What to Measure When Measuring Inequality?

Income inequality is a popular topic for many liberals. If you do a google search on Kevin Drum’s blog on income inequality you get quite a few hits. Crooked Timber also has a large number of posts on this as well. However, is income the best measure to use when looking at inequality?

Diana Furchtgott-Roth notes one reason why income may not be the best measure of inequality.

And spending is vital because it determines our current standard of living and our confidence in the future. It shows how much money Americans have. The usual pretax measures of income on which most inequality studies are based don’t show how much money Americans have and don’t provide an accurate measure of inequality.

The top 50% of earners pay 97% of income taxes, so all their income is not available for spending. Lower-income Americans receive transfers such as Food Stamps, housing vouchers, Medicaid, and Medicare, so they consume more than their stated income. Middle-income Americans have assets in pension and individual retirement accounts that are not included in income. Therefore, spending is a far better guide to well-being than pretax income.

The idea that one should use consumption spending vs. income is not new.

Consumption is often claimed to be a better measure of permanent income and thus well-being, but most studies of inequality and mobility using U.S. data focus on income. To examine inequality at a point in time, cross sectional data is sufficient. The evaluation of mobility, however, requires longitudinal data in order to follow particular individuals over time. One reason for the focus on income instead of inequality is that no longitudinal data has a complete measure of consumption.

What determines one’s standard of living is not income, although that is an important factor. Spending is much more what determines one’s standard of living. To the extent that one’s income is not available for spending (taxes) or that one’s income is supplemented (subsidies and vouchers) means that income is an imperfect measure for inequality.

John Quiggin thinks that the stability of consumption spending is a sign that people are using credit cards.

(Annual) Consumption inequality has not changed much since 1970. In my judgement, this reflects increased use of credit markets to smooth out short term fluctuations in income, which offsets increased long-run inequality

Frankly I don’t buy this. Borrowing is basically taking future income and using today. If one keeps doing that then eventually we’d expect to see a decline in future consumption. About the only way out of this problem is that people are declaring bankruptcy which is what Quiggin thinks is happening. However, I’m not convinced that bankruptcy is occuring frequently enough and has small enough costs/penalties to allow people to make up the difference in income. We are talking about a 30 year period here where incomes have become more unequal, but consumption has not. For example, Quiggin cites Todd Zywicki’s research on bankruptcy, but that data indicates that bankruptcies occur at a frequency of 14/1000 families in 2003. Further, Quiggin seems to mixing apples and oranges.

The typical story is that incomes are becoming less equal and, according to Quiggin, this difference in terms of consumption is being covered by credit. But, Quiggin also tells the story of people whose income has become more volatile and that they use credit to smooth out consumption. The second story, for which there might be reasonable evidence, does not mean the first story has to be true. So while it is true that bankruptcies have increased, I’m not sure it explains why consumption spending indicates much less inequality than does income.

Update: In comments John Quiggin explains his view of consumption and income inequality in a slightly different manner, one I find a bit more easily understood. His view is that there are two sources of “shocks” to a family’s income (and hence their consumption). One type of shock is transitory which is what is causing the increase in income volatility. The other is rising income inequality. Quiggin argues that using credit markets to try and cover the growing income gap is one possible reason that we have seen an increase in bankruptcies. It isn’t a bad story as economic stories go, I just have some problems with it.1

My problem is that growing income volatility can also lead to increased bankruptcies as well. For example, one might in a good year make $60,000 and in a bad year make $40,000. Thus the expected income is $40,000. But then things become more volatile and not only are the swings wider (say $70,000 in a good year and $30,000 in a bad) but the bad “year” is also variable going from say 6 months to 18 months. Miscalculating how long the “bad year” is going to be could lead to bankruptcy also. So disentangling the effects of increased volatility as well as rising income inequality is going to be problematic.

Another problem is that this would mean that people have some sort of persistant bias or irrationality that even when pointed out to them they don’t correct it. That is, you can’t use credit to cover the income inequality shock, only the income volatility shock. Given that people seemed to catch on to the Phillip’s curve employment/inflation trade off, it is going to take some pretty good data to convince me of Quiggin’s story.
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1By story, I don’t mean anything negative. All economic theories are put into terms of a “story” or “narrative”. For example, rational expectations were first used in a “story” about agricultural markets and futures. That story didn’t seem to interest too many people. Robert E. Lucas and Leonard Rapping (and later others) used rational expectations, but changed the story to inflation and monetary policy. That story was much more interesting (probably because of recent macro-economic events) and it stuck.

