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  • Why Does Income Inequality Matter?

    This is part one in a debate with liberal blogger Tim Mitchell on whether income inequality is a problem. In this post I lay out why income inequality isn’t a problem. For part one from Mr. Mitchell, click here. 

    When it comes to income inequality, the left argues that since 1979 the top ten percent of taxpayers are making an unfairly large portion of total U.S. income. This narrative is advanced by the widely accepted work of Thomas Piketty and Emanual Saez, showing that “the top 1 percent of Americans now receive 15 percent of all income, up from about 8 percent in the 1960s and 70s.”

    It’s also illustrated by this graph, from their research. While there are legitimate reasons to believe these figures by Piketty and Saez are overstated, the more fundamental question is, if all income levels are gaining, why does income inequality matter?

    Alan Reynolds’s research exposes some of the reasons the Piketty-Saez numbers are likely overstated. There’s not room to explain them all, but a few of his arguments are worth summarizing (see page 3 of his study for all of them)First, as Reynolds points out, shifting tax rates have influenced how income has been reported to the IRS. For example, after individual tax rate reductions throughout the 80s and 2000s, businesses shifted from corporate tax returns to individual tax returns, since they would pay less in taxes shifting income to the lower individual rate. This resulted in increased reported income at the top, when in reality there was a lot of income shifting – though not necessarily gaining – which Reynolds found to account for “more than half of the apparent increase in the top 1 percent’s income share since 1986.”

    Second, Reynolds argues that the Piketty-Saez tax return study excludes many transfer payments for low-income families, because these payments don’t show up in IRS data. These include things like Social Security, Medicare, food stamps and other lower-income subsidies. Excluding these payments shrinks the percentage of total income for lower income groups, making it appear to expand the percentage of total income top earners collect. Of course, employer health care contributions, which tend to favor upper-income earners and therefore offset some of the transfer payments to lower-income individuals, also need to be taken into account. But overall, middle- and lower-income earners receive more subsidies than upper-income earners.

    Third, tax rates also affect capital gains realizations. Prior to the 1987 capital gains tax increase, capital gains accounted for “18 percent or less of all the broadly defined income reported on the top 1 percent of individual income tax returns in the early 1980s,” according to Reynolds. However, starting in 1987, capital gains realizations as a share of the top 1 percent of incomes dropped to an average of 7.3 percent for the next decade.

    In other words, people took more of their income in the form of capital gains when the tax rate was lower, and shifted these earnings to other forms of income once the tax rate went up in 1987. Then, in 1997, when the capital gains tax rate was slashed from 28 percent to 20 percent, capital gains realizations again rose sharply, reaching 14.5 percent of the top 1 percent’s share of total income in 2000.

    This presents a problem for the Picketty-Saez estimates, as Mr. Reynolds argues:

    Because the Piketty-Saez estimates exclude capital gains (correctly, in my judgment), this sort of income switching means that their estimates from 1979 to 1986 were artificially depressed (because a larger share of top incomes came from capital gains and are therefore not counted) relative to those from 1987 to 1995. And that, in turn, created a largely illusory increase in the top 1 percent’s income share between those two periods. This form of income shifting is yet another reason why such income share figures cannot be properly compared before and after 1986.

    However, the fundamental question is, if all income levels have been making gains then why does income inequality matter? The implication of the inequality debate is that when the rich get richer the poor get poorer: that it’s zero-sum. Put another way, does creating wealth produce poverty?

    The truth is, nowadays people of all incomes are largely able to purchase the same goods and services. Consumption inequality is smaller than income inequality.

    Here’s an easy experiment. Ask your parents, “Do my siblings and I live less comfortably and experience fewer opportunities than you did growing up?” It’s likely your parents will go on a rant about all the opportunities you enjoy today.

    Consider the increased purchasing power. Things like automobiles, cell phones, computers, vacations, boats, air travel, etc., were originally available only to the rich. Today, people of all incomes afford these things. For example, in 1981, the Osborne 1 computer cost $1,795. Today, a laptop with far superior capabilities costs under a couple hundred dollars.

    Likewise, the first cell phone by Motorola, available in the early 80s, cost $4,000. Today, a top-of-the-line iPhone with capabilities unimaginable back then, costs as low as $199. Additionally, people spend 21 percent less on clothing and 22 percent less on food than a generation ago.

    All of this is available to us and our lives are made better off precisely because of the rich. Somebody got rich designing the iPhone. Somebody else got rich developing the laptop. And still someone else had to get rich building a more efficient vehicle. In other words, how is it possible, assuming one operates within the confines of the law, that somebody becomes rich without inevitably improving the standard of living for others?

