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Income inequality

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Responding to a comment to an earlier post, I said I planned to write a post on structural economic change. This is not that post. Rather, the commenter's reaction showed an implicit assumption that my promised post would address current trends in income inequality. It won't, because I don't see those trends as related to structural economic changes at all. Thus, this separate post on income inequality.

First, let's take at what could lead to a belief that income inequality was related to recent structural economic change. If you look at the U.S. line in the following graph, you'll see a steady increase in income inequality from around 1980 to 2000:


1980 was about when the microprocessor revolution began, which certainly resulted in continuing automation in various industries - automation that continues to this day. However, looking at more recent data shows that the steady trend towards increased income inequality has not continued:


Income inequality plummeted after 2000, before peaking again; the last year on this chart, which is the most recent data I can find, indicates that it was actually slightly lower in 2008 than in 2000, which may come as a surprise to some considering the presidential terms for which those were the final years. Since automation was certainly continuing during those years, income inequality cannot be explained as a result of automation.

Incidentally, while the marginal tax rate information is largely irrelevant to this post, it does also show that marginal tax rate does not seem particularly related to income inequality, as the lowest marginal tax rates, in the late 1980s, are associated with a period of decreasing income inequality.

So what does cause income inequality? Data from other periods and nations, such as the U.S. in the 1920s versus the period after 1930, and Chile under Pinochet versus Allende, indicate that increasing income inequality is highly correlated with periods of rapid economic growth. That's also true for the 1980-2000 period, which was a period of strong economic growth as well as increasing income inequality, as compared to 2000-2008, which was neither.

That's only a correlation, though; it still doesn't explain the causes of income inequality. For that, we need to examine another factor that's highly correlated with these periods of economic growth and increasing income inequality: entrepreneurship and risk taking.

Risk taking, of course, involves risk. Risk implies winners and losers. That results in increased income inequality: employees of a dot com that succeeds get a big boost to income, while employees of a dot com that fails make mediocre wages at best, even if they do the same work; similarly for all other entrepreneurial ventures at all levels of income.

So there you have it. Increasing income inequality is the direct result of entrepreneurship and risk taking; you need look no further for the explanation.
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On October 23rd, 2010 05:59 am (UTC), izmirian commented:
It sounds like your argument is that there could be many explanations other than automation for the increasing income inequality. That's reasonable. It would certainly take a lot more data to determine how big a factor automation is playing and I suspect that it is not the biggest factor at the moment. On the other hand, dismissing automation entirely because there is an 8 year period in which income inequality did not increase seems premature.

But, for the sake of argument, let's say that you are correct and that income inequality is the direct result of entrepreneurship and risk-taking. If so, is there anything that we should do about the increasing income inequality? Are there any limits beyond which we should begin to be concerned?
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On October 25th, 2010 04:02 pm (UTC), psychohist replied:
To the extent that policy affects income inequality, I think it's worthwhile to note that the empirical evidence suggests only two choices: encourage entrepreneurship and risk taking, as in 1980-2000, and earlier in the 1920s, and accept that the increase in everyone's income will be accompanied by a faster increase in the highest incomes, or don't encourage it, as in 2000-2008 and earlier in the 1930s, and accept that everyone's income will stagnate. While you might be able to stop the increasing income inequalities by preferring Bush economic policies, I think that the vast majority of the population would prefer the economic climate of the 1920s, 1980s, and 1990s, even though income inequality was increasing.

It's not clear how far policy can actually affect things, though. To see this, we may want to take a look at another graph showing income inequality across a longer time frame, from 1917-2008:

The vertical lines simply show that income inequality tends to stop increasing during severe economic crises - when everyone is hurt, the richest are hurt more. However, the largest decrease in income inequality on this graph is not during a financial crisis, but rather from about 1937-1942, while World War II was ramping up. There's also a significant decrease in 2001 and 2002, around when the World Trade Center attacks happened. If you actually want a reduction in income inequality, you may need more than economic policies that encourage stagnation: you may need a war.

There's one other interesting thing about this graph, and that is that income inequality is highly concentrated in a very small percentage of the population - that's why the lines are parallel. The top line, the income share of the top 20%, varies between about 32% and 48%, a factor of 1.5. The bottom line, the income share of the top 0.1%, varies between 2.5% and 11%, a factor of 4.4, nearly three times as much. Conversely, the income share of the lowest 80% varies by a factor of only 1.3. The driver, again, is not in the general population - it's at the very top, in the "winners" of the entrepreneurial lottery. That may also explain why changes in the marginal income tax don't seem to have much effect on income inequality: the people who actually have all the money aren't paying regular income tax rates, but are playing games with capital gains and charitable contribution loopholes.

