Should We Care About Rising Income Inequality?

The following is an excerpt from Economics21's new inequality primer, Income Inequality: Myths and Facts.

Among commentators today, primarily on the left, there is

a sense that President Obama put it mildly when he declared inequality "the defining challenge of our generation." Nobel Laureate Joseph Stiglitz has written that, "with inequality at its highest level since before the Depression, a robust recovery will be difficult in the short term, and the American dream -- a good life in exchange for hard work -- is slowly dying." New York Times columnist Paul Krugman--also a Nobelist--calls inequality "toxic." Economist Thomas Piketty, whose income concentration figures are ubiquitously cited, recently inveighed against tax cuts by saying they will:

But claims about the supposed harm done by rising income inequality are rarely substantiated, and a comprehensive read of the evidence as to inequality's consequences offers little cause for alarm. Inequality has been rhetorically linked to stagnant incomes among the poor and middle class, to slow economic growth, to diminished opportunity among children lower down the income ladder, to macroeconomic financial instability and household indebtedness, and to political inequality. The state of our knowledge about these links, however, suggests little reason to prioritize income inequality as a national problem.

Consider first the relationship between inequality and the living standards of the poor and middle class. It is widely believed that incomes below the top have stagnated as the rich have pulled away, taking an outsized share of income growth with them. However, the truth is that there is no inconsistency between the top receiving a large share of income gains and the poor and middle class seeing significant income growth.

To be sure, income growth below the top has slowed since the "Golden Age" of the 1950s and 1960s. As the chart below shows, annual income gains among the bottom 80 percent of households were stronger than among the top five percent between the peak years of 1948 and 1969, and gains were strongest among the bottom fifth (details on data sources here). Since the 1960s, income growth below the top has slowed. However, an indication that rising inequality has not been primarily responsible for this slowed growth is the fact that diminished income growth preceded the rise in income concentration at the top. The 1970s were a lousy decade for the poor, middle class, and rich alike. The reason? A slowdown in productivity across the industrialized world.

Income inequality did not increase that much in the 1970s, and while it increased thereafter, within the bottom 80 percent, the rise in inequality was confined to the 1980s. Overall, inequality within the bottom 80 percent has increased only modestly since the 1960s. In 1969, the middle fifth of households had an average income 2.5 times that of the bottom fifth--with the ratio rising only to 2.9 times larger in 2007.

Income concentration at the top rose after the 1970s, though even here, the increase shown in the chart is overstated. The figures--from Piketty and colleague Emmanuel Saez--do not account for public transfers, the value of non-wage employer benefits, or redistribution occurring through the tax code. They also focus on tax returns instead of households and do not adjust for declining household size. Two roommates constitute one household but two tax returns, and teens and college students who work part-time and file their own tax returns are counted independently of their parents. Estimates from the Congressional Budget Office that correct these shortcomings show smaller increases in income concentration over time. Figures from Piketty and Saez that focus on earnings and exclude investment income indicate even smaller increases in income concentration. While the figures in the chart above suggest that the share of income received by the top five percent rose from 21 percent to 34 percent from 1979 to 2007, the estimates using earnings show an increase from 17 percent to 25 percent. (See also Philip Armour's contribution to this primer, below.)

Note, too, that incomes below the top 5 percent did not stagnate. Incomes among the bottom fifth were one-third higher in 2007 than in 1979, and those among the middle fifth were 43 percent higher.

Turning to the relationship between inequality and economic growth, despite the attention given to an International Monetary Fund paper purporting to find that countries with more inequality experience weaker recoveries from recessions, the academic literature comes to no consensus. Studies are as likely to find that more inequality corresponds with higher growth as they are to find a negative relationship. The IMF study was primarily focused on developing countries, while including only a few industrialized nations in Asia. The liberal Center for American Progress has published no fewer than three studies concluding that, among the studies which directly examine the question, there is little evidence that higher inequality harms growth.

Of course, if inequality rises and economic growth does not increase, then the implication is that growth does not benefit the middle class or poor. But research by sociologist Lane Kenworthy shows that across industrialized countries, increases in inequality do not correspond with lower median income growth. A study by Christopher Jencks and his colleagues suggests that in recent decades, greater inequality growth corresponds with stronger economic growth, which would be consistent with increases in median income.

Income distribution is not a zero-sum game. Yet even if possible, limiting income concentration after 1979--by keeping the shares received by the bottom, middle, and top at their 1979 allocation--might have reduced subsequent income growth. If it would have done so by 0.5 percent per year or more, then preventing inequality from rising would have successfully kept the share of income received by the top from rising, but would have left the middle fifth no better off than they actually were in 2007. They would have received a larger slice than they actually did, but of a smaller pie.