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Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. John Quiggin says:

    You haven’t quite got my point here – I admit its a complicated one and I may not have expressed myself perfectly.

    Think of the variance of consumption across individuals as having two components – one reflecting long term differences between individuals and the other reflecting short term shocks.

    The first has increased, but the second has declined because people use credit to smooth consumption borrowing when they are short of cash and then paying it back.

    The problem, as you mention, arises when you try to use borrowing to offset a long-term decline in income, perhaps because you mistakenly think it will be short-term. Then you get bankruptcy, which has, as I mentioned, risen a lot.

    If you think about your figure of 14/1000, it’s not low at all. Multiplied by an adult lifetime of 60 years (and all adults are members of families) you get a risk of 840/1000 which is not small.

  2. I think a part of this is having a conclusion, then looking for data to support the conclusion. So how easy is it to find the data and does the data support the conclusion become a bigger factor than how reasonable is the data in answering the question.

  3. Steve Verdon says:

    Think of the variance of consumption across individuals as having two components – one reflecting long term differences between individuals and the other reflecting short term shocks.

    The first has increased, but the second has declined because people use credit to smooth consumption borrowing when they are short of cash and then paying it back.

    The problem, as you mention, arises when you try to use borrowing to offset a long-term decline in income, perhaps because you mistakenly think it will be short-term. Then you get bankruptcy, which has, as I mentioned, risen a lot.

    Yes, but my point is that it seems that eventaully this kind of cycle would catch up with people, unless lending institutions are not rational and borrowers are. So while your story is pretty good, I’m still pretty far from convinced.

    If you think about your figure of 14/1000, it’s not low at all. Multiplied by an adult lifetime of 60 years (and all adults are members of families) you get a risk of 840/1000 which is not small.

    This strikes me as wildly inappropriate since I’m not sure that the probability of bankruptcy in one year is independent of bankruptcy in a later year.

  4. Do you have any data beyond your math that would suggest 84% of Americans would file bankruptcy sometime in their lives (aka 840 out of 1000). That number just doesn’t compute with the world I know.

  5. RJN says:

    There is another source of funds that I did not see mentioned. I am thinking of real estate cash out, of course.

  6. Steve Verdon says:

    There is another source of funds that I did not see mentioned. I am thinking of real estate cash out, of course.

    I don’t know about John (Quiggin), but I’d consider that as part of the credit market myself. And this is where I can see John’s point about bankruptcy to some extent: people refinancing and taking out cash out to fund lifestyle expenditures vs. more prudent expenditures such as education, home improvement (improves the value of the house and maybe justifies the refinance, etc.). Still, I’m not convinced that this is all of it. Not everybody owns a house, and not everybody is going to fall into this trap, or more accurately a sufficiently large number of people will fall into this trap.

  7. M1EK says:

    If I get a ten million dollar inheritance, and then only spend $50,000 a year, I suppose I’m not rich?

  8. John Quiggin says:

    “I think a part of this is having a conclusion, then looking for data to support the conclusion. ”

    Quite the contrary, I assure you. In Steve’s terms, I saw a lot of seemingly contradictory evidence, and tried to come up with a story that make sense of it. Obviously, I haven’t convinced everyone, and there may be important points I’m missing, but I haven’t seen a better explanation of the facts.

    As regards the surprising result on bankruptcy, you haven’t taken account of the huge rise in recent years. In the past most people didn’t go bankrupt, but if the rates of the early 21st century are sustained most people will do so (thing about how divorce has gone from rarity to routine). The recent reform has cut bankruptcy rates for now, but I doubt that the effect will be sustained.

  9. Steve Verdon says:

    If I get a ten million dollar inheritance, and then only spend $50,000 a year, I suppose I’m not rich?

    And this has what to do with inequality?

    As regards the surprising result on bankruptcy, you haven’t taken account of the huge rise in recent years. In the past most people didn’t go bankrupt, but if the rates of the early 21st century are sustained most people will do so (thing about how divorce has gone from rarity to routine). The recent reform has cut bankruptcy rates for now, but I doubt that the effect will be sustained.

    Might not the prospect of reform pushed up bankruptcy rates? At least in part?