Russ Roberts on the income distribution

Students in my ECONS102 class would have gotten the message in the last week of classes that much of the rhetoric (in New Zealand, at least) around inequality is somewhat misleading, if not just plain wrong. For example: "Inequality is getting worse over time". No, it's not. At least, not in New Zealand since about the mid-1990s (the data supports this - there are any number of posts by Eric Crampton that show it, but try this one for starters). You might believe that inequality is a Bad Thing, but you don't need to overstate your case - inequality can be a Bad Thing even if it is not getting worse.

In a new article on Medium, Russ Roberts takes aim at another data fallacy:

Adjusted for inflation, the US economy has more than doubled in real terms since 1975.

How much of that growth has gone to the average person? According to many economists, the answer is close to zero...

But the biggest problem with the pessimistic studies is that they rarely follow the same people to see how they do over time. Instead, they rely on a snapshot at two points in time. So for example, researchers look at the median income of the middle quintile in 1975 and compare that to the median income of the median quintile in 2014, say. When they find little or no change, they conclude that the average American is making no progress.

But the people in the snapshots are not the same people...

Studies that use panel data — data that is generated from following the same people over time — consistently find that the largest gains over time accrue to the poorest workers and that the richest workers get very little of the gains. This is true in survey data. It is true in data gathered from tax returns...

One explanation of these findings is there is regression to the mean — if your parents are particularly unlucky, they may find themselves at the bottom of the economy. You, on the other hand, can expect to have average luck and will find it easier to do better than your parents. At the other end of the income distribution, one reason you might have very rich parents is that they have especially good luck. You are unlikely to repeat their good fortune, so you will struggle to do better than they did.

To see the problem with the pessimistic studies, consider a very simple economy with just three people. In 2005, Anna has income of $10,000, Bill has income of $20,000, and Charlotte has income of $70,000. The median income is $20,000. The total income of the bottom two-thirds of the population is $30,000. The lowest one third of the population (Anna) earns only one seventh of the earnings of the top one third of the population (Charlotte).

Now, say you collect some data on these same people ten years later, and find that Anna now has income of $20,000, Bill has income of $80,000, and Charlotte has income of $5,000. The median income is still $20,000. The median income is still $20,000. The total income of the bottom two-thirds of the population has decreased from $30,000 to $25,000. The lowest one third of the population (Charlotte) earns only one sixteenth of the earnings of the top one third of the population (Bill). If you ignored the dynamics of the income changes, you would either conclude that lower-income people are no better off than ten years earlier (the median income has not changed), or that they are worse off (lower total earnings, or higher inequality). But that would ignore the fact that two-thirds of the population is actually better off than before.

Comparing cross-sections over time is fraught, and the potential for drawing erroneous conclusions is high. As Russ Roberts concludes:

If we want to give all Americans a chance to thrive, we should understand that the standard story is more complicated than we’ve been hearing. Economic growth doesn’t just help the richest Americans.

And unlike much of what we read about incomes and inequality in the U.S., Roberts' conclusion is probably true for New Zealand as well.

[HT: Marginal Revolution]