The Inequality Debate

 A good friend of mine, recently turned lefty, has been harping on the income inequality tune lately. It's new to him, so he finds it quit convincing. We've been going back and forth on it now for some months (see here and here, for example) but he tried to address all of my arguments in one post. See here.

My response was too long for a single comment, so I broke it down into bits. I thought I'd post it here in full (with some minor typo and other corrections) for others to see as well. It's a good intro to the income inequality debate and the response to it from those that disagree.

You can start with his post here and my response is below.

Finally, a response. You have been harping the income inequality argument for some time now, and simply ignoring the responses that have come (see here and here, for recent examples). Lets discuss.

First, family size. You write, I'm told that the increase in inequality is due to the changing family structure. More single family homes. It's interesting that a lot of these responses I get come without evidence. It's just a claim that sounds plausible.

This is the wrong way to look at it Jon. Remember, it's not the right that is making the income inequality argument, it's the left. The reason you don't find a lot of responses controlling for family size is because frankly, there are few, if any solid ones. But that speaks ill of the left, not the right: after all, income inequality is their argument - their primary argument, in many ways - and the fact that they haven't taken the time to control for such basic differences speaks badly of their academic objectivity, wouldn't you say?

With that said, all you had to do was ask. Here is one, two, three, four, five, six, seven, eight and nine responses that deal directly with family size.  Remember, it's not just divorce rates and working hours that matter, it's also immigration and more importantly, the rise in single mothers and the age of the population that matters.

Second, total compensation. Were not just talking about 401k's here, were primarily talking about healthcare costs. And when you factor those in, almost all of the income inequality disappears. Cornell University professors Richard Burkhauser and Kosali Simon write in a NBER paper:

In this paper we take estimates of the value of different types of health insurance received by households and add them to usual pre tax post transfer measures of income from the Current Population Survey's March Annual Demographic Supplement for income years 1995-2008 to investigate their impact on levels and trends in measured inequality. We show that ignoring the value of health insurance coverage will substantially understate the level of economic well being of Americans and its upward trend and overstate the level of inequality and its upward trend. (emphasis mine)

But again, doesn't the dearth of studies that take into account health care costs and 401k's say something about the academic integrity of those that constantly put forth the income inequality argument (the economists, that is)? It's like they are cherry picking the data that most fits what they want to believe.

Third, consumption inequality. Then there are mitigating factors to income inequality. Income inequality just looks at the inputs to income but what about the outputs? In other words, instead of looking at wages, lets look at purchasing power. And when you do that, you see that the trend is the opposite:

Looking at trade data between 1994 and 2005, Broda and Romalis construct inflation rates for different income groups and find that rates for the richest outpaced rates for the poorest by about 4 percent over the period. Since income inequality between the top and bottom 10 percent of earners grew by about 6 percent, the different inflation rates among income groups wipes out about two-thirds of the rise in inequality.

This study is by two University of Chicago economists. This is how University of Chicago economist Steve Levitt (and author of Freakonomics) puts it:

Their argument could hardly be simpler. How rich you are depends on two things: how much money you have, and how much the stuff you want to buy costs. If your income doubles, but the prices of the things you consume also double, then you are no better off.

When people talk about inequality, they tend to focus exclusively on the income part of the equation. According to all our measures, the gap in income between the rich and the poor has been growing. What Broda and Romalis quite convincingly demonstrate, however, is that the prices of goods that poor people tend to consume have fallen sharply relative to the prices of goods that rich people consume. Consequently, when you measure the true buying power of the rich and the poor, inequality grew only one-third as fast as economists previously thought it did — or maybe didn’t grow at all.

What caused this dramatic drop in the prices of goods purchased primarily by the poor vs those by the rich? Levitt explains that as well:

Why did the prices of the things poor people buy fall relative to the stuff rich people buy? Lefties aren’t going to like the answers one bit: globalization and Wal-Mart!

China is able to produce clothes, electronics, and trinkets incredibly cheaply. Poor people spend more of their income on these sorts of things and less on fancy cars, expensive wine, etc. According to Broda and Romalis, China alone accounts for about half of their result....

MIT economist Jerry Hausman (who taught me econometrics in my first year of graduate school) and co-author Ephraim Leibtag have analyzed the impact of the entrance of a Wal-Mart superstore on local food prices.