    So, rather than begrudging the rich, we should be thankful that we benefit from their prosperity.

    Some, however, may not be satisfied with this reasoning, arguing that technology and productivity have advanced, but still middle-class incomes have been stagnant, as is currently trumpeted by the left:

    In 1988, the income of an average American taxpayer was $33,400, adjusted for inflation. Fast forward 20 years, and not much had changed: The average income was still just $33,000 in 2008, according to IRS data.

    Average income statistics are misleading, however, because they skew income data downward. Starting in the 80s, there was a large influx of immigration and thus many low skilled workers entered the workforce. Even though those workers were improving their own conditions and producing goods and services for society, their low wages brought average income statistics down as a result.

    An even bigger factor is the change in family structure and the rise of single parent households: Families have gotten smaller and there’s also a large disparity in hours worked between those at the top and those at the bottom.

    A more accurate way, then, to measure real income growth is by using median income statistics. In fact, progressive Stephen Rose of The Third Way does this along with adjusting for household size, employee benefits and health plans. He concludes that “real middle-class median income has risen 33 percent, or $18,000, since 1979.”

    Another way to view gains shared by the middle-class is looking at total worker compensation: wages plus benefits and pension (see here and here). Note the upward trend in this graph of real compensation per hour provided by the St. Louis Federal Reserve.

    Finally, the left advances the notion of a war on the middle-class, noting that as wages stagnate, the middle-class shrinks. Well, it’s true that the middle-class is shrinking, but only because more people are getting rich. As Rose notes:

    True, fewer people today live in households with incomes between $30,000 and $100,000 (a reasonable definition of “middle class”) than in 1979. But the number of people in households that bring in more than $100,000 also rose from 12 percent to 24 percent. There was no increase in the percentage of people in households making less than $30,000. So the entire “decline” of the middle class came from people moving up the income ladder.

    Equality of opportunity and equality of consumption have never been so ubiquitous. In terms of purchasing power, living standard, compensation, and overall quality of life, today people of all income levels live better than ever.

    If income inequality has been so destructive, ask yourself, would you rather be one of the richest people in 1913 (the first year of the Piketty-Saez study) or an average American today? That most people would choose the latter is testament to why inequality has been a good thing.

    Posted in Economics [slideshow_deploy]

    20 Responses to Why Does Income Inequality Matter?

    1. DanJ says:

      I explain to Lefties that income distribution is alive and prospering in the U.S.

      Consider a family of 4 with one full-time worker making minimum wage of around $15,000. This family will recieve on average $7,000 per person in credits, entitlements and assistence (even a free cell phone). That gives them a solid middle-class income of $43,000.

      The shame is that they are better off than the family where husband and wife both work full-time at $10/hour. They are not at the poverty level and have very little or no assistence available to them. What do they get for thier hard work? A lifestyle that is worse than the poor family above.

    2. JohnR22, Michigan says:

      I can't agree. I think the key to America's past (and future) prosperity is aggressive GDP growth with emphasis on high-tech. IMO aggressive GDP growth can best be obtained by cutting marginal tax rates (funded through reductions in govt spending), and selective reduction of regulation.

      Europe has tried a very different approach over the last 50 years. I grant that Europe has a much larger social safety net and perhaps even a "better" life because the larger safety net leads to reduced stress levels. However, this comes at a great cost; permanently higher levels of unemployment (and a much larger welfare-for-life subculture), anemic GDP growth, declining economic and military power, and significantly lower standards of living (evidenced primarily in housing).

      IMO european socialism is basically like eating your seed corn; you live better today, but it's at the expense of future generations. Europe has finally realized this and the election of "right wing" leaders is a clear sign they're trying to scale back the scope of their socialism….to better compete in the world markets in the future.

      Again IMO rising income inequality is one of the negatives we must accept if we're going to go the aggressive GDP growth route. And I view it as a very small negative; as long as GDP is growing and unemployment/inflation are in check, I really don't care about the inequality gap. Let's focus on the truly helpless (e.g. orphans, the disabled, the elderly) and make sure our safety net provides the basics…as long as we're doing this we shouldn't be fretting over the inequality gap.

    3. Adam Washington, Peo says:

      I don't mind when Bill Gates or Steve Jobs or even LeBron James gets rich. I do mind when corporate executives get rich (1) buying preferential treatment from government through campaign contributions, (2) setting their own salaries by stacking boards of directors with their cronies, (3) basing compensation on short-term corporate income or stock appreciation though the company later faces financial ruin, (4) immoral and/or illegal practices like NINJA loans and AAA credit agency ratings for MBSs from such loans, etc., etc.

