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Income Inequality from an Economic Perspective

Income inequality is a measurement of the distribution of wealth across households. It is a relative comparison of the gap in household incomes across a given region, country or the world. Income inequality is measured using the “Gini coefficient” and calculates the extent to which the income distribution in a country deviates from perfect equity. A Gini coefficient of zero indicates perfect equality (everyone earns the same income) and a coefficient of one indicates perfect inequality (one person holds all the income and everyone else has zero).¹ Formally measuring income inequality is often used as a benchmark for the welfare of a society or country—the relative poverty or prosperity of a society—and used as a justification of policy attempts at income redistribution.

Figure 1 presents a graphic representation of countries across the globe categorized by their Gini coefficient. Finland has relatively low levels of income inequality (in the .25 range) compared to the United States (in the .45 range) but solely based on those numbers it is not obvious which country is “better.” Income inequality measurements are simply a way of measuring how income is held, not necessarily representative of overall prosperity or flourishing.

In the United States, the Gini coefficient has become slightly less equal, rather than more equal over time. Figure 2 below highlights this. The United States Gini coefficient in 1967 was .399 and in 2001 it was recorded at .466. So we have become marginally less equal, but the question is are we better off? Do we have a greater levels of flourishing and how do the poor fare differently since 1967? We will examine these questions in greater detail as we articulate what goes into the numbers behind inequality.

Now that we understand what income inequality is, we need to examine why it occurs. Are there fundamental aspects to our economic condition—a world of choice under scarcity—that lead to an unequal distribution of income? Yes, there are and understanding them is important for knowing what policy is able or unable to accomplish, as well as what policy should attempt to accomplish from a Biblical perspective. Author David Levy, in his paper on income distribution, details four causes of income inequality listed below: family structure, technology, growing markets and immigration.² To that list we add two more: property rights and income mobility.

Family Structure

The latter half of the 20th century saw great changes in the labor force. The labor force participation rate rose from 59% in 1948 to 66% in 2005 and participation by women rose from 32% to 59%.³ The family norm went from two-parent, one-earner families to either low-income single-parent families or higher-income two-parent, two-earner families. In the latter cases, the households were making a greater income because a family in the top quintile contains two to three times as many workers.

Technology

Rapid advancements in technology through the latter half of the twentieth century that continue today have shifted labor demand from low-skilled labor toward high-skilled labor. Developments in computer technology have revolutionized cars, cell phones, healthcare; the way we work, shop, read and even worship. For example, you can follow along in worship using your Bible application on your smartphone.

Technological progress has changed the type of labor needed to support the way we live and work and has literally created jobs where there previously were none. Technology creates the need for specialized workers who can fix cars, iPads and hospital equipment and creates a need for higher-skilled labor. To this end, technological progress is correlated with increasing income inequality.⁴ However, that same technology reduces the prices of consumption goods and this has positive, real impacts on the well-being of the poor.⁵

Growing Markets

Globalized markets break down the boundaries of smaller, local markets and provide new platforms and new audiences for trade. They allow artisans, farmers and manufacturers to open their products and services to the global economy. This means that these purveyors do not have to rely on small, local markets to make a living and it means that others around the globe can have access to their goods. The International Monetary Fund (IMF) finds that the financial openness brought on by globalization increases the returns to human capital (puts a premium on higher skills) and increases income inequality.⁶ Their research goes on to say:

Real per capita incomes have risen across virtually all income and regional groups for even the poorest quintiles. Not only are the poor no worse off (with very few exceptions of post-crisis economies), in most cases the poor are significantly better off, during the most recent phase of globalization. Over the past two decades, income growth has been positive for all quintiles in virtually all regions and all income groups during the recent period of globalization. At the same time, however, income inequality has increased mainly in middle- and high-income countries and less so in low income countries.⁷

Immigration

Immigration into a country changes the supply of labor, usually low-skilled labor in that country. As the supply increases, there is a downward pressure put upon wages for low-skilled labor—more people competing for the same low-skilled jobs—and this can increase income inequality. The lowest quintile of income earners has more members. In 2009, 15.5 percent of the US labor force (24 million workers) was foreign-born.⁸ Remember, income inequality is a measure of the gap in income earnings across households. If everything else remained equal, and the lowest quintile got larger due to migrant workers in the US, it increases income inequality although recent research suggests the impact is small (different studies put it between 10 and 5 percent). ^{9, 10, 11}

