Wealth Inequality: It’s Complicated

Authored by Vincent Geloso via The American Institute for Economic research,

In the debates over wealth inequality that have followed the publication of The Triumph of Injustice (authored by Emmanuel Saez and Gabriel Zucman), there have been intense discussions of the methodological choices made in the book. There have been few considerations regarding the underlying assumptions regarding the sources of inequality. 

All inequalities are bundled as if they are one and the same. While they recognize that there is an optimal level of inequality (few in the popular press point this out; they simply assume that we must be beyond this optimum), no distinctions between inequalities are made. This is by far the greatest flaw in the book, and it is shared by other authors in the field. 

Why is it a flaw? Consider the following case: wealth (or income) inequality could increase even if everyone’s wealth goes up by the same proportion. This would happen as long as certain groups change in relative size within the overall population. For example, immigrants tend to have lower wealth stocks than natives. However, all immigrants could experience an increase in wealth equal to everyone else, but if the immigrants’ share of the total population doubles, then we will see an increase in inequality. This is called composition bias. 

Economists have long known that it is necessary to make adjustments for this bias, which generally emerges as demographic structures change. In the 1970s, Morton Paglin published a series of articles (including one in the American Economic Review) on the topic of making such adjustments for income inequality measures. The reason for making such adjustments is that these are mechanical increases of inequality that do not speak to the ability of someone to improve his economic condition relative to others. 

Why should we care today? Consider the following facts. 

First, there are more immigrants in the United States (their share of the population has doubled over the last decades). While immigrants are clearly better off after moving to America, they also tend to be slightly poorer than the average American. Because they swell the lower part of the income distribution, they give the impression of rising inequality (in both income and wealth). With regard to income, David Card pointed out that immigration explained 5 percent of the recent increase in inequality. 

In Canada, where immigration levels are higher, immigration explains an even larger share of the increase. But why should this increase worry us? Immigration research suggests that there are important wage gains to the natives, mild gains in economic growth, and little to no fiscal cost to the population. All of this is compounded by massive gains to immigrants themselves. Clearly, that increase in inequality is not worrisome. 

Second, the age of entry in the labor market has been pushed further and further back since the 1960s. As individuals in Western countries spend increasingly long periods of time in school earning nothing and investing in their human capital to earn more later, this is easily understandable. Yet, for inequality estimates, this means that there is an increase in inequality as long as scholarly pursuits are lengthened. Again, why should we be worried about that part of the increase in inequality? As Gary Becker and Kevin Murphy pointed out, this is bound to eventually produce a leveling off in inequality and probably even a decline as some other economists point out. 

Third, there is the role of old age. There is a strong age–wealth relationship: older individuals are likely to be wealthier individuals. Thus, a cross-section of all individuals in different countries could lead to incorrect inferences where older societies are confused with wealthier societies. If this misleading portrait can emerge in comparisons of different countries, it can also emerge in comparisons of one country over time if the older group grows in proportion to the rest of the population (and there are fewer younger individuals). 

Of the three factors I mentioned, this is probably the most important. Magne Mogstad and some colleagues, in an article in the Scandinavian Journal of Economics, made adjustments to avoid this problem. The results he and his colleagues found were that the level of inequality was lower and there was a mild decline in inequality. 

In another paper (published in the Journal of Economic Inequality) studying income inequality — in Norway, over a longer period of time (1967 to 2000) — Mogstad found a similar alteration: inequality fell when the adjustments for age structure were made even if the unadjusted figures suggest an increase. To be sure, such adjustments are data-intensive and these types of data are not available over very long periods of time. 

As such, there are some uncertainties as to whether or not the longer time horizon (say for a period covering 1950 to today) would yield the same result. I doubt that it would, but it is likely that increase will be dampened when the proper adjustments are made. Thus, should we be worried about the part of inequality that stems from aging? A case can be made that aging has downsides, but it’s hard to see how inequality is one of these downsides. 

The sum of these points is suggestive of an important task that we have as economists. We need to decompose inequality into its core components. There are components (like aging) that have no deep implications. There are components that tell us that we should welcome more inequality because it entails clear gains for everyone. This is the case with immigration, which is bound to increase inequality in a given host country (but reduce it globally by allowing massive gains to the world’s poorest). 

There are, however, components that ought to be tackled. Inequality resulting from your place of birth or from your parents’ situation is offensive to most people. If all of the increase in inequality came from this source, it would be understandable to want to tackle it. 

Similarly, inequality can also result from barriers being placed in the way of the poor that limit their chances at upward mobility. Rent-seeking, which redistributes to the politically connected to shield them from competition hurts the poor. Thus, as with inherited inequality, tackling these institutional sources of the inequality increase is necessary. 

These are crucial distinctions never discussed by many economists at the forefront of the conversation of inequality. They are harder to make. They require intellectual discipline and hard work (both historical and statistical). Nevertheless, they are crucial to understanding correctly the rise of inequality in recent decades. All efforts that fail to attempt this decomposition should be considered in a lesser light, and praise for such efforts should be scant.