Income inequality is one of the hottest political issues in the United States. It was at the center of the “Bernie Revolution” in the 2016 Democratic Primaries and continued into the 2016 General Election. A 2015 ABC News poll found that forty-six percent of Americans thought that “the way income and wealth are distributed in the U.S.” worries them a great deal (Feather, 2015). Similarly, Thomas Piketty’s Capital in the 21 Century argued for the dangers of inequality was praised by multiple Nobel Laureate Economists and is already considered one of the most influential books of the 21 century by economists across the spectrum but the issue of inequality is far from settled. This paper will summarize the literature, analyze the problem, possible solutions and offer one.
The literature on income inequality and income mobility is clearly a mixed set. Any fair review of it would have to start with Thomas Piketty’s Capital in the 21 Century. Published in 2013 by the French Economist, it has been praised by Nobel Laureates like Paul Krugman and Joseph Stiglitz but has also been hammered by economists on the right for a variety of reasons. The book’s central thesis is that the rate of return on capital is greater than the rate of economic growth over the long term resulting in the concentration of wealth and the increase in economic inequality. To understand what Piketty is arguing, we can look to an infamous study he published a decade earlier. In it, he analyzed income growth for multiple different income groups. His conclusion found that the rich were getting richer, but the poor were getting poorer and the middle class was stagnating (Piketty, 2003).
While this argument is very influential in economics and popular political circles, it is hardly without serious critics. As Economists Phil Gramm and Mike Solon argued in an article for the American Enterprise Institute, the study has both methodological errors and obvious errors in its practical implications. Piketty’s study looked only at pre-tax cash income. This is a massive flaw. It does not take into account taxes, which are usually paid by upper incomes, or the over hundred government programs like Medicare and Medicare which are offered to poorer Americans. The study also left out Social Security payments and non-cash benefits like health insurance which, have become a bigger part since the 1980s of compensation. Lastly, Piketty also excluded the first $500,000 from home sales. All of these would create a result which suggests more inequality than there is. On the practical side, the two economists observe that when inequality began to rise again, there was sky high inflation, high unemployment, and high-interest rates. Now when we have higher inequality we have much lower inflation, full employment, and low-interest rates. The conclusion from a simple analysis like this would suggest that less income inequality is not good itself (Solon, 2014). As Table 1 shows, adjusting for these factors will completely change the picture.
Table 1 Mean Income Growth by Quintile, 1979-2007
Source: Change in mean income from 1979-2007 using different definitions of income. National Bureau of Economic Research Retrieved March 24, 2017, from http://www.nber.org/papers/w19110.pdf
These critiques are supported by a 2013 study challenging Piketty’s work. The study used a more comprehensive definition of income as offered by the above paragraph above. Column 1 of Table 1 shows income growth from 1979 to 2007 using the Piketty methodology. In each column to the right, the study provides a more general definition of income so all factors are accounted for. Although it shows greater growth in all groups, it also shows much greater growth for the higher levels (Armour, 2013). Imagine a recent college graduate. He would likely be in the poorest twenty percent of Americans and let us say they are earning thirty thousand dollars a year. If we moved forward twenty-eight years, and all else being equal, they would be making forty thousand. At the same time, another college graduate who comes out richer would start out in the middle, earning fifty thousand a year. In the same period of time, and all else being equal, she would be earning seventy thousand. In real life, like this example, the rich person was getting rich faster than the poor person was getting rich but both were getting richer.
An estimate from an International Monetary Fund study found that increased inequality reduced income growth in the United States, while programs to increase income redistribution to counter increased inequality increased growth (Ostry, 2017). A study published in Social Indicators Research found that increased inequality leads to decreased life satisfaction (Ahn, 2015). A study published in the Global Economic Review finds that income inequality decreases economic growth (Lee, 2016). The Organization for Economic Corporation and Development (OECD) found in a study that income inequality reduces economic growth because of decreased investment in education (Inequality, 2014). As seen above, there is evidence to suggest income inequality is bad, but at the same time, there is also evidence to suggest the opposite.
On the other hand, a study recently published in February 2017 studying sixty-eight countries from 1981 to 2008 found that while inequality helps developing nations, it has no effect in advanced economies (Kelly, 2017). Another study from 2016, presented at the Brookings Panel on Economic Activity, compared estimates from an updated version of Piketty’s 2003 study and another study. They showed that although disparities in income did rise, it was far less than argued by Piketty and others in his camp (Bricker, 2016). In 2012, a pair of economists from the American Enterprise Institute analyzed the inequality debate through the lenses of consumption. They found that since the 1980s inequality measured through consumption increased “only marginally” and a Gini Coefficient (a measure of inequality from 0 to 1, 1 being completely unequal and 0 being completely equal) constructed from this data and found that inequality, as measured by consumption, was stable over time (Hassett, 2012).