Is this immigration good or bad for the US and for the migrant workers? Lerman suggests that the wages of immigrants in the US are much higher than they would have been in their home countries. To get the full picture we must understand the changing dynamics in the US labor force. In the US there is a rising share of the workforce with some experience and a declining share of the US workforce without a high-school diploma or GED. Immigrant workers however have less education overall, especially those that emigrate from Mexico or Central America.¹² Rather than immigrant workers competing directly with US low-skilled labor, they add less skilled labor to the overall workforce which results in lower prices on goods and services. This is beneficial to the lowest quintile in that it makes goods and services more accessible than they otherwise would be.

Property Rights

Rights in property affect all of economic life. The security of those rights is crucial for economic growth. Property rights involve rights to maintain, sell, transfer and modify that which you own. Property rights extend to both animate objects (houses, cars) and inanimate objects (ideas, air, spiritual gifts). Our accumulation of property tends to grow through our lifetime. When we are young we don’t own much, aside from what our parents give us and what we are endowed with. As we get older we acquire property through the fruits of our labor; we buy a home, start a business, and invest our capital in a variety of ways. By definition we will all acquire different levels of income and capital based on how we invest our resources (talents, spiritual gifts, skills and abilities) and some of those investments will have higher payoffs than others. Why is this? In a world of scarcity we must make choices over what to do with our time, what to consume and what to save for later.

Because of this scarcity, the vast resources that God has put on this earth have multiple and competing ends. For example, when you choose a profession, you probably have a variety of options based on your comparative advantage. If you are interested in the medical field you could be a nurse, doctor, or physician’s assistant. Because your time is scarce, you can’t be all three or even two. You may have the ability to be a doctor but choose to be a nurse. Perhaps you don’t want to spend 10 years in training. There are many reasons you could choose to be a nurse instead. Because being a doctor is a much more specialized skill, it commands a higher payoff. Over his or her lifetime the doctor may acquire greater property because doctors command a higher income.

This does not make them more or less valuable in God’s eyes. It strictly means the nurse will likely earn a smaller income, but a measure of their overall wealth might show something much different. It is important to make the distinction between income and wealth; they are not the same. Income is compensation for work, investments or government transfers. Wealth is the ownership of assets which produce income streams. Prosperity is related but different from either and has to do with the overall concept of flourishing, which extends beyond both income and wealth. Because we are all born with different gifts and created individually, we will all have different earthly income levels, which means income inequality will always exist on some level. Property rights are crucial for economic growth in a world of scarcity and based on Biblical truth. Theologian Walter Kaiser suggests that this comes first and foremost from the commandment “Thou shalt not steal” in Exodus 20:15. Kaiser goes on to say that not only does this command recognize individual ownership but it regards as criminal all attempts to take that property from a person in a fraudulent way.¹³

Income Mobility

Remember our definition of income inequality as measured by the Gini coefficient. It measures how income is held across a given cross-section of people. Another facet of economic life and market exchange which must be considered is dynamism. Markets for goods and services are not static; they are always moving and changing, ultimately based on the desires and preferences of those doing the purchasing. We greatly misunderstand the notion of income inequality if we do not understand income mobility.

In researching the topic over fifty years ago, Nobel laureate economist Simon Kuznets suggested the distinction between “low” and “high” income classes loses its meaning if the people within those groupings have changed over time.¹⁴ Remember that the Gini coefficient of one indicates that one person has all the income and everyone else has zero. While we don’t observe this in reality, we hear talk about the rich getting more income at the expense of the poor. If that is true, it’s also an undesirable situation. It assumes a zero-sum game. If I win it’s because you lose. Economies based on voluntary exchange are not zero-sum. If I trade some portion of my income for a winter coat, I benefit by freely giving up some of my income to gain extra warmth in the winter months.

If I work harder, become more innovative and earn a greater income through hard work and discipline, I benefit without harming anyone. In fact, the opposite occurs; I benefit through a higher income, if and only if, I serve others. As a coat manufacturer I must serve my customers well if I expect them to purchase my product. If I succeed in this venture, I will earn a higher income, which means I have moved out of one income quintile and into another. This is called income mobility, and is critical for getting a full picture of what income inequality truly implies.

