It’s probably time that I systematically collected and presented what you need to know in order to be an informed person on the topic of income inequality, its measurement, its importance, and whether any policy can do anything about it. At the end of it all, I will try to organize it into a summary piece to read more like a text chapter, but I’d like to keep each of these posts short, and not be too linear in the presentation.
File today’s idea under the difficulty with measuring or identifying “true” inequality.
Consider two workers, Profligate Petey and Wise William, each who earn $50,000 per year for 10 years of their lives. Suppose further that real interest rates in the economy are 5%, and that there are no taxes. Upon first glance you are probably convinced that there is no income inequality in this country (of course, there still may be, what if, for example, one of these workers is being discriminated against, and his true productivity is $60,000 and no competitive forces exist to help us get to such an outcome).
Suppose Petey spends all of his income every year on various goods. Therefore his measured income in 2021 will be $50,000. And that, too, would be the same as the “earned” income of William. However, suppose that instead of spending all of his money, William has been saving 50% of his earnings each year, and that starting in 2021, he begins to take, as income, the interest generated from those savings.
In this case, Will’s savings would be growing at a rate of 5%, and after 10 years, he would have had $314,447 accumulated in his bank account. He was able to do that by sacrificing consumption over a 10 year period. Petey did no such thing. Now, Will begins to take a 5% distribution each year from that accumulated fund. By how much will his measured income increase? $15,722. Therefore, his “unearned” income would be added to his earned income and his measured income would be $65,722.
Whereas in 2011, there was no difference in incomes between Peter and Will, now there is a 31% difference in their incomes. It would appear that income inequality is growing. Is it? According to the mechanical way of doing the calculation it has, but is there something inherently wrong or unfair about the outcome in 2021 as compared to the outcome in 2011? Indeed, if I added the role of taxation here, you would see that Will would have paid a larger share of his income in taxes as Peter. If the unfairness goes anyway in this example, it is in the way opposite of what the income inequality metrics tell us.
Now, some conservatives might say that the kind of inequality we ought to care about is consumption inequality, but that too is wrong, at least according to this example. We’ll explain why on Monday.
I know that technically investments count as part of income, but when people speak of income inequality, they are talking about what the individual earns from the job (their paycheck), not their investments. As individuals become more wealthy, less of their “income” comes from salary and more of it from investments. This is true for the upper class, not of the other 97% of the country. If you want to consider investments, you need to take a look at how upper class individuals also have better access to private wealth managers etc. which most people do not, and services as these also contribute to income disparity.
But then the people cite the data using total income. In any case, private wealth managers do not obviously give the rich an advantage, after all, they charge much larger fees. The non-rich can do what I do, use Vanguard at extremely low cost, and use the internet for planning advice. The advantage the rich have in this sphere is tax avoidance and long-term planning.
Of course William gets screwed by inflation, if the government takes care of Peter with paper money.
By the way, I would not assume rich people gain an advantage by hiring a gunslinging money manager. It depends on whom you pick, and what you tell that person to try. Long Term Capital Management comes to mind.
This does not mean that some arbs and short sellers have not struck it rich, but think about it: why would they cut you in on such a sweet deal, just because you have fifty million bucks? Because they like you?
Petey, not Peter. Petey the Profligate.
[…] On Friday, I left us off with the comment that using consumption as a measure of inequality, at least in the example I provided, would not be much more satisfactory to using income inequality. According to my example, in 2011, Will would be spending $25,000 and Petey would be spending $50,000 on consumption goods. But given that each of them earned $50,000 in that year, would you want to point to those consumption statistics and call it “inequality” and to go further, then to apply some ethical judgment to it? […]
Is this a question about taxation to make us all equal?
Suppose that a graduate from Bennington derives great joy from going to the public library and for the rest of her life reads Proust and Jane Austen, in between milking the Holstein cows of her Vermont neighbors, and through connections gets a lifetime ski pass to Vermont slopes. How does one calculate her benefits, versus the benefits of the effort of a Vermont farmer who likes to sail on a yacht off Martha’s Vineyard? How can one calculate this? By what they have left over in the bank?
I do not want to touch this question. Nor would Bastiat, given his epistemological humility.
Looking forward to Wintercow’s provacitive questions and observations, as well as the posts from readers of his worthy blog.
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