) in the U.S. increased between 1995 and 2004, but that its distribution became more unequal.

B. Median income and average income, adjusted for inflation, was considerably higher in 2004 than in 1995.

C. In 2004, the wealthiest 10 percent of the households owned 69.5 percent of the total wealth and the wealthiest 1 percent owned 33.4 percent; this compares with 67.8 percent and 34.6 percent, respectively, in 1995.

D. The bottom 90 percent of the households owned 32.2 percent of the wealth in 1995 and 30.5 percent in 2004.

E. Good news/bad news: While median and average wealth rose substantially, the bottom 90 percent of the households experienced less rapid increases in wealth.

F. There are various public policy questions that arise from this latest wealth information, including whether the estate tax should be eliminated.

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