Income Inequality

Charles Wolf, Jr., and John Godges on isolating its sources

Charles Wolf, Jr., holds RAND’s distinguished chair in international economics. John Godges, a RAND communications analyst, is editor-in-chief of RAND Review.

Income Inequality, which became the principal concern of the Occupy Wall Street movement of late 2011 and much of 2012, has remained a prominent issue throughout a presidential campaign season focused on jobs, the economy, and taxes. Unfortunately, the ongoing U.S. debate on income inequality emphasizes the magnitude of inequality and the changes in it. The debate neglects why inequality occurs, which reasons are good and which are not, and what, if anything, to do about it.

President Obama argues that the U.S. tax code has benefited the wealthy and well connected at the expense of the vast majority of Americans. His campaign asserts that a third of the 400 highest-income taxpayers paid an average rate of just 15 percent or less in 2008. That is why he has proposed the Buffett Rule, asking millionaires and billionaires to pay their “fair share.” Obama has also asked Congress to reform the tax code and to close tax loopholes for millionaires and billionaires, as well as hedge fund managers, private jet owners, and oil companies. Meanwhile, he has cut taxes for middle-class families and small businesses.

The crucial question is what accounts for the inequality?

Governor Romney, in contrast, argues that America’s individual tax code applies relatively high marginal tax rates on a narrow tax base, discouraging work and entrepreneurship, and that the country’s 35-percent corporate tax rate is among the highest in the industrial world, reducing the ability of the nation’s businesses to compete in the global economy. Romney promises to make a permanent, across-the-board, 20-percent cut in individual marginal tax rates; to eliminate taxes on interest, dividends, and capital gains for those with adjusted gross incomes below $200,000; to cut the corporate tax rate to 25 percent; and to repeal other taxes.

In the charged environment of the U.S. presidential election campaign, this debate is sometimes referred to as “class warfare.” The heated debate includes allusions to the role of inequality as a contributing cause of America’s recession, the increased inequality that has resulted from the recession, and the extent to which increased inequality has adversely affected the pace and vigor of recovery from this recession compared with prior ones.

Trader Peter Tuchman
  Beverly McKinney
Left: Trader Peter Tuchman shouts in triumph on the floor of the New York Stock Exchange on March 13, 2012. The January–March quarter brought the best quarterly gain in stock prices since 1998 and the first rise in U.S. home values since 2006.
Right: Beverly McKinney, 63, must sleep in her wheelchair at St. Martin de Porres Church in Yorba Linda, California, because a knee injury prevents her from sleeping on the floor. Her possessions include two blankets, spare clothes, and her husband’s ashes. She became homeless after his death in August 2011.

It is useful to consider the best single indicator of inequality: the Gini coefficient, named for the 20th-century Italian statistician Corrado Gini. The Gini coefficient represents the gap between a percentage of the population and its corresponding percentage of income received.

If 1 percent of the population receives 1 percent of total income, and 5 percent of the population receives 5 percent of total income, and all other population percentages receive their corresponding percentages of total income — that is, if there is no gap between the population and income percentages — then the Gini coefficient is 0, representing perfect equality of incomes. If, at the other extreme, a single recipient receives all income, then the Gini coefficient hits its peak of 1, representing maximum inequality. In the real world, the country with the greatest income inequality is Namibia, where the bottom 70 percent of the population earns only 7 percent of the income and the top 30 percent earns 93 percent of the income, resulting in a Gini coefficient of 0.71. Sweden has one of the lowest Gini coefficients, at 0.23.

According to the best U.S. government data estimating Gini coefficients around the world, the Unites States falls in the middle of the range (between 0.45 and 0.49). European countries show less inequality than the United States, as do Japan, South Korea, India, Turkey, and Israel. Several rapidly growing developing economies, including Brazil, show greater inequality.

But whether any level or change in the Gini coefficient is “good” or “bad” cannot be inferred from the coefficient alone. The crucial question is what accounts for the inequality? For those with more income, is it due to greater work effort, higher labor productivity, innovation, entrepreneurship, better technology, more efficient management; or, instead, to favoritism, nepotism, collusion, bribery, fraud, insider trading, special privilege, other forms of corruption, or unequal opportunity? If the explanation lies in higher productivity and better management, then the income inequality warrants encouragement. If, instead, the inequality is due to nepotism and corruption, it should be combated and reversed. If the answer is a combination, which explanation predominates? And how can the positive factors be encouraged, while the latter are reduced?

The mixed picture of income inequality around the world reinforces the basic take-away point: It is more important to know the underlying explanations for inequality across countries and within them, rather than the amount of inequality or changes in it. The inequality debate should focus more on the sources of and reasons for inequality, and less on how much inequality there is, or how much it has changed; more on explaining inequality, and less on deploring or defending it. square

Related Reading

“The Inequality Debate: The United States Versus China,” The International Economy, June 4, 2012, Charles Wolf, Jr.

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