Understanding inequality
Fri 26 Jul 2013 by Matt Nolan in HouseholdsInequality

My apologises again – I will have to extend my break from the tax series of articles I was writing up (latest one was the fifth on goods and services taxes).  While completing the article on the progressivity of taxes I realised that I needed to briefly mention how this interacts with inequality – but we haven’t had a discussion about what inequality means, and why we care.  As a result, I aim to talk about inequality a little bit here as a precursor for that!

Note that, just like the tax articles, the goal here isn’t to say what level of inequality is good or bad, whether we should have more or less, and how you should feel about the issue as a person.  Instead I’m just aiming to look at the causes of inequality, how this relates to fairness, how this relates to what is “attainable” and use this to provide a framework for discussing the issue.

Also, I did not catch the Institute of Policy Studies Inequality Symposium last week, and haven’t had the chance to read Max Rashbrooke’s book.  I will be sure to have a look at their material in the future – and I thought I should mention that this work was released recently!

Inequality as a bad!

Inequality is a strange beast.  Like “productivity”, or a change in a price, what inequality means only makes sense when we ask where it has come from.  Inequality is not poverty, we can’t point to it as directly making a harm.

Now there is a potential argument for viewing inequality as inherently bad – the idea that people will try to “keep up with the Joneses”.  The social pressure to buy status goods (Veblen goods) then forces people who are relatively poor to enter a status war they can’t win!  These status wars, combined with wealth inequality, could potentially increase social divisions and damage trust.  These ideas come from the old “Institutional” schools of economics during the early 20th century.

However, this is a qualified argument about lifetime income inequality, and as a result we need to take care with it.  The Spirit Level book, authored by Richard Wilkinson and Kate Pickett, has helped to publicise this idea in more recent times.  However, its results should be take with care as it greatly exaggerates the argument, mismeasures lifetime inequality, and as a result should not be taken as the primary starting point for the analysis of the impact of inequality.  My review of it is here.

There is a key point in all this though which is widely accepted by economists and policy makers, lifetime income inequality may be something that violates our perception of fairness and as a result may be something that we as a society want to reduce.  Often this boils down to the fundamental idea of equality of opportunity.

Static measures of income inequality exaggerate the level of lifetime income inequality (earning little income when you are young is different to earning little income when you are older and trying to raise a family), but we are currently a bit short on other data.  As a result, to really discuss inequality and interpret societies preference regarding this, we need to dig down think about the causes.  Which causes of changes in our measures are bad, which are good, and which are difficult to interpret in this lifetime sense?.

Splitting things up

We are primarily interested in thinking about causes when trying to understand both how we feel about observed changes in inequality as a society, and when it comes to thinking about how we might use government to respond to these changes!

So what are some common causes that may make the measures of income inequality (at a point in time) move as time changes, and how do they relate to lifetime income inequality?

  • Population or household structure can change through time: even if lifetime inequality was unchanged, changes in where a person is on their lifecycle (their age), and the type of household structure that exists, can change static measures of inequality.  For example, my income increased when I stopped being a student and began working, and it will decline when I retire from working.
  • Population distribution and human capital investment:  A subset of the point above.  Over a lifetime, different people invest different amounts in human capital (eg time spent training) – which offers a future return.  As a result, we would expect a younger population to look “more equal” than an older population even if lifetime inequality in the two societies was the same!
  • Technology and skill change:  Over time technology and the types of skills required by employees and investors changes.  Understanding the sort of process of change we are going through is important – for example, if technological change was making it very hard for some groups to ever get involved in the labour market at current prices this is reducing their opportunities even if the new technology is “increasing the economic pie”.
  • Changes in relative prices:  Related to the point above – a change in “inequality” in incomes may be largely due to changes in the relative prices goods and services we can buy?  For example, an increase in measured income inequality could occur when necessities have become cheaper even if there was change in the real goods and services different income groups can buy!  A growing price gap between “normal” televisions and slightly better televisions would be an example of such a change.
  • Changes in government policies and tax:  The types of legal system, regulation, and the progressivity of the tax system will have an impact on how income is distributed.  Furthermore, government spending (which aims to increase the provision of/demand for certain goods and services) will also impact on this.

There are a number of other causes we could think of, and we could boil these broad categories down into narrower ones. 

On top of this we need to define what the unit of interest is, is it the individual, households, families?  What is our economic and social ‘unit’ for measuring outcomes?

Ultimately, the idea of trying to pin point what set of “causes” have changed in the distribution in income, and thereby income inequality, is wildly complicated.  And the question of how it matters adds another hard complication!  Hence why we can get very different results from different economists (see this from the US and then this regarding changes in the US income distribution through time – as a sidenote in the NZ context work in this area has been done with this from Motu).

