The Mismeasure of Inequality: Focus on equal opportunity, not outcomes
September 17, 2012
In october 2011, the Congressional Budget Office published a report, “Trends in the Distribution of Household Income between 1979 and 2007,” showing that, during the period studied, aggregate income (as defined by thecbo) in the highest income quintiles grew more rapidly than income in the lower quintiles. This was particularly true for the top one percent of earners. This cbo study has been cited by the media and politicians as confirmation that income inequality has increased “substantially” during the period studied, and has been used to support President Obama’s claim that income inequality is a serious and growing problem in the United States that must be addressed by raising taxes on the highest income earners.
We will show that much of what has been reported about income inequality is misleading, factually incorrect, or of little or no consequence to our economic well-being. We will also show that middle-class incomes are not stagnating; in fact, middle-class incomes have risen significantly over the 29 years covered by the cbo study. Lastly, we will address assertions that the rich are not paying their “fair share” of taxes.
In our view, Americans should care about the well-being of the nation as a whole rather than whether some people earn more than others. To that end, the focus of public policy should not be on equality of income but on equality of economic opportunity. Policies designed to reduce income inequality inevitably involve redistribution of income through increases in transfer payments and marginal tax rates. But these policies discourage hiring and investment, which depresses economic growth and opportunity. In sharp contrast, policies designed to enhance equality of opportunity will increase economic well-being for all, most particularly those in lower income households.
Perhaps the most important question left out of almost every discussion about income inequality is, “Why should we care about it?”
Many of those who worry about high income inequality argue that it is an indicator of social injustice that must be remedied through redistribution of income (or wealth). Unfortunately, those who make this claim have not provided any generally accepted criteria for determining when an economic system is unjust. Nor have they provided a convincing argument that such injustice is widespread in the U.S. (In considering this issue, it is worth noting that Greece, Spain, and Italy all have substantially lower income inequality than the U.S. The same is true for Afghanistan, Pakistan, and Bangladesh.)
Measuring inequality using the Gini coefficient. There are at least five methodologies used to measure income inequality. The most commonly used is the Gini coefficient (also called the Gini index) developed by Italian statistician Corrado Gini. The Gini coefficient is a method of measuring the statistical dispersion of (among other things) income, consumption, and wealth. The figure of merit for the Gini coefficient for income inequality ranges from zero to 1.0, where zero represents total equality (all persons have identical incomes) and 1.0 represents total inequality (one person has all of the income). By this measure, the U.S. has substantially higher income inequality than almost all other industrialized nations. In 2010, the Census Bureau reported that the U.S. Gini coefficient was .469, while the average Gini coefficient for the 27 European Union nations was .31.1
The U.S. Gini coefficient cited here comes from an annual report of the Census Bureau, which uses what it calls “money income” in its measurement of income inequality.2 Money income, which is the definition of income typically used in public references to inequality, consists of cash income only, does not subtract taxes, and excludes the value of noncash transfer payments (such as nutritional assistance, Medicare, Medicaid, and public housing), as well as many other components of income. In addition to transfer payments, which are a substantial portion of income at the low end of the income scale, some of the other missing components of income are: employer-provided fringe benefits (primarily retirement benefits and health insurance, which can amount to as much as 30 percent of income3), capital gains, imputed rent from owner-occupied housing, and increases in the value of home equity. We believe excluding these items renders this measure of income inequality relatively meaningless. However, since this measure is so frequently cited, it is worth noting that during the 29-year period covered by the cbo study, inequality of money income (as measured by the Gini coefficient) grew only about 10 percent.4
Using a comprehensive definition of income provides a much more meaningful measure of income inequality. The Census Bureau’s 15th definition5 is superior because it includes most of the income items listed above and subtracts taxes. Based on this more relevant definition, income inequality declined 1.8 percent during the sixteen-year period between 1993 and 2009, when the Gini coefficient dropped from .395 to .388.
An important shortcoming in the October 2011 cbo report is its almost singular focus on income as a measure of economic well-being, when there is a clear consensus among economists that the best measure of living standardsover the long term is not income, but consumption. Focusing on consumption rather than income provides a very different picture of inequality.
There is a body of research indicating that consumption inequality is not only substantially lower than income inequality, but has been declining in recent years. For example, a 2006 study, “Economic Inequality Through the Prisms of Income and Consumption,” conducted by the Bureau of Labor Statistics (bls) found that in 2001, the Gini coefficient for consumption was only .280 (almost 30 percent lower than the Gini for comprehensive income, and about 40 percent lower than the Gini for money income), indicating that inequality with respect to this most meaningful measure of living standards is relatively modest. Moreover, according to the bls, during the fifteen-year period between 1986 and 2001, consumption inequality went down slightly; from a Gini of .283 to a Gini of .280…