by David R. Henderson for Reason

The Truth About Income Inequality

Should we be worried about the wealth amassed by the so-called 1 percent?

"The issue of wealth and income inequality, to my mind, is the greatest moral issue of our time," said presidential candidate Sen. Bernie Sanders (I–Vt.). Former Secretary of Labor Robert Reich claims that "great wealth amassed at the top" will cause us to lose democracy. To fight economic inequality, presidential candidate Sen. Elizabeth Warren (D–Mass.) is calling for a 2 percent annual tax on household net worth between $50 million and $1 billion and a 3 percent tax on net worth above $1 billion.

Language like that and proposals like Warren's make increasing inequality sound like a crisis. But they misread the situation and misdiagnose the underlying problems.

On a global scale, inequality is declining. While it has increased within the United States, it has not grown nearly as much as people often claim. The American poor and middle class have been gaining ground, and the much-touted disappearance of the middle class has happened mainly because the ranks of the people above the middle class have swollen. And while substantially raising tax rates on higher-income people is often touted as a fix for inequality, it would probably hurt lower-income people as well as the wealthy. The same goes for a tax on wealth.

Most important: Not all income inequality is bad. Inequality emerges in more than one way, some of it justifiable, some of it not. Most of what is framed as a problem of inequality is better conceived as either a problem of poverty or a problem of unjustly acquired wealth.

Measuring Inequality

First, though, let's look at how much inequality there is. The Congressional Budget Office (CBO) produced a report in November 2018 on the growth of household income in each of five quintiles. Between 1979 and 2015, average real income for people in the top fifth of the population rose by 101 percent, while it rose for people in the bottom quintile by "only" 32 percent. For the middle three quintiles, average real income increased by 32 percent as well.

Or at least those are the numbers if you ignore the effects of taxes and direct government transfers. But you really shouldn't leave those out: If you're debating whether to increase taxes on the rich and transfers to the poor, it seems important to take into account the taxation and safety net already in place. Once the CBO researchers subtracted taxes and added welfare, Social Security, and so on, the picture changed dramatically for the lowest quintile: Income rose by 79 percent. (For the middle three quintiles, it increased by 46 percent. For the highest quintile, it went up by 103 percent—slightly more than before, probably thanks to Ronald Reagan's and George W. Bush's tax cuts.)

The above data on real income growth actually understate the growth of income for each quintile. When the CBO compares incomes over time, it measures inflation using the Consumer Price Index (CPI). But many economists have concluded that the CPI overstates inflation by not sufficiently adjusting for new products, improvements in quality, changes in the mix of goods and services purchased, and shifts in where consumers buy their goods. (The latter factor is sometimes called "the Walmart effect," but that term is arguably dated. Maybe we should call it "the Amazon effect" instead.)

Stanford economist Michael Boskin estimates that the CPI overstates inflation by 0.8 to 0.9 percentage points a year. That's small for any given year, but over time it doesn't just add up—it compounds up. If you go with the conservative estimate of 0.8 percentage points and adjust the CBO's after-tax, after-transfer data accordingly, the top quintile's average real income between 1979 and 2015 increased by 168 percent and the bottom quintile's average real income increased by 136 percent.

That's still an increase in income inequality, of course. But it's not an inequality increase in which the poor and near-poor are worse off. They're much better off. Everyone is.

And those numbers don't do complete justice to how much better off we are. Donald J. Boudreaux, an economist at George Mason University, has compared the prices of items you could have bought from a Sears catalog in 1975 with prices for similar items in 2006. He shows that with the average wage in 2006, you would have to spend far less time working to earn enough to buy the items than you would have had to spend in 1975. Moreover, he notes, the 2006 items are almost always of much higher quality. Who wants a 1975 TV? In 2010, my local Goodwill wouldn't even accept a working 1999 TV. And those awful primitive cellphones everyone had in 1975? Oh, wait.

I asked Boudreaux to update his data to 2019. Since 2013, he told me, the "time cost" of his chosen goods has fallen by another 30 percent.

I should note that while most consumer goods have been getting cheaper, education, housing, and health care have become more expensive. Interestingly, these are all areas in which governments have had a substantial influence on prices. In education, state and local governments have almost a monopoly; in housing, governments on the West Coast and in the Northeast have so restricted new construction that supply has not kept up with demand, causing prices to explode; and in health care, extensive regulation and subsidization have driven up the cost, though not always the price, of health care. (The difference is that the price to the consumer is often low because insurance and government subsidies hide the true cost, which is often high.)

On a global level, meanwhile, inequality is declining—and it's likely to fall further.

