Editor’s Note: The Institute for Faith, Work & Economics released a new research report entitled, “Why Does Income Inequality Exist? An Economic and Biblical Explanation” by Dr. Anne Bradley, Ph.D. This week our blog will highlight the key findings from this report.
We greatly misunderstand the notion of income inequality if we do not understand income mobility—the movement of individuals through time. 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. This represents only a snapshot in time, which can be useful. But what we really care about is how individuals move through income brackets over time. Markets are dynamic so we can’t solely rely on static numbers to make predictions of the welfare of individuals.
More than 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.
When the Gini coefficient equals one it indicates that one person has all the income and everyone else has zero. While we don’t observe this in reality, we do 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, where if I win it’s because you lose. However, economies based on voluntary exchange are not zero-sum.
If I work harder, become more innovative and earn a greater income through hard work and discipline, I benefit without harming anyone. In fact, I benefit through a higher income, if and only if, I serve others. This is called income mobility, and is critical for getting a full picture of overall prosperity.
In a market economy, most people start out at a lower income bracket and move to higher incomes. 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. All of this is based on people using their gifts and talents to serve others. They are even serving people they don’t know!
There is another problem with income inequality data. Solely looking at income inequality levels from one decade to the next does not tell us anything about the actual people inside 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. Evidence supporting this theory include a 2008 report by the United States Treasury on income mobility which 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.
What this tells us is that to stay in the very richest percent of the population is really difficult. To start in the lowest and move upward is much easier.
But let’s look at the growth of income. The Congressional Budget Office reports that from 1979 to 2007 real (inflation-adjusted) average household income grew by 62 percent. This means that the average household experienced economic growth; they benefited from growing income which moved them into different income quintiles than they were before.
This suggests that most US citizens are quantitatively better off than they were in 1979. 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. 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.
And finally, let’s unpack this notion of how we earn income. Some assume there is a fixed economic pie, but there is no preexisting pot of income that gets divided 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. 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.
Our real concern should be the state of income mobility. Will it always be relatively easy to start at a low income and work your way up? Do we live in a society that protects the individual’s right to utilize their talents?
Free-market exchange supported by well-defined private property rights protected under the rule of law is the only empirically-tested way to protect human dignity and unleash the creativity with which we are created, all for the purpose of serving the common good. That is the best way to foster income mobility.
Question: Think about when you first started off in your career. Have you moved through income brackets since that time? Leave a comment here.