Economics

Federal Reserve bank: ‘Income inequality should not be vilified’

I just stumbled across a fascinating analysis of U.S. income inequality produced by the Federal Reserve Bank of St. Louis and currently being highlighted on its website. It’s from 2008, so there is no reason its pre-Occupy insights aren’t as valid today. And this is the gutsy conclusion by author Thomas Garrett, a St. Louis Fed staffer: “Income inequality should not be vilified, and public policy should encourage people to move up the income distribution and not penalize them for having already done so.”

See, the study notes how income growth—as measured by the U.S. Census Bureau—reveals that the income for wealthier households has been growing faster than the income for poorer households. Real income for the wealthiest 5 percent of households rose by 14 percent between 1996 and 2006, while the income for the poorest 20 percent of households rose by 6 percent. As a result, the income of the wealthiest 5 percent of households was 8.1 times that of the income of the poorest 20 percent of households in 1996 and increased to 8.7 times by 2006. Thus, income inequality increased over that time period.

But the study says those numbers create “an inaccurate picture” of income inequality for the following reasons (highlights and summaries by me):

1.The snapshot problem. These census stats only provide a snapshot of the income distribution at a single point in time. The statistics do not consider the reality that the income for many households changes over time, i.e., incomes are mobile. The income of most people increases over time as they move from their first low-paying job in high school to a better paying job later in their lives. It is also true that some people lose income over time due to business cycle contractions, demotions, career changes, retirement, etc. The point is that individuals’ incomes are not constant over time, which implies that the same households are not in the same income quintiles over time. Thus, comparing different income quintiles over time is the proverbial “comparing apples to oranges” because incomes of different people are being compared at different stages in their earnings profile. (See above chart of U.S. Treasury study on income mobility.)

2. The non-cash resources problem. Another problem with the inequality statistics is that they do not consider the non-cash resources received by lower income households and the tax payments made by wealthier households to fund these transfers. Lower income households annually receive tens of billions of dollars in subsidies for housing, food, and medical care. None of these is considered income by the Census Bureau. Thus, the resources available to lower-income households are actually much greater than is suggested by their income. On the other hand, these non-cash payments to lower income households are funded through taxpayer dollars, mostly from wealthier households since they pay a majority of overall taxes. One research report estimates that the share of total income earned by the lowest income quintile increases roughly 50 percent, whereas the share of total income earned by the highest income quintile drops roughly 7 percent when transfer payments and taxes are considered

3. The household size problem. The census statistics also do not consider the fact that the households in each quintile contain different numbers of people, and it is differences in income across people that provide a clearer measure of inequality. Lower income households tend to consist of single people with low earnings, while higher income households tend to be married couples with multiple earners. Thus, lower income households have fewer people than higher income households, thereby skewing the income distribution. When considering household size along with transfers received and taxes paid, the income share of the lowest quintile nearly triples and the income share of the highest quintile falls by 25 percent.

And here’s the study’s amazingly candid bottom line:

It is important to understand that income inequality is a byproduct of a well-functioning capitalist economy. Individuals’ earnings are directly related to their productivity. Wealthy people are not wealthy because they have more money; it is because they have greater productivity. Different incomes, thus, reflect different productivity levels. The unconstrained opportunity for individuals to create value for society, which is reflected by their income, encourages innovation and entrepreneurship. Economic research has documented a positive correlation between entrepreneurship/innovation and overall economic growth. A wary eye should be cast on policies that aim to shrink the income distribution by redistributing income from the more productive to the less productive simply for the sake of “fairness.” Redistribution of wealth would increase the costs of entrepreneurship and innovation, with the result being lower overall economic growth for everyone.

Income inequality should not be vilified, and public policy should encourage people to move up the income distribution and not penalize them for having already done so.

Exactly right. Indeed, vilification of wealth and anti-innovation rhetoric—such as blaming ATMs for high unemployment—helps create a public atmosphere hostile to entrepreneurship and economic dynamism.

2 thoughts on “Federal Reserve bank: ‘Income inequality should not be vilified’

  1. Your analisis falls short it leaves out verious aspects and your assumptions are lacking. First you do not take into account accumilated wealth i.e. inherited wealth which earns income without any link to productivity or any labor.

    Second starting point is not taken into account or should I say the relationship between family conections to wealth or political power. While there maybe some merit to some of your arguments the simple fact is current policies that attempt to reward the so called achivement of those who are by your definition the most productive also punish those who are productive and labor keeping the slaves in thier place.

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