    4. Darrin, Minneapolis says:

      I agree DanJ, I take care of the kids at home but my wife makes about $41k as a teacher, that's above the assistance level but also very very close to our cost of living total, no matter how hard we try to keep our costs down (my goal is always to live below our means). Yet we figured out how much we spend on health insurance, food, rent, etc and we could easily have my wife make half as much $ but live basically the same or better because of assistance.. messed up. Of course we're the worst case scenario living so close to the line.

    5. Jack, Virginia says:

      David,

      Well-articulated article. You are illustrating Attribute of Liberty #9: "Standards of living for the many increase as they utilize improved products and services conceived by the few"

      Compare that to Attribute of 'Soft' Tyranny #9: "Standards of living for the many decrease even as they utilize property redistributed from the few"

      All 10 attributes can be found at StreamingLiberty.com

      Thanks for the continued work in the cause of Liberty.

    6. Lista says:

      When it comes to seeking Aid, such as a College Grant, my Father always said, "If you are Rich, than you do not Need the Aid. If you are Poor, you can Qualify for it, but if you are Middle Class, than you're just out of Luck."

    7. Darrell says:

      So the American Dream is alive and we can all expect to live better than our parents. Hmm, then why do all the people I know in their 40's and 50's have a lower standard of living than their parents even though they have reached a higher education. That's the only fact one needs, compare their standard of livng with their parents at the same age. Wages are going down for middle America no matter how much malarky the author wants to create. Fact, the average wage of the jobs lost during the latest recession was $25, the average wage of the jobs that are now being created coming out of the recession, $15. If we keep our head in the sand about wage disparty and the negative effects it has on an economy then we will continue to fall behind the rest of the world in education, health care, and job opportunities.

      When my dad graduated college he had 8 job opportunities. Today, most kids graduate college and are lucky if they are serving meals to someone. America is becoming the land of the lost opportunity as the wealthy seek to increase their wealth by shipping our jobs to someone in Asia who will do it for 1/5 the wage. Time to change the equation and save the Country.

    8. Kristin, Atlanta, GA says:

      DanJ: It's true that we do have income distribution working through the economy. However, where do those entitlements and welfare checks come from? Taxes, right? It's government money that is received from taxpayers in which the bottom 3rd of the country has been footing the bill exponentially increasing compared to that of the top 1% earners for years now. It's essentially robbing Peter to pay Paul. The problem is not the distribution of wealth.

    9. Bobbie says:

      DanJ, my family is quite comparable to your comment. We had two incomes at one time, 8 years ago and overnight we were left with one income due to health issues.

      We receive(d) no government aid as that is the furthest from our minds. We don't go out of our way for public attention to our struggles and sacrifices for sympathies as many have to enhance the illusion of a crisis.

      What we do want is fair taxes all around as our state is running on any amount that cushions GOVERNMENT EMPLOYEES LIFESTYLES! Less taxes would lessen the struggles and sacrifices.

      We have nothing left to give up so government can continue their overpay to much of their worthlessness, invading and intruding on individual freedoms and responsibilities and lifestyles..

    10. Bobbie says:

      The people of wealth are not our concern. The opportunities being removed to become, is.

    11. mulp, merrimack, nh says:

      So, the reason the lower class is not worse off since the 80s is that since the 80s, the welfare state has increased the welfare payments to the lower class?

      So, the argument is that Reaganomics hasn't been bad for the lower class is its policies has increased the welfare state,….

      In my youth, the game for high income earners was to become a corporation to lower income tax rates – doctors and lawyers incorporated, for example. But this was also part of a shift from payroll employment to contract employment, from hospital radiologists to Hollywood actors. President Reagan was a union boss at a time when actors were on the studio payroll just like steel workers and auto workers, were and still are. Sport shifted from payroll to contracts.

      But few people who shifted from payroll to contract as a corporation earned the high incomes that resulted in the 90% then 70% Federal tax rate, and States changed their tax codes to hit these personal corporations – NH, the no-income-tax State has a small business income tax which hits them – so the Federal and State tax laws quickly created the vehicle for corporate income being taxed as personal income, long before the 80s. Partnerships were taxed at individual rates, and S Corps were established in law in 1958.

      Of course, the real dodge has been converting earned income to capital gains. But the scandal in the low capital gains tax rates has been the incentives to pump and dump. We've seen the pump and dump for low capitals gains create the stock market and real estate bubbles in the 80s, followed by the NASDAQ bubble from the 1997 tax incentives to pump and dump, then the pump and dump stock market and real estate bubbles in the past decade, all driven by the mindset that taking productive capital worth $1 based on the cost to build it and selling it for $2, the $4, then $8 makes economic sense and that buying something for $5 that you can make for $1 if you take the time creates wealth because you expect to resell it for $10.

