Almost Everything You’ve Been Told About Inequality Is Wrong

By John C. Goodman 

Originally posted on Forbes, February 2016

Inequality was the single most popular topic when economists gathered at their annual convention in San Francisco last month. But here is what everyone should know. Most of the studies you read about in newspapers are flawed. A new study exposes those flaws and presents a much rosier picture of the American economy. (Full disclosure: I provided early funding for this study in a previous job.)

A typical study of the distribution of income compares people on the top and bottom rungs of the income ladder. The problem: the entire population is on the ladder. That means these studies are comparing retirees with people who are working. They are comparing people who are at the peak of their career earnings with people who are just starting out.

Studies of the distribution of wealth typically have an even bigger problem. They count private savings (such as an IRA or 401(k) account) and private pensions as part of an individual’s wealth. But they ignore Social Security and other entitlement benefits, even though people pay taxes to these programs at the same time they are contributing to their private retirement accounts.

A 60 year old couple, each having earned the maximum FICA wage over their work lives, is entitled to Social Security benefits worth $1.2 million. If they delay the collection of benefits until age 70, their Social Security wealth is about $1.6 million. Does anyone think this hidden asset should be ignored in comparisons of the distribution of wealth?

The new study is by Alan J. Auerbach (Berkeley), Laurence J. Kotlikoff (Boston University) and Darryl Koehler (Fiscal analysis Center).  It departs from previous studies in three important ways: (1) it recognizes that the only meaningful way to compare income and wealth is to do it for people of approximately the same age, (2) it chooses people’s after-tax consumption (standard of living) as the best measure of wellbeing – not just at a point in time, but over the remainder of individuals’ entire lives and (3) it includes such government benefits as Social Security, Medicare and Medicaid in calculating people’s expected consumption.

To appreciate what difference this approach makes, take people in their 40s. Those in the top fifth of the distribution can expect to enjoy 55.3 percent of this age group’s lifetime resources over the remainder of their lives. People in the bottom fifth can expect only 4 percent. That’s a wealth difference of almost 14 to 1. But after government transfer programs do their redistribution, the wealth difference is cut in half: the difference in lifetime consumption drops to 7 to 1.

It is well known that inequality increases with age, with the greatest inequality existing among the elderly. Other studies have concluded that the main reason for this is differences in saving behavior, not some mysterious Wall Street malfeasance imagined by Paul Krugman or Bernie Sanders. Those who save more when they are young accumulate more and have more when they retire. Those who save very little, will have a lot less in the retirement years.

This study finds that among 20 year olds, the wealth difference between the highest and lowest fifths is 7 to 1. But among 70 year olds the difference in wealth is more than 70 to 1. That change over the lifecycle of a group of cohorts is rather astonishing. Even so, after government redistribution takes its toll, the difference in remaining lifetime consumption falls all the way down to 8.6 to 1 for this age group.

One reason for these results is our highly progressive fiscal system. Consider again, those people in their 40s.  For those in the top 1 percent of this age group, the expected net tax rate going forward (taxes minus entitlement benefits) is 45 percent.  For those in the top fifth of the distribution, the average net tax rate is 32.5 percent.  But for those in the bottom fifth, the net taxes are negative: every dollar of private sector income is matched by a 34 cent government subsidy.

Among those in their 70s, the redistribution is much greater. The top 1 percent in this age group faces a remaining lifetime net tax rate of 26.8 percent.  In contrast, those in the lowest fifth face a negative net tax rate of nearly 700 percent! For every $1 of private income, they get $7 from the government.

Interestingly, one important contributor to inequality of lifetime consumption is inequality in life expectancy. The gap in expected years of life for those in the top and bottom fifths of the income distribution has been growing for some 30 years and it has a big effect on lifetime consumption. Take people in their 20s. The authors estimate that if those in the bottom fifth lived as long as those in the top fifth, they would get one-third more benefits from government over their lifetimes.

Overall, our fiscal system is highly progressive. There is a price to be paid for this progressivity, however. The more redistribution that takes place, the smaller the rewards for working, saving and investing and the larger the rewards for not working, not saving and not investing. That has to be bad for economic growth.

This article was originally posted at Forbes on February 1, 2016.