It's interesting to speculate what would happen if an entrepreneur friendly climate could be sustained past the peaks on this graph. Would income inequality continue to increase? Or would it stabilize, with new winners displacing the old winners, kind of like the Ellisons of the new economy have eclipsed the Soroses from the 1980s? Of course it may be self limiting; with sufficient concentration of wealth, the winners of the entrepreneurial lottery have an incentive to shut off threats from a new generation of entrepreneurs, and indeed that may be part of what happened in the 1930s, and in the present time starting around 2000.
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On October 26th, 2010 05:44 am (UTC), izmirian replied:
I like the graph that you've got there and that's a good point about much of the income inequality being driven to a significant extent by the top 0.1%. I haven't actually looked at the math behind the Gini to see whether it is also largely driven by the top 0.1%.

"If you actually want a reduction in income inequality, you may need more than economic policies that encourage stagnation: you may need a war."
I'm suspect that's not the best lesson to draw from the data. Hopefully there are peace-time policies which can both boost the income for the poor and middle-class Americans (improved education, for example) as well as a more progressive tax burden that minimizes any adverse effect on overall growth of the economy.

Another interesting graph shows a wider range of the income percentiles in constant $2007. Note that the vertical axis is a log axis so the highest income Americans are increasing their income advantage over the poorest Americans at an exponentially higher rate (higher slope of the approximately linear line on the log graph).

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On October 26th, 2010 07:59 pm (UTC), psychohist replied:
"Hopefully"? Economic policies based on hope and wishful thinking rather than on factual reality are generally the most damaging policies around. There's a reason that economics is called "the dismal science".
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On October 27th, 2010 02:48 am (UTC), izmirian replied:
I definitely want economic policies based on factual reality. I was just hoping to get some of your suggestions (ideally other than starting a war) since I know you're not in favor of using taxes to adjust for income inequality after the fact.
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On October 27th, 2010 03:57 pm (UTC), psychohist replied:
The two cases I mentioned don't involve "starting a war" anyway, as they didn't involve us attacking but rather foreign attacks on U.S. territory - Pearl Harbor and 9/11. Of course in at least one of the cases a lot of the change occurred before the actual attack, and may have been associated with overseas concern in the late 1930s driving business to the U.S. and restoring middle class incomes. From a global perspective, that may not be a reduction in income inequality at all - just a shift of most of the U.S. population into the "rich fat cat" category.

The reason I'm not in favor of using taxes to adjust for income inequality is because the empirical evidence is that it just doesn't work, as I pointed out above. Increasing the highest marginal tax rate, in particular, doesn't even tax the right people, since the top 0.1% who are actually driving the income inequality make most of their money in capital gains that are taxed at a different rate and easily manipulable.

Indeed, based on the factual evidence, there doesn't seem to be any voluntary government policy at all that will substantially reduce income inequality, given that the "war" option isn't a policy, but rather something that just happens to us. That's the problem with knowing how the world works: it turns out that most of the things we'd like to be able to do aren't actually possible.

As it turns out, I do favor increasing taxes on that 0.1%, by eliminating loopholes like that for appreciated assets donation, changing the capital gains treatment from a lower tax rate to inflation adjustment instead, and making dividend payments deductible from corporate income and taxable as normal personal income. However, I'm not under the impression that will actually reduce income inequality; rather, those are just ways to remove economic inefficiencies and perhaps make the tax burden more equitable.
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On October 27th, 2010 04:29 pm (UTC), izmirian replied:
Those sound like good steps to take even if the overall effect on income inequality is small (or even zero).
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On October 27th, 2010 04:41 pm (UTC), psychohist replied:
A safe position given that no one in a position to matter advocates them right now.
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On February 27th, 2011 03:52 am (UTC), psychohist replied:
Oh, and looking back on this, the vertical axis does not look like a log axis to me.
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On August 13th, 2011 02:50 am (UTC), psychohist replied:
Link to higher resolution version of income inequality chart:

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On September 18th, 2013 10:02 pm (UTC), (Anonymous) commented:
Entrepreneurship and risk taking
In this 2010 entry you conclude that the increase in income inequality in our country is a direct result of entrepreneurship and risk taking. You provide virtually no support for this conclusion.

How can you closely examine what you suppose to be a high correlation between entrepreneurship and risk taking on one axis and income inequality on the other? The two brief paragraphs before your conclusion hardly provide enough evidence to justify that conclusion. Indeed they provide no actual data whatsoever.
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On September 19th, 2013 04:23 pm (UTC), psychohist replied:
Re: Entrepreneurship and risk taking
Just to be clear, I don't think the correlation means entrepreneurship and risk taking should be avoided. Rather, I think it means we need to accept a certain degree of income inequality - and that we need to look for ways to prevent that income inequality from choking off the next generation of entrepreneurs.
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