When It Comes to Inequality, Consumption Is What Matters
The following is an excerpt from Economics21’s new inequality primer, Income Inequality in America: Myths and Facts.
The most well-known
work on inequality has focused on the distribution of wages, earnings, or taxable income, leaving consumption out of the discussion. There are several reasons why consumption is a critical tool in measuring inequality and well-being. Consumption reflects typical income and is thus more permanent than measured income which often fluctuates from year to year. This permanence is because people tend to “smooth” their consumption over time as income fluctuates by borrowing or saving. Measures of income also do not reflect all available resources, including wealth, that improve well-being. For instance, more than 80 percent of people over 65 own a house and may make small or no payments on it. This is not factored into measures of income. Similarly, measures of income do not reflect access to credit, which differs across groups, nor do they reflect price changes in assets such as houses and stocks.
There are also difficulties in effectively measuring income for the purposes of inequality. Measures of income usually do not account for taxes and transfers, which have large effects on income inequality. For those near the bottom of the income distribution, income tends to be underreported, partly due to the exclusion of many non-cash transfers from the government.
There are also challenges to measuring consumption accurately, but many of the supposed weaknesses of consumption data are overstated or wrong. At least for those at the bottom of the distribution, consumption is more accurately captured in household surveys than income.
In the Consumer Expenditure Survey, the accuracy of the consumption measure depends on what type of consumption is being measured. For instance, the accuracy is high for rent, utilities, groceries, cars and gasoline. As might be expected, people are less accurate in reporting their consumption on alcohol, clothing, and furniture.
My coauthor, James Sullivan of Notre Dame, and I used information from a subset of total consumption that includes important spending categories that tend to be well reported, including housing and utilities, food at home, and transportation. These categories make up most of non-medical consumption, and relative to overall price changes, those for this core group have been small.
Even when using consumption rather than income, the question still remains: has inequality changed in the past 50 years? Looking at the ratios of the incomes of the 90th, 50th, and 10th percentiles compared to each other, the data do present a story of generally widening inequality, increasing from the 1970s on, even when taxes and non-cash benefits are factored in. However, when these ratios are considered using comparisons based on consumption, a very different story emerges. This shows that inequality in consumption rose at a much slower rate than income inequality over the past several decades. In recent years, even the direction of the change has differed.
Since 2006, the ratio of the 90th percentile to the 10th percentile shows rising inequality when incomes are compared, but a decline in inequality when consumption is examined. What exactly caused this shift is not entirely clear, but changes in housing and financial asset values can explain some of the pattern. Furthermore, one observes lower absolute levels of inequality when looking at consumption. A similar phenomenon of lower inequality is seen when comparing the 50th percentile and the 10th percentile, or the 90th and 50th percentiles.
When talking about consumption, a common question is “Have people over-consumed?” This question is largely irrelevant. For measurement purposes, it does not matter. A consumption measure shows us whether a person drives a car or eats a meal regardless of other factors, and spending cut-backs are recorded as well. The financial crisis and recession forced many people to adjust their consumption plans when their incomes and asset values changed—there are, perhaps, better questions to be asked when it comes to how people are spending.
One such question is, “Does the balance sheet of the population look worse than in the past?” Our research provides the answer. In these terms, the bottom 20 percent of the population has little assets or debts, so there is little to examine. The middle 20 percent has seen a rise in debt, but this level is now well below its peak. Moreover, the net worth of this quintile is also above what it has been in the past, except for the years around the peak of the housing bubble. It would seem, then, that the balance sheet of the population does not look worse than it has in the past.
Over the past five decades, both income and consumption inequality have risen. The level of inequality is much lower for consumption than income, and since 1980, consumption inequality has risen considerably less than income inequality. Income inequality has generally increased episodically, with concentrated spurts in the late 1970s, early 1980s, and in the last several years. And since 2006, though income inequality has been rising, consumption inequality has been falling.
The causes of these differences are somewhat unclear. Demographic changes can account for some of the changes in consumption and income inequality, particularly in the 1980s, but account for few of the changes overall. The quality of the income data at the bottom may also explain some of the differences. Changes in asset prices could play the biggest role in explaining the difference, at least in recent years.
As for inequality being the defining issue of our time, our research indicates that when looking at inequality from a more holistic perspective, and when measurement tools are thoroughly analyzed, there may be more facets to inequality than commonly considered. While there is evidence of income inequality increasing over the past five decades, the increase has only partially affected consumption inequality, which is where policy-makers should concentrate their efforts.
Taken from the Economics21 issue brief, Income Inequality in America: Myths and Facts.
Bruce Meyer is the McCormick Foundation Professor at the Harris School of Public Policy Studies at the University of Chicago.
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