What about the impact of inequality on opportunity? The conclusion of mobility expert and sociologist Michael Hout in 2004 remains true today: "[The] literature to date has offered surprisingly little evidence that links intergenerational difference and persistence (mobility and immobility) to economic or other inequality." Economists Alan Krueger and Miles Corak have argued in recent years that the positive association across countries between income inequality and intergenerational mobility implies that the former diminishes the latter. However, this correlation has not held up across labor markets within the United States, suggesting that cultural and other differences across countries may be responsible for any correlation between inequality and mobility. Indeed, the relationship is as strong between mobility and population size as between mobility and income inequality, and there is no association between mobility and wealth inequality.

Furthermore, the mobility measure used by Krueger and Corak indicates less "mobility" when inequality increases more. When a measure of mobility is used that is unaffected by changes in inequality and focuses on whether parental income rank is related to the income rank of adult children, Sweden and the United States have the same mobility (despite having very low and very high inequality, respectively). The implication is that when inequality is not baked into the mobility measure, there may be little correlation between inequality and mobility, let alone a causal relationship.

Does income inequality lead to financial crises and indebtedness? While former Labor Secretary Robert Reich and Raghuram Rajan, chairman of India's central bank, have suggested that high and rising inequality led to both the Great Depression and the Great Recession, the most rigorous research on this question indicates that this is a classic case of an omitted variable. Economists Michael Bordo and Christopher Meissner looked at financial crises across countries and over time, and found that rising inequality was incidental. Rather than causing crises, rising inequality tends to co-occur with the inflation of credit bubbles. But it is the credit bubbles that lead to financial crises.

Another argument, made most prominently by economist Robert Frank, is that when inequality increases, people below the top feel pressured to overspend to "keep up with the Joneses." The not-quite-rich spend more to keep pace with the rich, the upper-middle-class follow suit, and so on, all the way down to the poor. States and counties that saw bigger increases in inequality during the 1990s also saw more growth in bankruptcy filings. However, we do not know that the stronger rise in bankruptcy filings in these counties was concentrated among the poor or middle class.

In another study, middle class households in states with more inequality also spent more relative to their incomes than their counterparts in other states. That could have reflected greater spending out of housing wealth as income concentration bid up the value of homes, although middle-class households in high-inequality states were also more likely to say they were worse off financially than a year ago. The specific areas of spending that rose disproportionately among the non-rich in response to income gains at the top mostly involved personal appearance and home maintenance, suggesting that if income concentration increases spending, the additional dollars are spent on discretionary items rather than necessities. These facts hardly constitute a case for public policy to intervene to save consumers from themselves.

Finally, concern about whether income inequality leads to political inequality is also excessive relative to existing evidence. Here, too, the alarmists' case is built on inapplicable research and selective citation. Many commentators cite the work of economists Daron Acemoglu and James Robinson, who show that inequality in developing countries is associated with the creation and maintenance of political institutions that redistribute money into the hands of elites. However, Acemoglu and Robinson provide no evidence that this occurs in modern industrialized democracies. 

Commentators worried about inequality often cite the research of Larry Bartels and of Martin Gilens, who separately find evidence that political outcomes are more aligned with the preferences of the rich, than with those of the poor or middle class. However, Robert Erikson and Yosef Bhatti find no evidence of unequal representation in research that directly addresses the Bartels paper.

In 2004, a task force on inequality convened by the professional association of academic political scientists concluded, "We know little about the connections between changing economic inequality and changes in political behavior, governing institutions, and public policy." More recently, a 2011 book summarizing a political science conference on unequal representation, summarized the conference findings:

The authors of the book found that the policy preferences of poor, middle class, and upper-income Americans do not differ all that much, and where there are differences, they are long-standing ones that have not changed as income inequality has risen.

The case that inequality has substantial costs is simply overstated by conventional wisdom. That is not to say that new evidence will not emerge that could change this conclusion--and it may be that despite the weak evidence, rising inequality really has been problematic. But policymaking must be based on evidence, not biases or hunches (unless, of course, it is argued that inequality is just wrong even if it has no costs). Looking at the facts, it is difficult to see why we should focus on inequality over any number of other potential policy issues if we are concerned about the poor and middle class, or the state of the economy, or of our democracy.

In this volume, we evaluate several facets of the income inequality debate. Empirical analysis shows that many commonly accepted ideas about income inequality are false or overstated. The debate over economic mobility--and how income inequality contributes to it--is an important debate. However, if policy recommendations are to be effective, they must be informed by an accurate picture of the current situation. 

Taken from the Economics21 issue brief, Income Inequality: Myths and Facts.

Scott Winship is the Walter B. Wriston Fellow at the Manhattan Institute for Policy Research. You can follow him on Twitter here.

Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning eBrief.