Does inequality hurt an economy? Is inequality increasing or at a dangerous level? For inequality to be a problem, the answer to one or both would have to be yes, but the body of evidence does not support that. When I talked with economic and political journalist Will Ricciardella he said, the “first thing you need to look at is how much inequality is good?” As he went on to say, people have different jobs, skills, circumstances along with a litany of other differences. There is no reason to think that an economy should have equal incomes, if anything, we should expect inequality. The real question in determining if there is a problem is “are we allotting scarce resources efficiently? That is what causes living standards to rise.”
When it comes to the question of living standards, the literature is split. Some studies say it hurts both developed and developing economies. Some say it hurts developed economies while helping developing economies while others say it helps developing economies while being neutral of developed economies. The evidence here is simply too mixed to draw a conclusion with certainty.
On the second question, the answer is much clearer. Almost all the evidence says that inequality is increasing—the only question is by how much. Some studies, like those by Piketty, show a massive increase in incomes for the richest while only minor increases to shrinkages in the incomes of poorer Americans, but his studies suffer serious flaws, mainly a too narrow view of income. When expanding income to look at taxes, welfare payment, and other variables which affect income, studies find an increase in the richest incomes, in some cases even bigger growth, but they also find much more growth in the poorest incomes. Similarly, looking at income through consumption- buying power- does show growth in inequality, but much less than suggested by Piketty.
In 1979, those making over $350,000 accounted for six-tenths of a percent of the population but were one point eight percent in 2014. Similarly, those making over $100,000 were only thirteen percent but were thirty-one percent in 2014. This increase came from a shift from the bottom ($99,999 or less) to the top ($100,000 or more). In 1979, eighty-seven percent of the population was in the “bottom”, as defined in the line above, but in 2014 it was only sixty-nine percent. The income brackets are adjusted for inflation (Zumbrun, 2016). This data does support the claim that the middle class is shrinking, but it refutes the corollary that often goes with it—that people are getting poorer. The middle class is shrinking, but not because people are moving down, but because they are advancing—people are getting too rich to be in the middle class.
The Gini Coefficient for the United States shows a mixed picture on the subject. The index has shown that when looking at US persons, is has remained between .506 and .525 from 1961 through 2013, but it has risen in the same period for households and families (Perry, 2014). This is inflation adjusted. This apparent inconsistency would be at least partially due to shifts in the size and composition in families and households. A single person will always be a single person so the unit of measurement will always stay the same, but the size of households and families is constantly changing. This data further suggests that inequality is a subject that depends on the lenses you are using. Similarly, determining a problem would first require a debate on which lenses or lenses we should use.
Those who believe inequality is a problem have a variety of solutions which will be discussed here.
Any talk about solution should start with the solutions offered in Capital in the 21 Century. Thomas Piketty proposes at least an eighty percent global tax on wealth. While Piketty is certainly on the extreme end, and there is evidence that a progressive income tax would reduce inequality, this discussion must also take place within the context of a discussion on equality versus efficiency. A basic tradeoff recognized by all economists is that policies which increase equality reduce efficiency because they decrease incentives. An eighty percent tax would certainly be a massive disincentive for what it taxes—as the law of demand says, whenever you raise the price on something you decrease demand for it. While this policy could reduce inequality, it could also cause a massive drag on to the economy. It must also be kept in mind that countries would have it in their best interest to become a tax haven for those subject to the tax. Less extreme proposals, like those of Senators Bernie Sanders and Elizabeth Warren, which raise the upper tax rates on income and investment to over fifty percent, would also have to deal with these challenges.
The OECD study referenced above identifies a lack of education spending due to a rise in inequality as the main reason income inequality would lower economic growth. Assuming this analysis is correct, one way to offset the problems of income inequality would be to ensure a robust education system. While this would not directly fix income inequality, it would offset its problems. How this would be done if a different debate.