      When I was a kid, capital gains were sometimes taxed more than labor income so we didn't see either stock market or real estate bubbles. In the second half of my life, the years since Reagan took office, I've seen 3 of the 3 stock market bubbles and 2 of the 2 real estate bubbles during my lifetime.

      If the income inequality is the result of some profiting from bubbles that created losses, most small, and for some large, for most of the people, is this a virtue?

    12. David says:

      It does matter, and your arguments are flawed. You can play around with numbers all day, but it doesn't negate the fact that greed is a bane on our society. And the fact that technology keeps improving does little to support your case. Nobody is complaining about the engineers making $50k a year who actually develop new technologies. It's the fat cat executives who do nothing but boss people around and make 100x more than their employees. Hot shots living off the labor of their subordinates does not help improve the overall quality of life of our civilization. And just because someone is getting rich off something does not mean it is beneficial for society, i.e. cigarettes or porn.

    13. Joel, Kansas says:

      Americans in general have gotten caught up in this notion that wages in and of themselves mean something. Wages mean nothing until compared to purchasing power.

      To wit: it doesn't matter if you make $1 an hour and a loaf of bread costs 18c or if you make $10 an hour and a loaf of bread costs $1.80. You have the same *purchasing power*…almost. You have to figure in that the government and various levels makes more revenue through the higher income taxes and higher sales taxes. So don't expect governments to work too hard to curb inflation. It's a hidden tax increase.

      Also, we must redifine who we consider "wealthy." If I asked what the levels of Wealthy, Upper Class, Middle Class, Lower Class, and Poverty were, most people would immediately think of an income range for each.

      Wealth is truly more about maintaining your purchasing power against inflation. The people who are situated to do this are business owners…not necessarily the billionaire club, but anyone who is able to adjust their "income" through pricing to reflect increases in costs.

      For every 4% increase in costs (labor, materials, taxes, etc.), the producers compensate by increasing prices to maintain their purchasing power (generally 8% so when they go to the store, they can purchase the same amount). They must spend 8% more, but they also are making 8% more. The "working class" consumer LOSES 5% purchasing power because they are not able to compensate for their increased costs (in their case, at the store). They make a 4% more, but they must pay 8% more. That's a loss of 4% purchasing power, combined with the higher taxes that gig them another 1%.

      If to day you make $10 an hour and you want to purchase items costing $1, you can only purchase 9 due to that 7.5% sales tax that makes them cost $1.07. You have 33 cents left over in your pocket.

      You get a 4% raise ($10.40) and take that hourly wage and purchase the same items. First, you will find they now cost $1.08 each. Second you will only take home 8 items because with tax they cost $1.16 each. Yes, you will have more money in your pocket ($1.11 change) but you will have one fewer item.

      This is why it's important if we want to save our economy to abandon Keynesian economics which has spurred 4% annual inflation since FDR instituted the failed, logically flawed economic policy in the 1930s. We also must get people to think about wealth in terms other than income and understand that raises and promotions should be based on productivity and merit, not COLA and seniority. And to do that, you are going against the labor unions, which thrive under the fallacy of Keynesian economics. You would also have to change the mindset of AARP recipients and other people who expect / demand a 3% to 4% annual COLA.

      Capitalism and Socialism have one thing in common: they both recognize that the worker must be paid in accordance with his or her productivity toward the final product. The difference is how each system views the contribution of the general labor.

      Keynesian economics claims the Job is more important than quality, quantity, cost, price, or productivity. Just show up and at the end of the day someone gives you a check. This is why the Liberals all scream "Jobs! Jobs! Jobs!" instead of "Productivity! Productivity! Productivity!" This is also why the Labor Unions (another FDR pet) thrive under Keynesian economics while they can't survive in pure Capitalism and would bury pure Socialism (outside of Totalitarian Communism) with their excessive demands.

      It's not income we need to worry about, but purchasing power.

      It's not how much we get paid that we should worry about, but whether we position ourselves to be able to compensate for inflation from the top rather than from the bottom.

      It's not a disparity of income that is the problem, it is a variety of factors centering on Keynesian economics which have been slowly strangling the American economy since the 1930s.

    14. Bobbie says:

      I hope you don't think government is the answer. Your complaint is speculative and influenced by the words of government. Why don't you want the freedom (without government intervention) to make what YOU can? And if you can't, move on.

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