Not only are Wal-Mart’s prices lower, but its entry also induces competitors to lower prices. The impact is much larger on the poor than the rich, both because the poor are more likely to shop at Wal-Mart and because they spend more of their income on food.

In other words, the two greatest forces in mitigating the impact of income inequality are precisely the other two things the left dislikes most: globalization via China and Walmart.

With that said, I don't want to leave the impression that I think there has been no increase in income inequality. I do believe that there has been in fact real inequality and it has been growing (and for precisely the same reasons economists generally believe: technology, greater division of labor etc). I just disagree with the magnitude and more so, the importance of it.

Fourth, culture. Much of the increase in income inequality is a result of cultural changes, specifically in marriage mating. Arnold Kling writes:

There is also another factor at work. A trend is underway in America for marriage to be increasingly “assortative.” That means children of well-educated parents tend to marry one another and the children of less educated parents tend to marry one another. This was less the case a few generations ago. For example, sociologists Christine Schwartz of the University of Wisconsin and Robert Mare of UCLA found that beginning in the early 1970s there was a striking “decline in the odds that those with very low levels of education marry up.” And they found that between 1940 and the late 1970s the likelihood that someone with only a high-school diploma would marry someone with a college degree dropped by over 40 percent.

Indeed, economists Betsey Stevenson and Justin Wolfers at the Wharton School at the University of Pennsylvania believe that a revolution in modern marriage has taken place. According to their view, two generations ago, a husband and wife married in order to share production, with the man working in the market and the woman working at home. Today, the husband and wife are both likely to work in the market, and they choose one another because they have similar tastes in consumption....

Stevenson and Wolfers point out that it may well have been the case a few generations ago that “opposites attract” and the production-based marriage benefited from differences in backgrounds and skills. Today, the consumption-based marriage benefits from the couple’s similarities. Thus, marriage becomes less a driver of mobility across income segments and more a driver of income inequality.

The full article, which I highly recommend, can be found here.

Fifth, the benefits of income inequality. Let's remember from our basic economics course that some income inequality is good. It serves as a signal mechanism to encourage more productive behavior, such as, getting an education. This is the basic argument that Gary Becker and Kevin Murphy of the University of Chicago make here.

Sixth, the irrelevance of income inequality.There are powerful arguments on why income inequality should be ignored. For example, here and here. But my favorite of em all, is the growing irrelevance of income inequality. Don Boudreaux explains:

But I here suggest that economic growth, even as it might generate ever-larger income inequality, increasingly renders these same differences in money income or wealth less and less relevant as a measure of differences in quality of life. Some examples:

- Inexpensive consumer electronics enable almost all Americans, even the poorest, to listen at their leisure to the world’s finest orchestras perform great music; contrast now with, say, 1880, when only the relatively rich could afford to hear great music – and only the superrich (by hiring their own chamber orchestras) could enjoy listening to such music whenever they wished.

- Today’s inexpensive Chevrolets and Kias are more reliable and better equipped than were top of the line Cadillacs of 40 years ago.

- Fifty years ago European vacations were a luxury enjoyed mostly by the rich and upper middle classes; today – chiefly because of inexpensive air travel – such vacations are within the means of a much greater proportion of the population.

- The clothing worn by wealthy Americans is virtually indistinguishable from the clothing of ordinary Americans; Bill Gates, Tom Hanks, and Laura Bush are not distinguished from the vast majority of Americans by their clothing. In both quality and quantity, clothing is nearly super-abundant in modern western society.

The further back you go in history, the greater were the material differences that separated rich from poor. Many of these distinctions were evident to the untrained eye (for example, the rich rode in carriages; the poor walked). Fewer of the distinctions today between rich Americans and middle-class Americans – even poor Americans – are as palpable, as salient, as stark, as were the distinctions of generations past.

Bill Gates has many more zeroes in the accounts of his finances than I have in the accounts of my finances. But I don’t see these. What is seen, what is experienced, what is palpable, as differences between Gates’s financial status and that of ordinary Americans is increasingly disappearing.

In other words, whats important here is economic growth, if you have that, income inequality matters less and less.

Update: Jon responds here. (Originally published: 12/16/2010)