Other solutions offered to fight inequality include raising the minimum wage, strengthening unions and creating a more robust safety net. While this would raise wages, advocates of this solution would have to deal with multiple negative effects, including increased unemployment (the law of demand says the higher a price of a good is the less of it is demanded), higher prices and labor-to-labor substitution (switching out less qualified employees for more qualified ones). Stronger unions would raise wages for unionized employees, but it would also come with less employment and increased business failure (Frandsen). Lastly, a more robust safety net would need to be constructed to avoid the pitfall of being a disincentive to work because of a welfare cliff– earning more money could actually lead to less money because of a loss of benefits. Although workers would gain jobs, they would not generate enough income to equal benefits from the safety net, but too much for the worker to qualify for the safety net.
Many of these reforms carry the same problems. Will Ricciardella put it this way, “many proposals to help the poor, like raising taxes, actually end up hurting them.” The biggest challenge is to find a reform that maximizes the tradeoff between benefits and costs. The best solution for any problem deriving itself from inequality would be education reform. This is the only solution which directly addresses why inequality would be a problem, would be the least complex and have the least negative effects. Unlike other policies, education reform would not necessarily have the issue of being a disincentive investment on investment or taking high wage jobs. It would also not have the effect of limiting the supply of jobs in a tradeoff for higher wages which would help create a permanent underclass.
How education reform should be done is another complex question, but I will lay out the foundations for that discussion. Education reform, in the context of the inequality debate, should have the goal of increasing the long-term prospects of students in employment. Providing students the skills they need to succeed beyond their years in school is critical. By increasing their earnings, we can narrow the gap between Americans without creating excessive disincentives to those who are at the top.
Ahn, H., Roll, S. J., Zeng, W., Frey, J. J., Reiman, S., & Ko, J. (2015). Impact of income inequality on workers’ life satisfaction in the U.S.: A Multilevel Analysis. Social Indicators Research, 128(3), 1347-1363. doi:10.1007/s11205-015-1082-7
Armour, P., Burkhauser, R. V., & Larrimore, J. (2013). Levels and trends in United States income and its distribution a crosswalk from market income towards a comprehensive income approach. doi:10.3386/w19110
Bricker, J., Henriques, A., Krimmel, J., & Sabelhaus, J. (2016, September 13). Measuring income and wealth at the top using administrative and survey data. Brookings Institution. From https://www.brookings.edu/bpea-articles/measuring-income-and-wealth-at-the-top-using-administrative-and-survey-data/
Feather, A. (2015, March 19). Top 15 issues that have Americans worried. ABC News. From http://abcnews.go.com/Politics/top-15-issues-americans-worried/story?id=29758744
Frandsen, B. (2013). The surprising impacts of unionization on establishments: Accounting for selection in close union representation elections. Manuscript. Department of Economics, Brigham Young University.
Hassett, K. A., & Mathur, A. (2012). A new measure of consumption inequality. AEI Economic Studies. From http://www.aei.org/wp-content/uploads/2012/06/-a-new-measure-of-consumption-inequality_142931647663.pdf
Inequality hurts economic growth, finds OECD research. (2014, September 12). From http://www.oecd.org/newsroom/inequality-hurts-economic-growth.htm
Kelley, J., & Evans, M. (2017). Societal inequality and individual subjective well-being: Results from 68 societies and over 200,000 individuals, 1981–2008. Social Science Research, 62, 1-23. doi:10.1016/j.ssresearch.2016.04.020
Lee, D. J., & Son, J. C. (2016). Economic growth and income inequality: evidence from dynamic panel investigation. Global Economic Review, 45(4), 331-358. doi:10.1080/1226508x.2016.1181980
Ostry, %. D., Berg, A., & Tsangarides, C. G. (2014). Redistribution, inequality, and growth . From https://www.imf.org/external/pubs/ft/sdn/2014/sdn1402.pdf.
Perry, M. J. (2014, June 5). Sorry Krugman, Piketty and Stiglitz: income inequality for individual Americans has been flat for more than 50 years. From http://www.aei.org/publication/sorry-krugman-piketty-and-stiglitz-income-inequality-for-individual-americans-has-been-flat-for-more-than-50-years/
PIKETTY, THOMAS, and EMMANUEL SAEZ. “Income inequality in the United States.” The Quarterly Journal of Economics 118.1 (2003): n. pag. Web. 26 Mar. 2017.
Solon, M., & Gramm, P. (2014, November 11). How to distort income inequality. From http://www.aei.org/publication/distort-income-inequality/
Zumbrun, J. (2016, September 09). Not Just the 1%: The upper middle class is larger and richer than ever. From http://blogs.wsj.com/economics/2016/06/21/not-just-the-1-the-upper-middle-class-is-larger-and-richer-than-ever/