What Drives Income Inequality?


(The Orange County Register)

Occupy Wall Street demonstration in October 2011

Occupy Wall Street demonstration Oct. 2011

photo by Kimberlyki/Flickr.com

by Charles Wolf, Jr. and John P. Godges

October 24, 2012

The U.S. presidential campaigns have emphasized the magnitude of the changes in income inequality. Unfortunately, despite the rhetoric, the key questions continue to be ignored: Why does inequality occur? Which reasons contribute to economic growth and hence are good, and which are injurious and warrant countervailing action?

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.

At one extreme, if 1 percent of the population receives 1 percent of the total income and 5 percent of the population receives 5 percent, and all other population percentages receive their corresponding percentages of total income, then the Gini coefficient is 0, representing perfect equality of incomes. There is no gap between the population and income percentages.

At the other extreme, if 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 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 United States falls mid-range, between 0.45 and 0.49, having risen from a 45-year low of 0.386 in 1968 to a 45-year high of 0.477 in 2011. European countries show less inequality than the United States, as do Japan, South Korea, India, Turkey and Israel. Several rapidly growing 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.

Wolf holds the distinguished chair in international economics and Godges is editor-in-chief of RAND Review at the nonprofit, nonpartisan RAND Corporation. This op-ed is adapted from an essay that first appeared in RAND Review.

This commentary originally appeared in The Orange County Register on October 22, 2012. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.