Government and the Distribution of Income 1

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Government and the Distribution of Income 1

• PADM 625
• Economics of Public Policy
• Ben Muse

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Topics

• Measures of income distribution
• Changes in U.S. income distribution
• Alternative measures of change
• Some explanation
• Efficiency and equity arguments for government
  intervention
• A note on poverty

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You are not responsible for

• Last two sentences on page 207 to end of first
  paragraph on page 209 (diagrammatic analysis of
  public good argument)
• Social welfare function discussion from page 214
  through Edgeworth discussion on page 218 (but
  read box 7.2)

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Three ways of measuring inequality in the size
distribution of income

• (Quintiles, the Lorenz curve, and the Gini
  coefficient)

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Quintile shares

• Rank the population by income
• Divide the population into five equal groups
• These groups are quintiles each containing a
  fifth of the population
• Report the share of total income received by each
  quintile

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Household shares of aggregate income
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The Lorenz Curve

• A graphic device for illustrating the
  distribution of income
• Horizontal axis cumulative percentage of the
  number of households ranked according to income
• Vertical axis cumulative percentage of income
  received by families

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Using text data, Table 7.1, page 196
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The straight line shows equal distribution of
income
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The curved line shows an unequal distribution of
income
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50 of the families may have less than 50 of the
income
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The Gini coefficient measures the difference
between the lines
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Ratio of the yellow area to the yellowgreen
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Gini coefficient values

• If the income distribution is perfectly equal
  (each family has the same income) the two lines
  coincide the Gini coefficient is zero
• If the income distribution were perfectly unequal
  (one family as all income) the Gini coefficient
  is one

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Is income inequality increasing in the U.S.?
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Household shares of aggregate income
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What does the graph show?

• Begins to fall in the mid-1930s
• Falls dramatically in the later 1930s and WWII
• Fall continues to late 1960s

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What does the graph show?

• Inequality was very high in the early years of
  the century
• Rose and peaked in the great depression (about
  1931-32)

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What does the graph show?

• Then begins long sustained rise
• Through the 1970s, 1980s and early 1990s

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A note on numbers

• Reasonably good information since WWII
• Fragmentary information before
• These authors made estimates of earlier values

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Interpreting the U.S. distributional facts
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Do people stay in the same quintiles all their
lives?

• Even if had same ability and opportunity
• Incomes would vary
• People value different things
• Incomes tend to vary over the life-cycle
• Random chance and variation

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Measures of economic mobility

• Treasury study no more than a third of taxpayers
  in the lowest quintile in 1979 were in the lowest
  quintile in 1988
• Urban Institute over 60 of persons were in a
  different family quintile after ten year periods
  beginning in 1967 and 1977

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Income mobility

• Census Bureau Year to year changes in family
  income to poverty ratio (IPR - income divided by
  the poverty threshold).
• Between 1994 and 1995, IPR decreased by more than
  5 for 36.8 or persons and increased by more
  than 5 for 40.5 of persons

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Income mobility and Gini

• Since incomes change over time
• Measured inequality over longer periods is
  smaller
• Gini coefficients are almost 8 smaller over
  seven year period than a one year period

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Alternative income measures

• Census official cash income before taxes,
  including cash transfers received from government
  like social security and welfare
• Census comprehensive adds to this capital gains
  income, noncash govt transfers and imputed
  return on homeowners equity

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Alternative income measures

• CBO adjusted family income (AFI) family
  comprehensive income divided by poverty threshold
  (IPR) for family with similar characteristics.

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Alternative income distribution measures
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Consumption inequality

• Is consumption a better measure of welfare than
  income?
• Lower income quintiles tend to spend more on
  consumption that their incomes
• Unreported income, gifts, running down savings

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Wealth inequality

• Is net worth a better measure of welfare than
  income?
• Net worth assets - liabilities
• Allows a household to maintain consumption when
  income fluctuates
• financial independence

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Consumption and wealth
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International comparisons

• International comparisons of income inequality
  are dicey
• requiring care to use comparable definitions
  across countries
• Luxembourg Income Study is a good source
• U.S. appears less equal than other industrial
  countries

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Theres a lot to explain here
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Theres a lot to explain here

• Economists hold different views about what causes
  these shifts in income inequality

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Distribution of income depends on supply and
demand

• for productive services
• not an endorsement
• but a way of thinking about the subject

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Distribution of income depends on

• prior distribution of wealth
• physical and financial assets
• but human capital as well

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Human capital is most important

• Capital is a produced good used to produce future
  goods
• By analogy we could talk about investing in
  human capital

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Investment in human capital

• Education, of course
• Investment in health
• Parental example, culture

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In fact,

• Human capital is extremely important
• Wages and salaries are much larger than dividends
  and retained earnings

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Personal income(billions of dollars)
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So...

• Labor income is about 73 of total income
• Percent doesnt vary much
• Inequality in income distribution
• Is going to be heavily dependent on unequal
  abilities to provide human services

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Human capital and investment

• Capital suggests produced resources
• Can be misleading
• But points to important fact...

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Human capital and investment

• ...that is,
• people can and do invest in themselves
• inherent skill and investment enter in