Economists measure inequality with something called the Gini coefficient. A coefficient of 100 would mean that one person gets all the income while everyone else gets nothing; a coefficient of zero would mean complete equality. In a 2015 study published by the Peterson Institute for International Economics, Tomas Hellebrandt of the Bank of England and Paolo Mauro of the International Monetary Fund tracked the global Gini coefficient from 2003 and 2013. During that time it fell from 69 to 65, thanks to rapid economic growth in lower-income countries—not just India and China but also sub-Saharan Africa. Hellebrandt and Mauro project that by 2035 it will have declined to 61.

What About Mobility?

Often when we look at income inequality, we do it by comparing income "quintiles." That is, we ask how much better or worse the richest fifth of the population did over a span of time vs. the second-richest, the middle, the second-poorest, and the poorest fifths. But it's important to keep in mind that there is substantial mobility from one quintile to another, even over just a few years. In a 2015 report for the Census Bureau, Carmen DeNavas-Walt and Bernadette D. Proctor concluded that "57.1 percent of households remained in the same income quintile between 2009 and 2012, while the remaining 42.9 percent of households experienced either an upward or [a] downward movement across the income distribution."

That's important to remember when considering the frequently stated worry that the middle class is disappearing. The middle class is getting smaller—but it's disappearing, for the most part, because it's moving up.

Now, it matters how we define the middle class. If the middle class is defined as the middle three income quintiles, then in 2018 it consisted of households with income between $25,600 and $130,000. In 1967, the middle three quintiles had income ranging from $19,726 to $54,596 (in 2018 dollars). The people in the middle, in other words, are considerably richer than their counterparts a half century ago.

Of course, defining the middle class that way means that exactly 60 percent of households will always qualify. That seems too broad. American Enterprise Institute economist Mark Perry, on his blog Carpe Diem, defines the middle class more narrowly to include any household with an income, in 2018 dollars, of between $35,000 and $100,000. In 1967, he notes, 54 percent of households were in that category; by 2018, that was down to 42 percent. That wasn't because they slipped; it was because they rose. In 1967, only 9.7 percent of U.S. households had income of $100,000 or more (in 2018 dollars). By 2018, that percentage had more than tripled to 30.4 percent.

And remember that this calculation adjusts for inflation using the CPI, and the CPI overstates inflation. So in some ways, the improvements are even greater than Perry's data suggest. On the other hand, the numbers arguably overstate the progress for people who live in coastal California, other urban parts of the West Coast, and the coastal northeastern United States, where the cost of housing has skyrocketed thanks to barriers erected by local and state governments.

On a related note: It's important to distinguish the concepts of inequality and poverty. The distinction seems obvious, yet even some economists confuse the two. In 2015, for example, University of Oregon economist Mark Thoma, author of the popular Economist's View blog, wrote: "Recent research…from UCLA's Fielding School of Public Health provides evidence that income inequality is associated with inequality in health. In particular, lower income is associated with 'high levels of stress, exhaustion, cardiovascular disease, lower life expectancy and obesity.'"

Notice that Thoma subtly jumps from "income inequality" to "lower income." Absolute real incomes certainly could be plausibly connected to health, but that's a separate question from how well off someone is relative to others. It's hard to believe that if group A's real income increases by a large percent but group B's income increases by an even larger percent, group A's health would worsen.

The 1 Percent

One reason so many people worry about income inequality is that they believe the share of income that accrues to the top 1 percent has increased dramatically. This became a hot issue during Bill Clinton's run for the presidency in 1992, and President Barack Obama harped on it repeatedly during his years in office. French economist Thomas Piketty's influential 2014 bestseller, Capital in the Twenty-First Century, also put a lot of emphasis on this assertion.

Piketty and the Berkeley economist Emmanuel Saez have estimated that, for the United States between 1979 and 2015, the top 1 percent's share of pretax income (including capital gains) increased from 9.0 percent to 20.3 percent. But in a 2018 paper, economists Gerald Auten of the U.S. Treasury Department and David Splinter of the congressional Joint Committee on Taxation came to a very different conclusion. To get a better measure of income, they accounted for all of national income, including unreported income, retirement income missing from tax returns, and income due to changes in the tax base that resulted from the Tax Reform Act of 1986. Their conclusion: Between 1979 and 2015, the share of pretax income going to the top 1 percent rose from 9.5 percent to 14.2 percent, and the share of after-tax, after-transfer income rose even less, from 7.2 percent to 8.5 percent.

