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.