Academic journal article AEI Paper & Studies

The Inequality Illusion

Academic journal article AEI Paper & Studies

The Inequality Illusion

Article excerpt

"As we acquire more knowledge, things do not become more comprehensible, but more complex and more mysterious."--Albert Schweitzer

The state of debate on income inequality has reached exactly this juncture. To see why, consider the following. A recent co-authored paper by economists Thomas Piketty and Emmanuel Saez finds that the share of income going to the top 1 percent of the population has more than doubled from 9 percent in 1976 to 20 percent in 2011. In other words, the top tail of the distribution now enjoys an ever-larger slice of the pie than it has historically done so. In a 2013 paper, however, economist Richard Burkhauser and his co-authors counter that by some measures, the growth in incomes at the top has been significantly lower than in incomes at the middle and bottom, such that the income share of the top quintile has in fact declined since the 1980s. The Congressional Budget Office's (CBO) analysis shows that incomes of the top 1 percent grew by more than 250 percent between 1979 and 2007. In another recent paper, Greg Mankiw posits that perhaps inequality is not a problem as long as the compensation of the top 1 percent reflects their contribution to society--the "just deserts" principle.

Clearly, the more we know, the more elusive the real answer becomes.

One of the problems that plagues the research on income inequality is the lack of a common definition of income. Piketty and Saez use pre-tax pre-transfer income data from the tax records of filers and include realized capital gains. Thus, they fail to account for transfers and payments like Social Security, Medicare, food stamps etc. In addition, it is also worth noting that by focusing on reported taxable incomes, their data are biased by the fact that taxable incomes respond to changes in tax rates. There is a plethora of literature studying the taxable income elasticity. Essentially, when tax rates are high, reported incomes are lower since people engage in tax avoidance or tax evasion. Burkhauser, on the other hand, argues that the true measure of income should focus on the Haig-Simons definition of income. In other words, we need to include accrued capital gains on housing and other wealth along with earnings and transfer incomes to get at what people actually think of as income. The CBO provides a post-tax and post-transfers definition of income, but does not include accrued capital gains.

So after decades of research on income inequality, do we really know where we stand?

At the heart of this debate, the real conversation is about living standards. Are people enjoying better lives today than they did twenty to thirty years ago? In popular perception, income inequality is bad to the extent that it reflects a general worsening of conditions for the common man. When politicians pitch the top 1 percent against the middle income classes, it engenders a belief that somehow the wealthier families are enjoying their comforts at the expense of the middle and lower class families. But is that the truth? Or is it simply the case that the size of the economic pie has grown over time, and while everyone is enjoying the benefits, a larger share of the benefits are going to the top?

To study this issue further, my colleague Kevin Hassett and I conducted a study to track changes in consumption inequality over time. Why did we use consumption instead of income to track inequality? One thing economists agree upon is that consumption is a better measure of well-being than income. What we buy and consume with our income directly adds to our utility and happiness, and also has a direct impact on our standard of living. Individuals are also better able to smooth consumption rather than income over their lifecycle. While a retired, older individual has low levels of current income, he can still enjoy a high standard of living due to lifetime savings and other forms of wealth. A student with low current incomes can borrow to finance education and household expenses in the hope of earning high incomes in the future from a relatively well-paying job. …

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