The Sources of Inequality

January 7, 2014 · by · in , , , , , ,

All men are created equal but they do not stay that way for long. As they age the dispersion of incomes increases dramatically. So there are two questions here. Why does this happen and is it a problem?

A couple weeks ago the President made a speech in which he outlined what he described as his raison d’être, “Making sure our economy works for every working American.” It is a little difficult for an economist to unpack a colloquialism like this. You picture yourself at the bar asking the guy on the next stool during a break in Monday night football, “Say, what about that economy? Is that working for you?”

Although the President eschewed the notion of “providing equal outcomes” rather than “striving to deliver equal opportunity”, the balance of his comments actually lamented the unbalanced outcomes rather than finding any serious fault with the set of opportunities from which any newborn American can choose. So how do outcomes diverge over time?

The New York Times describes “the elements of class distinction or prestige” in America as profession, education, income and wealth. To a great extent, these are also the key factors in this evolution of inequality. After 30 or 40 years those babies that all started out with similar opportunities will be facing very different circumstances.

Much of this income divergence has to do with ability, motivation, some luck and, most importantly, the choices we or our parents make. Studies show that even small differences in nutrition or even in utero shocks from weather events can have a permanent impact on cognition.

What did we eat? Where did we go to school? What grades did we get? Did we choose a high-income profession or not? Who did we marry? Did did we stay married? The answers to these questions will determine our lifetime income.

A recent Rasmussen poll found that 80 percent of Americans who are working, work more than 40 hours a week and that a select nine percent work over 50 hours a week. A recent survey by the Pew Charitable Trusts found that “over 40% of Americans consider hard work, ambition, and drive to be among the most important factors for economic advancement. Only ten percent thought that initial wealth was important to a successful life (Pew 2011).”

Gini Coefficient

So, as most people expect, outcomes are clearly unequal – but by how much? Without digging into a lot of math, the world measures inequality with the Gini Coefficient that is based on comparing the cumulative distribution function of incomes (Lorenz Curve) against a perfectly equal distribution. Perfect equality is a Gini Coefficient of zero. Perfect inequality is a Gini Coefficient of 1.0. The U.S. Gini is shown nearby. Although 0.49 is much higher than other OECD countries on a pre-tax basis, our after-tax Gini is pretty much in the range of industrialized nations.

Developing countries with high-growth rates tend to have greater income inequality. China is a good example. Their Gini was around 0.25 in 1985. Since then it has risen to a level equal with the U.S. In the intervening decades the Chinese economic shift has lifted tens of millions out of poverty. I don’t think any one would make a case that China should return to the 1980s simply to reduce income inequality. The statistical reality is that economic systems with greater opportunity will inevitably have higher Gini coefficients.

That brings us to the topic of poverty and upward mobility. The President worried that the U.S. has less economic mobility than France. He made his point by comparing the likely fact that it is easier for a poor child to rise to a median income in France than in the U.S. The reality, however, is somewhat different. A family living at the median income in France ($20,650) is actually below the poverty line in the U.S. ($23,000). So perhaps people can move up easier in France but after they do we would still consider them to be poor. The lack of opportunity means that they are more equal in outcomes. In exchange for that equality, they accept that they will all be much worse off. It is a less extreme case but similar to China in 1985.

One of the clearest lines of inequality demarcation is education. A child born in the bottom quintile income group is six times more likely to rise to the top quintile if they have a college degree according to a recent study by the Federal Reserve Bank of San Francisco. More importantly, education is the great equalizer. Life outcomes for poor kids with a college degree are the same as those for rich kids from the top quintile with no degree. In effect, education can completely offset the advantages of wealth at birth. In the U.S., this is why there is a 67 percent probability that any child born today will earn more than her parents at every age during her lifetime.

Total Taxes Paid by Group

Finally, we would like to analyze another source of inequality in our economy: taxes. As the graph nearby depicts, one of the benefits of income inequality with a progressive tax system is that the rich pay for most of the nation’s social services. Note the surprising (for some) result of lowering marginal tax rates in the Reagan years was an increasingly progressive structure of tax payments. Under the much-maligned Bush tax cuts the top five percent of earners hit a historic high by paying over 60 percent of the total income taxes in 2007.

So the U.S. may be less equal in terms of the Gini coefficient, but we are all better off because of the greater opportunities that contribute to that inequality. The high potential upside drives entrepreneurial ambition and economic expansion. As President Kennedy put it, “a rising tide lifts all boats.”

So I guess our conclusion is that inequality is a function of a bigger range of opportunities and the choices (mostly educational) that people make. If we force equality of outcomes through government policies, the reduced economic growth means that all of us will be worse off – especially those at the bottom of the income ladder.

Finally, if we could send a message to one-percenters like Andy Grove, Gordon Moore, Bill Gates, Steve Jobs and Sergey Brin, it would be, “Thanks for working so hard and thanks for paying for everything.”