The Income-Inequality Problem Is Overblown
Spending is the metric we should focus on
Ask almost anyone the most important economic facts about income distribution in America, and you are almost certain to hear that income distribution has worsened dramatically over the past generation and over the past decade in particular, with people at the top getting a bigger fraction of total personal income.
On Wednesday President Obama declared that "increasing inequality is most pronounced in our country, and it challenges the very essence of who we are as a people."
But measuring inequality is not simple. The choice of the measure of income and the measure of the household influences the results. Should income be measured before the government removes taxes, or after? Should income include government transfers such as food stamps, Medicare, Medicaid, unemployment benefits, and housing supplements? How about wealth?
One measure of well-being is spending, and government spending data show that the ratio of spending between the top and bottom 20% has hardly changed over the past quarter century. In terms of total spending, inequality is at the same level as 1987.
Why do other measures show increasing inequality? Some studies use measures of income before taxes are paid and before transfers, such as food stamps, Medicaid, and housing allowances. Including these transfers reduces inequality. The top 5% of income earners paid almost 60% of individual federal income taxes in 2010, and those in the bottom quintile receive transfers.
Most studies do not take into account changes in the composition of households over the past 25 years. We have more two-earner households at the top, and more one-person households at the bottom.
Some the increase in measured inequality since the 1970s is due to the Tax Reform Act of 1986, which lowered top individual income-tax rates from 50% to 28%, below the 35% corporate tax rate. After 1987, it appeared that incomes rose, but some of this was small businesses filing taxes as individuals rather than as corporations.
Quintiles differ in the number of people per household and the number of earners per household, so comparisons of quintiles are misleading. Table 1 shows that in 2012, households in the lowest fifth had an average of 1.7 people, and in half these households there were no earners. The highest fifth had 3.1 persons per household, with two earners.
Surprisingly, a higher percentage of low- income Americans own their homes free of mortgage debt than do upper-income Americans. Some 28% of households in the lowest-income group and 31% in the next-to-lowest group owned their homes without a mortgage in 2012. More seniors are in the lower two quintiles, and many have paid off their homes. In the top quintile, 11% of households own their homes debt-free, the smallest share of any quintile — a counterintuitive result.
One reason for income inequality is the differing number of earners per household in upper and lower quintiles as women moved into the workforce in record numbers in the 1980s. If there were more one-earner households, the distribution of income would be far more even.
Another change is the shrinkage in household size at the bottom of the income scale, adding to a false perception of increased inequality. This is due to the increased longevity of today’s seniors and to the higher numbers of divorced people and single- parent households.
Figure 1 shows the increase in the percentage of one-person households between 1960 and 2012. In 1960, 13% of households had just one person. By 2011, 27% of households, more than double the previous share, had one person.
A superior measure of well-being that avoids these pitfalls is spending per person by income quintile. Spending power shows how individuals are doing over time relative to those in other income groups. These data can be calculated from published consumer expenditure data from the government’s consumer expenditure survey. An examination of these data from 1987 through 2012 shows that spending inequality has not changed.
I calculate spending on a per-person basis because the number of persons in a household varies by quintile in order to produce comparable measures. These data are converted into 2012 dollars using the Bureau of Labor Statistics Consumer Price Index for all urban centers. For a given level of income, a family is better off with fewer people.
Table 2 shows that the average annual spending for a household in the lowest quintile in 2012 was $13,032 per person. In contrast, the average spending for a household in the top quintile was $32,054 per person.
On a per-person basis, households in the top fifth of the income distribution spent 2.5 times the amount spent by the bottom quintile. That was about the same as 25 years ago. There is no increase in inequality. In addition, the overall level of inequality is remarkably small. A person moving from the bottom quintile to the top quintile can expect to increase spending by only 146%.
All income groups spent less in real terms in 2012 than in 2007 because of the recession. Those in the bottom group spent 2.3% less, those in the middle quintile spent 8.5% less, and those in the top quintile spent 4.3% less. The fact that higher-income groups reined in spending more is not surprising, as a higher portion of their income is discretionary.
Compared with 1987, the big winners are the lowest-income group, whose expenditures increased by 12.1% in constant dollars. In contrast, the highest group spending per person increased by only 9.2%. This shows that even though the distribution of income might be wider, those at the bottom are doing better than they did 25 years ago because they have greater spending power, after adjusting for inflation.
From 1987 to 2007, all groups did better. But over the past five years, expenditures per person have declined in all groups.
President Obama bemoans inequality, but much of this concern is a problem in search of reality, caused by problems of measurement and changes in demographic patterns over the past quarter-century. Spending shows remarkable stability over the past 25 years and, if anything, a narrowing rather than an expansion of inequality.
This piece originally appeared in WSJ's MarketWatch
This piece originally appeared in WSJ's MarketWatch