There are severe limits to our knowledge – and this makes useful intervention harder

The fact there are many potential causes (and different causes imply that different policies are appropriate), and that it can be difficult to separate them is only part of the reason why our “knowledge is limited”.

Often when we look at these issues we suffer from an illusion of control – thinking we have a greater ability to control and understand the consequences of our actions than we actually do.  In truth, not only do we not know what real causes (the causes we care about) are behind inequality – we have a pretty bad idea around how policy changes will impact on the income distribution in a general sense.

Now, we do know that progressive taxation and transfers will do the trick, and is the economists’ main suggestion for doing so – the hard bit is trying to tie that back to the very reasons society cares!  This is a pretty important question for us to ask when trying to figure out what “social preference” we are trying to satisfy, and what price we are willing to pay, with our policy choices!

People are different, so some inequality is “good”

Sometimes people take the idea of reducing income inequality too far, and start to assume the goal is equality.  The Spirit Level didn’t help matters by mixing up the two, and confusing income inequality with other forms of inequality by often using the world ‘inequality’ to represent all these things!

However, it is quite easy to make the case that complete equality is bad – fundamentally people are different.  Some people don’t mind working as much, some people value consumption a lot more than others, and some people really enjoy leisure time.  Furthermore, even if we were all 3D printed copies of one another we know we want different things, have different skills, and earn different amounts through time – complete equality would not allow for this.

Forcing people to have the same amount of income, or do the same amount of work, instead of “trading” these things between themselves will leave them worse off.  And this is exactly what many schemes of complete equality of income does!

As a result, in order to get the equality of opportunity we desire we need to ask what the best level of income inequality is!  We actually have a social preference for some level of lifetime income inequality.

When people talk about fighting inequality to help with trust and social cohesion, they have the noble goal in mind of helping us co-operate with each other.  And yes, as individuals we should co-operate and care for each other – no person is an island.  However, this would make an awful argument for complete equality – individuals are inherently different and a society that cares about individuals is one that learns to accept and work with this fact. 

And of course the elephant in the room is how government policy choices have an impact on trust and co-operation.  What drives these matters, and would a society that tries to more closely control means of production and income actually create greater trust and social cohesion? 

As a result, both extremes of looking only at the island or only at the person are inherently flawed.

Total income is not independent of our push to make things “fairer”

An incredibly important point that is often missed is that many of our schemes to make the income distribution “fairer” will lower the size of the pie.  There is an “equity-efficiency” trade-off as we discussed in the article on income taxes.  The more we de-link the private value of investment/work from the social value by increasing redistribution the smaller the “economic pie” will be.

The Spirit Level book mentioned earlier aims to dismiss this link – but it gets itself confused on causes.  To quote one of my work colleagues, “to the extent that greater equality comes from greater social cohesion, one might believe that greater equality is also associated with greater welfare.  Where it comes unstuck is when equality becomes the objective and leads to policies that discourage effort and enterprise”.

This is fine, in no world are we simply trying to make the pie as big as possible.  But it is a trade-off we need to think about, and it is a cost we need to admit when looking at the benefits of our perceived increase in fairness!

Don’t use this as an excuse to do nothing – let’s just make sure we have thought it through

Many people reading this will see the sort of exercise I’m running through as an excuse to do nothing.  And to be fair, many people run through this sort of exercise and then state that nothing should be done.  But in truth, all I am doing is noting down the points we have to keep in mind before we try to run out and save the world with policy – there are good intentions out there, so the goal of discussing trade-offs is to add a layer of understand to shape those intentions into the right actions.

These concerns make targeting “inequality” in of itself a bit of a strange thing to do – we just have too much uncertainty about what it means.  Instead our focus needs to be on issues that we understand, or where our social preference if very much against something.

Absolute poverty is the clearest of these examples – as a society we have a preference that members of our society should not live on less than a certain income, and we use government policy to deal with that.  Working for families can be taken as another example, where we say that as a society we want to transfer resources towards those who decide to raise children.

Now I have no place to tell you what policies we should as a society pick.  Ultimately, there is some social preference for fairness out there that involves the acceptance of some trade-off between “equity and efficiency” that I cannot see and comment on – and it should be left for society to determine.

But this broad framework gives us an idea of thinking about why we have a social preference over inequality as a society (or more fundamentally the causes of inequality), and some of the matters we need to consider if we want to meet this.  This will allow us to move onto to thinking about progressivity in the tax system next fortnight.

Related Articles