I Dream of Gini

Some who talk about inequality would like you to think they are talking about the plight of the poor.  In fact, the inequality gap tells you nothing about the life of those at the bottom of the income distribution.  Not understanding this can lead to dangerous policies which hurt the entire society, and perhaps the poor the most. 

In just the past few weeks, a ground swell of discussion regarding income inequality and its inherent evils has been heard.  The leader of the world's largest economy, US President Barrack Obama, as well as the moral leader of 1.2 billion Catholics, Pope Francis, have led the charge. 

Very quickly, US Media outlets picked up on the theme, praising both men whilst deploring the inequality problem.  Expect increasing chatter on this topic later in the month after the President delivers his State of the Union Address.

Before we get too far along, however, let me beg you to hold your applause.  What these gentlemen did (intentionally or not) was to equate income inequality with the plight of the unfortunate.  In fact, the two are not related and not understanding this will lead to the adoption of precisely the wrong economic policies.  Allow me to explain.

Just because the income gap between two people or groups is large or has grown, really tells us nothing about whether the gap is inherently good or bad or about the fate of each group.  Take the two person world of Oprah Winfrey (the highest paid celebrity of 2013) and Brett Gallagher.  The income gap is incomprehensible, I can assure you.  In a case like this one, any policy that focuses on a meaningful redistribution of wealth away from Ms. Winfrey would reduce both our incentives to work - a sub-optimal result for any society.  A slightly larger hypothetical might be the distribution of income at a successful hedge or private equity fund where the top partners walk away with a lion's share of the income, but where everyone does pretty well.

What some who talk about inequality want you to think is they are addressing the plight of the poorest.  As the preceding hypotheticals show, the inequality gap itself tells you nothing about the life of those at the bottom of the distribution.  Any policy that focuses directly on reducing the gap, rather than growing the pie is likely to produce perverse results.

Measuring Inequality

Before we can discuss inequality, we must measure it – a problem in and of itself.  The most commonly cited measure is the Gini Coefficient (sounds like "Jeanie").  The GC for any economy ranges from 0 (a perfectly equal distribution of income where the bottom 5% of the population make 5% of the income, the bottom 20% make 20%, and so on) to 1 (one person makes all the money).  Many pundits use results drawn from the GC to support redistribution conclusions – and they are wrong to do so.  Again, not only is inequality not an issue, but I would also guess the majority of its adopters also don’t understand the limitations of the Gini.

The mathematical formula for the calculation of this number is complex and would make little intuitive sense to most of us.  However, the concept itself is relatively easy to grasp.  Perfect equality, or a Gini equal to 0, is represented in the graph below by the straight line drawn at a 45 degree angle (where 5% of the people earn 5% of the income, etc).  In no society have we ever seen such a distribution.  Typically, the more realistic distribution is represented by a saucer-shaped line, drawn with an increasing slope, called the Lorenz Curve, below.  Such a depiction measures a situation where the lowest earners earn less a share of the income than their share of the population and the highest earners earn a greater share of the income than their representation in the economy.  The Gini Coefficient is the ratio of the area between the two lines (shaded Grey) and the total income (the sum of the Grey and Blue areas). The greater the inequality, the bigger the Gini Coefficient.

While this calculation may be a convenient way of capturing in one number the distribution of income in an economy, it does have numerous shortfalls that do not lend themselves to support many of the conclusions pundits have drawn.

First and foremost, the most oft cited measures of the GC do not take taxation into account.  Nor do they consider transfer payments received by the poorest.  When such figures are included, the differences in spending power within a given economy decreases universally.

Secondly, there are situations where a GC can rise (a supposedly a less equal income distribution), but where the ratio of incomes between the lowest and highest wage earners actually narrows.  What causes the GC to decline in such cases has more to do with the way income is spread amongst the middle portion of wage earners than just the spread between the highest and lowest.

Different income distributions
with the same Gini Index

Household Group	Country A Annual Income ($)	Country B Annual Income ($)
1	20,000	9,000
2	30,000	40,000
3	40,000	48,000
4	50,000	48,000
5	60,000	55,000
Total Income	$200,000	$200,000
Gini	0.2	0.2

Also, we can also look to the real-world example of China, where over the past two decades, between 400 and 600 million have been moved out of poverty (depending upon who you believe), yet where the GC has steadily increased.  In this case, the rising “inequality” of income has in-arguably been a very good thing.  Conversely, one might note in the preceding graphs for Greece and the US, "inequality" decreased during the recent economic troubles, yet few would argue that the poor were better off.

We can also show a homegrown example from the United States (1979 through 2010) where the GC rose from 0.40 to 0.47 (i.e. incomes became less “equal”), but where the lowest wage earners actually saw their incomes increase, even after adjusting for the drag of inflation.  In fact, those earning more than $100,000 (measured in 2010 dollars) rose from 11.5% of the population to 20.5% while those earning less than $35,000 fell from 38.6% of the population to 36.6% (those earning less than $15,000 fell from 14.6% to 13.1%).  In other words the US poor are better off than they were 30 years previously, even as the gap between them and the “rich” grew.  Unless envy is one’s true concern, anything which allows you to increase your quality of life should be viewed as a good thing – even if your neighbor’s quality of life improved more.

The following chart shows the progression of incomes in the United States, by quartile, over this time period.  Note, that these figures are pre-tax and pre-transfers, so the gap in disposable incomes is not as great as first appears.  What it does show, however, is that income growth for the poorest 50% of Americans has been anemic and that, not the gap, is the issue that must be addressed.

While I acknowledge that a dramatic difference between the “haves” and “have nots” can create stress within a society, I would also argue that it would be naïve for the government to proffer policies to address the “gap” itself, rather than trying to pursue policies that increase economic growth which lift all its citizens to a better life style.  Most would agree that we are not really better off as a society if we all have less.  So, when a political figure or media pundit calls for reducing inequality, an informed person should consider three things:

•        Are they really talking about the plight of the poor or are they just upset by the gap?
•        How do they measure the inequality they are talking about?  Are they literally measuring the difference between one sizeable segment of the population and another or are they looking at 500 CEO’s and comparing their income to that of the average worker (and then offering prescriptions that reach well beyond these “Fortunate 500”)?
•        Do the policies they put forth directly address the plight of the poor, or are they simply redistribution efforts which are unlikely to increase the economy’s overall wealth?

I am deeply worried that policies proposed in the name of helping the poor climb up the economic ladder (i.e. a sharp rise in the minimum wage - see Bill Gates comments here), will in reality result in anti-growth policies that will hurt us all.  An honest debate about the plight of the poorest among us, does not seem to be in the cards.