Income Inequality

How much income inequality is appropriate? This is a hotly debated topic among economists and politicians. Nearly everyone in industrialized countries agrees that we should have some degree of income inequality. The debate is about how much inequality is fair. The current degree of inequality in the United States is shown in the table below.

Inequality has remained relatively constant in the United States recently. It has widened since a few decades ago though. For example, in 1979 the top 20% earned 44% of the total income. In 2015 (the latest reported year as of this writing), the highest income earners (top quintile) earned 51.1% of the country’s total earnings. Thus, the highest income earners are earning more as a percentage of total earnings in the country. The lowest quintile of income earners’ share has decreased since a few decades ago. Is this a bad thing? Not necessarily. While the relative share of the lower income groups has declined, the absolute amount (absolute standard of living, or purchasing power) of all income groups has increased. It is true that the highest income groups gain the most, but looking at any average 10 year period of time, even the real (inflation adjusted) income of the poorest 20% rises by about 6%. The total income pie (see pie chart below) gets bigger because of economic growth.

Percentage Distribution of Households, by Income Group

Income Amount in Current Dollars (for 2015 data), appr. 25 million households in each quintile Percent of All Income Received (2015)* Percent of All Income Received (2013)* Percent of All Income Received (2011)* Percent of All Income Received (2009)* Percent of All Income Received (2007)* Percent of All Income Received (2006)* Percent of All Income Received (2005)* Percent of All Income Received (1979)*
Lowest quintile; under $22,800 3.1 3.2 3.2 3.4 3.4 3.4 3.4 4.2
Second quintile; upper limit = $43,511 8.2 8.4 8.4 8.6 8.7 8.6 8.6 10.3
Third quintile; upper limit = $72,001 14.3 14.4 14.3 14.6 14.8 14.5 14.6 16.9
Fourth quintile; upper limit = $117,002 23.2 23.0 23.0 23.2 23.4 22.9 23.0 24.7
Top quintile; over $117,002 51.1 51.0 51.1 50.3 49.7 50.5 50.4 44
Top 5% of all income earners; over $214,462 22.1 22.2 22.3 21.7 21.2 22.3 22.2 16.4

*Quintile percentages may not add to 100% due to rounding.
Source: United States Census Bureau (www.census.gov)
For the latest statistics on income distribution in the United States, visit https://www.census.gov/data/tables/2016/demo/income-poverty/p60-256.html

Are the Rich Getting Richer and the Poor Getting Poorer?

Even though the income inequality between the top and the bottom earners in the United States is widening, the overall standard of living (even after adjusting for inflation) for the large majority of people during most (with the exception of recessionary) years in this country is rising. In great part, this is because of income inequality. A free market economy leads to income inequalities. However, a free market economy also encourages hard work, innovation and increased productivity and increases the standard of living for many. Some people might feel worse off in comparison, but in an absolute sense, most people can afford to buy more and enjoy more purchasing power and higher quality products in comparison to years ago.

Economists who claim that the poor are getting poorer and the rich are getting richer are only partly correct. They are correct about the rich getting richer, both in absolute and relative terms. But the poor are getting poorer only in relative terms, not in absolute terms. Thus, they are incorrect about the poor getting poorer, if they are referring to the absolute standard of living and purchasing power (the size of the slice) of the poor.

The pie charts below illustrate this trend. Let’s study the income shares of the poorest quintile in year A (for example, 30 years ago) and year Z (today). Let’s say that in year A, the poorest quintile earned 4 % of all income. Let’s say that in year Z, the poorest quintile earned approximately 3 % of all income. The year A share is a bigger percentage of that year’s total pie. However, the year Z share is a bigger absolute slice. Would you prefer 4 % of a small pizza, or 3 % of a large pizza?

piechartsincineqnew

Income Mobility

Another consideration of the “Are the poor getting poorer?” debate is whether the poor people in year A are the same poor people in year Z. The Census Bureau has conducted studies of people, and tracked them over ten-year periods of time. It found that during a recent decade, nearly 60% of people who are in the lowest income quintile (20%) moved to a higher quintile within ten years (https://www.stlouisfed.org/publications/itv/articles/?id=1920). Countries with income inequality and free market opportunities tend to be dynamic and mobile, and most people have significant opportunities to improve their economic situation over time. Conversely, high income earners may experience downward mobility; 57% of the richest 1% moved out of this category ten years later (possible explanations include: lower job earnings; retirement; family break-ups (keep in mind that the statistics measure household incomes).

Transfer Payments and Taxes

Other factors to consider in the discussion about income inequality are non-cash transfer payments (food stamps, housing subsidies, government medical insurance assistance programs, etc.) to mostly the poorest 20%, and tax payments made by mostly the wealthiest 50% of all income earners. These two components are not included in the income distribution numbers. If non-cash payments were included, the Census Bureau estimates that income of the poorest 20% would increase by roughly 50%.  If tax payments were included the income of the wealthiest 20% would decrease by 7% (https://www.stlouisfed.org/publications/itv/articles/?id=1920).

The Lorenz Curve

A diagram illustrating the extent of income inequality in the United States is drawn below. This so-called “Lorenz Curve” indicates that the further the curve bows outward, the greater the country’s income inequality. The Lorenz curve illustrates the extent of a country’s income inequality based on the cumulative earnings of the different quintiles. Using the figures from the table above, the cumulative earnings are as follows:

Percent of All Families Cumulative Percent of All Income Received (2015) Percent of All Income Received (2007)
Lowest (poorest) 20% 3.1 3.4
Lowest 40% 11.3 12.1
Lowest 60% 25.6 26.9
Lowest 80% 48.9 50.3
All Households (100%) 100 100

The United States distribution shows the Lorenz curve traveling through Point A, at which the poorest 20% earn 3.2% of all income. At point B, 60% of the poorest income earners receive 25.6%.

The straight line indicates perfect income equality. This means that each quintile earns 20% of the country’s total income.

FIG91

The Gini Coefficient

The Gini coefficient is a ratio between 0 and 1. It represents the amount of income inequality in a country or area. If a country has a Gini coefficient of zero, then it has perfect income equality. This is when everyone has the same amount of income. If the coefficient is 1, then there is perfect income inequality. This is when one person has all the income, and the rest of the country has nothing. The closer the Lorenz curve is to perfect equality (the 45 degree line), the closer the Gini coefficient is to zero.

The Gini Index

The Gini index is simply the Gini coefficient expressed as a percentage. For instance, if the Gini coefficient is .3, then the Gini index is 30%. In 2015, the United States Gini coefficient was .479, so the Gini index was 47.9%. By comparison, Japan, Canada, and most industrialized Northern European nations have Gini indices ranging from 25 – 40% (less income inequality). Many third-world countries have Gini indices ranging from 50 – 75% (significant income inequality).

Video Explanation
For a video explanation of income distribution and income inequality, please watch: