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Why Does Income Inequality Matter?

Posted By David Weinberger On March 11, 2011 @ 1:30 pm In Economics | Comments Disabled

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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 [2]. 

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 [3], 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 [4], 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 [5] 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 [6], 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. [7] Today, a laptop with far superior capabilities costs under a couple hundred dollars [8].

Likewise, the first cell phone by Motorola, available in the early 80s, cost $4,000 [9]. Today, a top-of-the-line iPhone with capabilities unimaginable back then, costs as low as $199 [10]. Additionally, people spend [11] 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 [12], 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 [6] 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 [13] 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 [14] and here [15]). Note the upward trend in this graph of real compensation per hour provided by the St. Louis Federal Reserve.

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Finally, the left advances the notion of a war on the middle-class [17], 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 [13]:

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.


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2011/03/11/why-does-income-inequality-matter/

URLs in this post:

[1] Image: http://www.foundry.org/wp-content/uploads/money_stacks0902114.jpg

[2] here: http://voicesofreasonblog.blogspot.com/2011/03/affirming-proposition-income-inequality.html

[3] Thomas Piketty and Emanual Saez: http://www.econ.berkeley.edu/~saez/saez-UStopincomes-2007.pdf

[4] this graph: http://elsa.berkeley.edu/~saez/TabFig2007.xls

[5] research: http://www.cato.org/pubs/pas/pa586.pdf

[6] employer health care contributions: http://www.heritage.org/research/reports/1999/09/income-inequality

[7] $1,795.: http://oldcomputers.net/osborne.html

[8] couple hundred dollars: http://laptops100.com/

[9] $4,000: http://advice.cio.com/al_sacco/a_brief_history_of_the_mobile_phone_1973_2007

[10] $199: http://www.slashgear.com/apple-iphone-4-199-for-16gb-and-299-for-32gb-coming-june-24-0788717/

[11] spend: http://www.yale.edu/law/leo/052005/papers/Warren.pdf

[12] have been stagnant: http://money.cnn.com/2011/02/16/news/economy/middle_class/index.htm

[13] concludes: http://www.washingtonpost.com/wp-dyn/content/article/2007/12/21/AR2007122101556.html

[14] here: http://www.heritage.org/Research/Reports/2007/06/Analyzing-Economic-Mobility-Compensation-Is-Keeping-Pace-with-Rising-Productivity

[15] here: http://www.heritage.org/Research/Reports/2006/10/Shared-Prosperity-Debunking-Pessimistic-Claims-About-Wages-Profits-and-Wealth

[16] Image: http://www.foundry.org/wp-content/uploads/income-inequality-graph.jpg

[17] war on the middle-class: http://www.epi.org/analysis_and_opinion/entry/a_long_and_persistent_middle-class_squeeze/

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