Who's right? Piketty and Saez have moved in Auten and Splinter's direction with a more complete accounting for income. Their new approach found that the top 1 percent's share rose from 9.1 percent in 1979 to 15.7 percent in 2014. Half of the remaining difference between Piketty/Saez and Auten/Splinter is due to how the pairs handle underreported business income. Piketty and Saez assume that underreported income is proportional to reported business income, whereas Auten and Splinter assume that lower-income business owners disproportionately underreport. Auten has been at Treasury since 1987, which makes me inclined to trust his instincts here, but you can decide for yourself.

In any case, one thing that is clear from the data is that the higher your income, the higher the percent of your income you pay to Washington. In 2015, according to a recent study from the Tax Foundation, people in the lowest quintile paid 1.5 percent of their income in federal taxes, on average; the second quintile paid 9.2 percent; the middle quintile, 14.0 percent; the fourth quintile, 17.9 percent; and the highest quintile, 26.7 percent. Those in the top 1 percent paid a whopping 33.3 percent. This includes all federal taxes: income taxes, taxes for Social Security and Medicare, corporate income taxes, and excise taxes.

That means that whenever there is a large federal tax cut, those in the top quintile will almost certainly get a much bigger benefit, both in dollars and as a percentage of their income, than other quintiles. This is especially true when most or all of the cut is in the individual income tax, because that tax is disproportionately paid by higher-income people. But do they get a bigger cut as a percentage of their federal tax burden? For the George W. Bush 2001, 2002, and 2003 tax cuts and the Donald Trump 2017 tax cuts, the answer has been no.

Because of Bush's tax cuts, people in the second-lowest quintile in 2004 saw a 17.6 percent cut in their income taxes, the biggest percentage tax cut of any quintile. The middle quintile's cut was 12.6 percent, the second-highest quintile's cut was 9.9 percent, and the highest quintile's cut was slightly more than 11 percent.

Similarly, the 2017 Trump cuts reduced taxes most, percentage-wise, for the second-lowest quintile, cutting their taxes by 10.3 percent. The middle quintile got an 8.7 percent cut; the second-highest quintile, a 7.5 percent cut; the top quintile, a 6.7 percent cut; and the top 1 percent, a 4.6 percent cut. The lowest quintile had its taxes cut by 7.3 percent—it's hard to cut taxes for a quintile whose members mostly don't pay them.

Many people who worry about income inequality want to tax higher-income people more. Given what economists know about the harmful effects from raising already high marginal tax rates even higher, tax increases could certainly reduce measured inequality—because they would cause higher-income people to reduce their taxable income by working less, by taking more pay in the form of untaxed fringe benefits, or by investing more in municipal bonds, whose interest is not taxable by the feds. Of course, none of this would make lower-income people better off. Indeed, to the extent that higher taxes discourage capital accumulation, they slow the growth of worker productivity. One of the main ways to increase worker productivity is to increase the amount of capital per worker. With a slower growth rate of capital, worker productivity will grow more slowly—and so will real wages. This makes lower-income people worse off than they would have been.

Piketty recognizes that higher tax rates won't yield much additional tax revenue. In his 2014 magnum opus, he wrote that when a government "taxes a certain level of income or inheritance at a rate of 70 or 80 percent, the primary goal is obviously not to raise additional revenue (because these high brackets never yield much)." Instead, he argued, the goal is to "put an end to such incomes and large estates."

Because of limited space, I have focused on income inequality rather than wealth inequality. I will point out, though, that a tax on wealth—proposed both by Piketty and by Warren—would reduce the incentive to invest in capital, decreasing worker productivity and, therefore, workers' wages.

Two Kinds of Inequality

When is a growth in inequality justified, and when is it not? Consider two opposite cases: an innovator and a seeker of privilege.

In 1949, Robert McCulloch introduced the 3-25, a one-man chainsaw weighing only 25 pounds. This revolutionized forestry. A friend of mine, now in his late 80s, told me that when he was a teenager, his father made him cut wood for a whole winter of heating a large house. When my friend found out about the 3-25, he used his own allowance to buy one. It changed his life.

McCulloch made a lot of money with his chainsaw. But everyone who bought a 3-25 wanted it. It's likely that almost all of them got a large benefit from the purchase. McCulloch got richer, and so did his customers, who were able to save huge amounts of time and effort. Eventually, competitors produced their own chainsaws to compete with McCulloch's—products that were better, cheaper, or both.

That increased the benefits to consumers while reducing the profits to McCulloch. Still, he made a lot—enough that his innovation almost certainly increased income inequality, by raising McCulloch's income far above most other people's.

