Income disparity has not skyrocketed in recent years

Conventional Wisdom

Tax cuts for the rich have pushed income inequality up rapidly to record levels.

Facts

The most common measure of income inequality is the Gini Index, a calculation that captures in one number the difference between actual income distribution and perfectly even income distribution. The Gini Index summarizes the dispersion of income and ranges from 0, or perfect equality, to 1, or perfect inequality.

       Perfect equality would correspond to a Gini index of 0. In this scenario, the top 1% of income earners in a population would receive 1% of total income and the bottom 1% of the population would also get 1% of the income. A Gini index near 1 would be extreme inequality where, for example, the top 1% of the population receives 99% of the income and the remaining 99% of the people have to share out the remaining 1% of the income. A more complete explanation of the Gini index concept is shown in an appendix.¹⁸

      After increasing for 25 years, income inequality in the U.S. as measured by the Gini index was essentially stable from 2001 - 2005, the latest year for which information is available. The Gini Index had increased from .386 to .466 between 1969 and 2001 indicating increased inequality. Since then it has averaged .466, with the latest figure being .470 (+.004 over four years). What this tells us that the increase in income disparity in four years was so small it is not visible on a chart showing the Gini index for the two years..

The questions remain though, what caused the long-term increase in income inequality, and is it reason for concern? Former Federal Reserve Chairman Alan Greenspan writes in his book, The Age of Turbulence: Adventures in a New World, that the increase in income disparity from 1980 to 2003 is troublesome. This comment was widely reported in the press, but his explanation for the increase and the reason for his concern were not.

       Greenspan's explanation is very different from the conventional wisdom that tax cuts for the rich caused the increase in disparity. (It should be evident from our analysis in Chapter 2 that this could not mathematically be the case.) Rather he points to differences in educational standards between rich and poor as the cause and his recommended solution is to improve the quality of education for all Americans in order to provide advancement through educational opportunities for the poor. The reason for Greenspan's concern about increasing disparity is that lower income earners would pressure legislators to implement misguided policies purely out of their resentment for the rich.

      The International Monetary Fund, looking at income inequality on a more global scale points to a different but related cause for increasing disparity. According to a lengthy study by the IMF, "per capita incomes have also risen across virtually all regions for even the poorest segments of the world's population, indicating that the poor are better off in an absolute sense ... although incomes for the relatively well off have increased at a faster pace."¹⁹ They observed that income disparity has been on the rise everywhere, not just in the U.S., and they trace the increase to differences in the availability of technology. Quite simply, the more education and technical skill a person possesses, the better off financially he or she is likely to be.

Assessment

Blaming increases in income disparity on recent tax policies is false and leads to misguided solutions. The solution is to address the causes and improve education and technology availability among the poor.

Conventional Wisdom  (this is a continuation of section 6)

Poor people are doomed to stay poor while the rich get richer.

Facts

Income and social-class mobility are alive and well in the United States, as indicated by several recent studies. A 2007 Report from the Department of the Treasury, based on the examination of federal income tax returns from 1987 and 1996, reported that more than half of U.S. households (56% by one measure and 57% by another) moved to a higher or lower income quintile between 1987 and 1996. Approximately half of households initially in the bottom 20% of the population moved to a higher quintile within ten years. The largest percentage increases in real incomes were, in fact, earned by those who started out in the lowest income groups.²⁰

      A separate study by the U.S. Census Bureau published in 1998 reported that, on average, more than 41% of Americans increased their inflation-adjusted income by 5% or more per year from 1984 to 1994. The primary reasons for the change in income from year to year was either a change in marital status, a change in the number of workers in the household, or moving into or out of full-time year-round employment.²¹ A study by the Economic Policy Institute in 2000 showed that almost 60% of Americans in the lowest income quintile in 1969 were in a higher quintile in 1996, while over 61% in the highest income quintile had moved down into a lower income quintile during the same period.²²

Assessment:

Is there a substantial difference in income between rich and poor in this and all countries? Yes, but that's the wrong question. The correct question is: "Can the poor improve their lot? And, are they doing it now?" That is, can the poor move up the income ladder?

   Here's one way to look at it. Imagine that you have a choice between being in the bottom income quintile in two different countries. In Economy A (as shown in the diagram) the bottom quintile earns an average of $10,000 a year and the middle quintile earns $30,000. In Economy B, the bottom and middle quintiles earn averages of $10,000 and $50,000 respectively. So which one would you choose?

      If you can move up the quintile ladder, certainly Economy B is the better choice. If you can't move up, Economy B is still better because when the higher quintiles spend money, it fuels the economy and the rung you're on is likely to go up more than it will in Economy A. The only reason you might prefer Economy A is if envy is more important to you than opportunity.

      The U.S. is the land of opportunity and everyone has a chance to move up, so long as they demonstrate the capacity to learn and improve. Most people begin on the first rung. They are likely to move up over time. And in time some individuals or their children will make it to the level of Donald Trump or possibly even Bill Gates, and that's a good thing. Individuals at that level of income spend a lot of money to build the economy, and people like Bill Gates give away a lot of their money to help other people achieve wonderful things. Why would anyone want that to change?

Inequality: No Cause for Alarm

       Here's one more look at the Gini Index and how it measures income inequality. After increasing for 25 years, income inequality in this country has been essentially stable since 2001. The Gini Index is the most common measure of income inequality. It's simply a way of capturing the amount of inequality in a single number. A real world income distribution might look like the one below, where the lowest-earning fifth of the population earns 7% of the total income. In this graph, when you move right to 20% of the population, you only move up to 7% of cumulative income.

      The next fifth (or quintile) might earn 12%, and so on. When you get to 100% of the population, you of course reach 100% of the cumulative income. In the curve below. the straight line represents a "perfectly even" income distribution; the lower one, known as the Lorenz curve, is a more typical distribution. The Gini index is a measure of the area between the two curves, in the shaded area. The larger the area, the greater the income disparity.

Gini Explained

The Gini index is a way of capturing inequality in a single number. Since inequality is, by definition, a comparison of actual income distribution against perfectly equal distribution, the starting point for the Gini is a graph of "equality." If you plot the cumulative income of the five quintiles (fifths) of a population in which everyone has the same income, it looks like this:

This means simply that if you start with those earning least, on the left, and move up until you've reached 20% of the population--shown below.

 ...you will also have reached 20% of the cumulative income...

Since everyone earns the same amount in this scenario, 20% of the population = 20% of the income. 40% of the population = 40% of income, and so on.

 A real world income distribution might look like this one, where the lowest-earning fifth earns 7% of total income. In this graph, when you move right to 20% of the population, you only move up to 7% of cumulative income, not 20%.

The next fifth might earn 12%, and so on. When you get to 100% of the population you are of course always up to 100% of the cumulative income.

Take a look at the two curves below. The first (actually a straight line) is the "perfectly even" income distribution. The lower one, known as the Lorenz curve, is a more typical distribution. The Gini index is simply a measure of the area between the two curves, the shaded area. A larger area means income inequality is greater.

Here is what the U.S. Lorenz curve looked like in 2000 and 2005.

The chart below shows the curves for 1986, 2000, and 2005.