The Economic Reasons to Care about Income Inequality

Frank Manzo IV is the Policy Director of the Illinois Economic Policy Institute (ILEPI). Visit ILEPI at www.illinoisepi.org or follow ILEPI on Twitter @illinoisEPI. This post is part of the “Frankonomics” series.

Year after year, economic data show that income inequality is rising.

There are many causes of this phenomenon. Structural changes in the American economy– such as increased globalization and the polarization of jobs into good, high-skilled occupations and poor, low-skilled occupations– has played a key role. Dramatic hikes in CEO pay compared to the average worker are also a factor: The average CEO earned 29 times the amount of his or her workers in 1978, but it is over 300 times now. The problem is that there is no evidence that CEO pay is based on actual corporate performance. Instead, research has shown that firm size, tenure, and favorable tax code changes are the causes. Finally, trends in the labor market have led to increased inequality. These include, but are not limited to, the declining real value of the minimum wage, which has particularly risen inequality among women, and the long-term decline in labor union membership. Unions have been found to raise wages most for lower- and middle-income workers and to reduce inequality within a workplace by 25%. The decline in unionization rates explains between one-fifth and one-third of the growth in inequality in America.

Income inequality is not necessarily bad. Workers need incentives to work hard, to invest in their own human capital, and to be entrepreneurial. At some threshold, though, the marginal benefit from these incentives is less than the marginal costs of declining wages, reduced consumer demand, diminished equality of opportunity, social unrest, and psychological costs.

Potentially the biggest threat to the economy derived from economic inequality is that poorer Americans spend a larger share of their incomes in the economy. By making the rich richer and the rest of Americans poorer, the redistribution of wealth to the top has implications on national consumer demand. Indeed, multi-source evidence from the Panel Survey of Income Dynamics, the Survey of Consumer Finances, and the Consumer Expenditure Survey demonstrates that a $10,000 increase in income is associated with 1 to 7 percentage point increase in a household’s savings rate. Furthermore, from 1980 to 2007, consumption inequality largely mirrored income inequality: during that time, after-tax income inequality increased by 33% while consumption expenditures grew more unequal by 17%. At some point, extreme income inequality reduces overall consumer demand, resulting in job losses throughout the economy.

Declining equality of opportunity also poses a serious threat to economic growth. With great disparities in income, opportunity is polarized, with the poor having fewer resources to invest in their own education or in entrepreneurial activity. Those with less access to opportunities or who are credit-constrained are disadvantaged in free-market economies. In addition, intergenerational class mobility stagnates, meaning that the talents of many poor and middle-class children go unrealized.

Extreme income inequality can also have real social repercussions. Recent research has found that income inequality may be harmful to economic growth by increasing the probability of financial crises. Income inequality has also been shown to be correlated with lower life expectancy and higher mortality rates, especially among middle-aged white men. Income inequality also may increase the level of crime.

Finally, while rising national income is strongly associated with increased national happiness, greater income inequality reduces wellbeing. Since 1990, the “inequality of happiness” has worsened by 4% nationwide. For every decade since the 1970s, the South has had the greatest happiness disparity in America, likely due to lower wages and incomes. Other researchers find that taking a dollar from a rich person and giving it to a poor person results in an aggregate wellbeing gain because the benefit to the poor individual exceeds the loss to the rich person. Since the goal of economic policy is to maximize happiness, societies may be able to become more efficient through policy changes which increase equality.

Income inequality has increased to levels not seen in decades, characterized by significant income growth at the very top of the income distribution. Extreme income disparities can have negative effects on the economy by reducing consumer spending, polarizing opportunities, stagnating intergenerational mobility, causing financial crises, worsening health outcomes, increasing criminal activity, and decreasing happiness.

That is why all Americans should care about income inequality.

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