Now consider a story in which someone used political power to make himself and his wife very wealthy. In 1942, a young congressman from Texas had a net worth of approximately zero. But by 1963, when he became president of the United States, Lyndon Johnson and his wife had a net worth of about $20 million, a large part of which could be attributed to a license from the Federal Communications Commission (FCC) to operate the radio station KTBC in Austin, Texas.

During the 1964 presidential campaign, Johnson claimed that his wife had turned an asset she bought for $17,500 into a property worth millions by working hard. Not quite. Lyndon had worked hard—at using his political influence as a congressman. Before his wife acquired it, KTBC's owners had spent years trying to get the FCC's permission to sell the station. On January 3, 1943, Lady Bird Johnson filed her application to buy it, and just 24 days later, the owners were suddenly allowed to sell. That June, the future first lady applied for permission to operate for more hours a day and at a much better part of the AM band. She received permission a month later.

While all this was happening, the FCC was under attack by a powerful congressman, Eugene Cox, who wanted to cut the FCC's budget to zero. Lyndon Johnson strategized secretly with an FCC official named Red James and used his influence with House Speaker Sam Rayburn to deflect the attack. James later admitted that he had recommended to Lady Bird that she apply for the license.

Over the subsequent decades, the FCC didn't just clear an easy path when her radio station (and, later, a television station as well) needed an application approved. When a competitor wanted to make a move, the agency would put regulatory barriers in its way. In this manner, Lady Bird's company came to dominate Austin broadcasting.

So here we have two examples of income and wealth inequality increasing. In the first case, inequality increased because a man's company introduced a product that made the lives of those who bought it substantially better, raising their real incomes. In the second case, inequality increased because a politician used his influence to get monopolistic privileges from a federal agency, making the politician wealthier and lowering the real incomes of people in the Austin area.

There are at least two reasons to think differently about these two cases. The first is that McCulloch's actions improved others' well-being in addition to his own, while the Johnsons' actions benefited themselves at the expense of others. The second is why McCulloch's actions had those benevolent social effects and Johnson's didn't. McCulloch's wealth—and the benefits to his customers—were rooted in voluntary transactions in the marketplace. The Johnsons' wealth was rooted in raw political power.

There is a third possible source of wealth for the very rich: inheritance. Some people inherit wealth from fortunes like McCulloch's, and some inherit it from fortunes like the Johnsons'. The important question, as far as I'm concerned, is how the money is initially acquired. But in any event, the long-term importance of inheritance in American inequality is overstated. In the May 2013 American Economic Review, Steven Kaplan of the University of Chicago and Joshua Rauh of Stanford analyzed the fortunes of the superwealthy. They found that only 32 percent of people on the Forbes 400 list in 2011 had come from very rich families—down from 60 percent in 1982. Moreover, 69 percent of the 400 had started their own business. In short, a majority of those who made fortunes made fortunes. Maybe they made it the McCulloch way, maybe they made it the Johnson way, or maybe it was a mix. But they didn't simply rely on their parents.

The Real Problem Isn't Inequality

The word inequality sparks thoughts of the very rich and the very poor. But data on the degree of inequality tell us nothing about the degree of poverty or the lives of the poor. Inequality can grow even while the poor and almost everyone else are becoming better off. Indeed, in the last half-century, while U.S. income inequality grew, the poor and the middle class became substantially better off. And the even better news is that global income inequality has fallen and is likely to fall even further.

Great wealth, meanwhile, is a problem only to the extent that it is unjustly extracted. Government favoritism to politically powerful people may increase income and wealth inequality, as it did in the case of Lyndon Johnson and his wife. But it is the government favoritism, not inequality per se, that is the true problem.

The Important Role of Work

Many people, including many economists, who worry about income inequality overlook the role of work. You might imagine that the rich are generally idle while the poor work their fingers to the bone. But that's not the full picture.

The Department of Commerce's Census Bureau gathers data annually on characteristics of the five income quintiles. One thing that changes very little from year to year is the number of workers per household.

The data for 2018 are no exception. Each quintile that year was made up of 25.7 million households. For the lowest quintile, 16.2 million households had no one working at all during 2018. For the highest quintile, by contrast, only 1.1 million households had no one working. How many households in the bottom quintile had two earners? Only 1.1 million, or 4.3 percent of the total number of households. For the top quintile, 14.1 million households, or 54.7 percent of the total, had two earners. Not surprisingly, therefore, the average number of workers per household in the bottom quintile was 0.4, while the average number for households in the top quintile was 2.1.

The lesson seems clear for people who want to avoid being in the bottom quintile: Try your hardest to get a job year-round. Fortunately, that is relatively easy in the current economy, with its less than 4 percent unemployment rate. To further improve your chances, get married to—or just live with—someone else who works year-round as well.