Go back to our Gini-coefficient-of-one situation. If one person holds all the income and everyone else has zero, it’s not just a bad situation because the needs of everyone else go unmet; it’s a bad situation because there is no obvious way for those who have zero to gain income. In a market economy, most people start out at a lower income bracket. They enter the labor market with low skills and little experience. As they progress in their work they gain both. As they gain skills, knowledge, experience and awareness of what they are good at, they earn more income over time.

Solely looking at income inequality levels from one decade to the next does not tell us anything about who is in those income brackets. Those people who are in the lowest quintile in 1990 are probably not in the lowest quintile in 2000 or 2010, because with the passage of time those people who started at the bottom have theoretically gained skills, experiences and knowledge to be better at what they do. And there is evidence to support this theory. A 2008 report by the US Treasury on income mobility found that between 1996 and 2005 more than half of all US taxpayers moved into a higher income quintile. Roughly half who started in the lowest quintile in 1996 moved into a higher quintile by 2005, in only nine years. For the highest income earners the results were not the same:

Among those with the very highest incomes in 1996—the top 1/100 of 1 percent—only 25 percent remained in this group in 2005. Moreover, the median real income of these taxpayers declined over this period.

Additional research supports this data. A 2010 report by the St. Louis Federal Reserve economist Thomas Garrett suggests that it is much more likely for a person in the highest one, five and ten income percentiles to move to a lower group than it is for a person in the lowest income brackets to remain where they are or move down.¹⁵ The data is presented graphically in Figure 3 and 4 below.

The report also found that the levels of income mobility described above were unchanged from the former decade (1987-1996),¹⁶ meaning that income mobility is neither new nor particular to this time period.

The Problem of Measurement

Our attempts to understand the economic implications of income inequality and the basic facts of economic life reveal that some level of income inequality is inevitable. In other words, we will not all make the same income, and this is a fact of economic life. Efforts to lessen income inequality run counter to the way we are created—to the human condition.

To truly understand income inequality we must understand the nuance in how it is measured. Measuring inequality is a complex task, and getting the measurement correct has important ramifications for policy responses. For if income inequality is shown to be on the rise, as has been reported in recent years, a common response is to legislate policy that will redistribute that income so as to lessen the inequality.
Estimates of rising inequality are often based on federal income tax returns. Those income tax returns appear to show that the share of U.S. income going to the top one percent has increased substantially since the 1970s.¹⁷ This has received a great deal of press in the last few years and is a point of protest for the “Occupy Wall Street” movement. Before proceeding to the measurement problems that plague inequality data, it is important to note that in a dynamic economy “share of income” is a mental construct.

There is no preexisting pot of income that gets divided by some person or agency based on who did what. Income is created by the voluntary exchange of individuals through the buying and selling of goods and services. Profit is a reward for meeting consumer demand; loss is a penalty for not meeting consumer demand. Not even a government can create income, because they don’t buy and sell their services through voluntary exchange. To raise “income” they must coercively tax or inflate (print money). Rather than say “income going to the top one percent,” it is better said as “income earned by the top one percent.” Anyone who seeks and gets preferential support from the government through subsidies, favors or tariffs is not earning that income through voluntary exchange. Rather, they curry protection at the expense of some other business or a competitor.

There are significant issues that make understanding the real level of income inequality difficult. We mentioned that most claims about income inequality rely on data that suggests that it has increased substantially since the 1970s. Recent research by economist Alan Reynolds can provide a greater understanding as to why this is so.

Changes in U.S. Tax Rules

Since 1980 there have been several significant changes to the U.S. tax rules that change how income is reported. There were sharp reductions in individual income tax rates in both 1981 and 1986. As a result, corporate executives switched from accepting stock options taxed as capital gains to nonqualified stock options reported and taxed as salaries. Thus, the tax change caused a shift in the reporting of income from corporate to personal, making it appear as if income inequality increased. In those specific years, all that occurred was that income changed categories. The Tax Reform Act of 1986 caused the top marginal tax rate to go from 50 percent in 1986 to 37.5 percent in 1987 to 28 percent in 1988, which means that corporate executives reported more income on their tax returns. This shifting between corporate and individual tax reporting has accounted for more than half of the increase in the top 1 percent’s income share since 1986.¹⁸

Changes in Investment Income

Prior to 1980, most income from investments was reported on individual tax returns. Since then, an increasingly large share of middle-income investment returns have been sheltered inside 401(k)s, IRAs and 529 college savings plans. These investments are not reported on tax returns and are largely used by the middle-income groups.¹⁹ This trend makes it look like the middle-income earners have less, when in fact some portion of their income is protected from taxation, so they are actually better off.

How We Define Income

The data cited by Piketty and Saez in their 2003 study documents the most egregious increase in income inequality, and is most often used in the rhetoric around income inequality. Their data suggest that the top 1 percent of Americans “receive” 15 percent of all income and that this is up from 8 percent in the 1960s and 1970s. However, their data does not account for transfer payments.²⁰

A transfer payment is a one-way exchange by the government to a favored class of persons and is a form of wealth redistribution. Examples include Social Security, welfare payments, and farm subsidies. In 2000, there were $1.07 trillion in federal transfers. About 29 percent, or $312 billion, was means tested (earmarked for the poor)²¹ which represents an increase in income. If this is not reflected in the data, it exacerbates the level of income inequality. The other 71 percent of that money was given out without regard to need. Even if all of it was given to the poor, there would be no visible change in income inequality if those transfers are not reflected in their incomes. This raises the question of whether those transfer payments help meet the needs of the poor, which will be taken up in another paper.

US Trends in Income Inequality

The Congressional Budget Office (CBO) reports that from 1979 to 2007 real (inflation-adjusted) average household income grew by 62 percent.²² This means that the average household experienced economic growth; they benefitted from growing income which moved them into different income quintiles than they were before. During that time, the report suggests that different income quintiles experienced different rates of growth in income, as seen in Figure 5 on the following page. Those in the highest twenty percent of the population, the highest quintile, experienced income growth of 65 percent over that period. For those in the middle income quintiles (21st through the 80th percentiles) the growth was around 40 percent. For the lowest quintile, the growth was 18 percent.²³ It is especially important to understand that these numbers are dynamic and not static.

Remember the first data point sited: average income across all quintiles grew by 62 percent. Most people are quantitatively better off than they were in 1979. Secondly, even though the rate of growth across quintiles is not the same, all quintiles experienced growth. This has a critical implication: most of those who were in the bottom quintile in 1979 were in a higher income quintile by 2007. The 2007 numbers represent a new set of people. People who were born in 1979 and made no income were 28 years old in 2007 and when they are 48 years old they will most likely be in a higher income quintile than they are now. If this data actually followed individuals from one year to another, then we would have a sense of the migration from one income quintile to the next. This would give us a more accurate measure of individual well-being.²⁴

A society characterized by economic freedom and prosperity is one that provides opportunities for individuals to lift themselves into higher income quintiles. How is that accomplished? Value is created through exchange. That is what most of those in the highest income quintiles have done. Unless we all make an equal income, we will always be able to divide people into income quintiles. What matters is not so much how wide the gap is, but the ability to move from one quintile to the next and the relative prosperity of those in the bottom quintiles.

Another way to measure this is consumption equality. What can the US poor, those in the lowest income quintiles, afford to purchase? The poor in the US are defined as those households with incomes below the official poverty thresholds. In 2011, the poverty threshold for a family of 4 was $22,350.²⁵ According to the Department of Energy RECS study in 2005, 99.6 percent of the poor have a refrigerator, 97.7 percent have one television and 32 percent have more than two televisions, 97.7 have a stove and oven, 81 percent have a microwave and 78 percent have air conditioning. 63.7 percent have cable or satellite television and 70.6 percent have at least one VCR (See Figure 6).

This is not to say that there are none in the lowest quintile who aren’t destitute or that the poor don’t have difficulty paying for these things. The issue is the relative prosperity of those among income quintiles and their ability to move out of that quintile, rather than the absolute earnings across quintiles.

The US poor fare much better in terms of consumption equality than the poor in other countries, many of whom live on less than $1.25 per day. The World Bank reports that in 2005 1.4 billion people in developing countries live on less than $1.25 per day. Not coincidentally, this is down from 1.9 billion in 1981, and the developing world is on track to halve poverty from its 1990 levels by 2015.²⁶ Free-market exchange supported by well-defined private property rights protected under the rule of law is the only empirically-tested way to make this happen.

The relative prosperity and consumption ability among both the US rich and poor is a new phenomenon. Most of human history has been an experience in mere survival. Now the poor and rich benefit from indoor plumbing and home refrigeration among countless other innovations which make life easier across all income quintiles.

READ PART TWO