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Measuring Income Inequality

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Measuring Income Inequality IJA TRAPEZNIKOVA Royal Holloway University of London, UK Measuring income inequality Summary measures of inequality differ from one another and give different pictures of the evolution of economic inequality over time Keywords: inequality, Gini coefficient, interdecile ratios ELEVATOR PITCH Lorenz curves show income inequality is higher in Brazil than the US and Norway Economists use various metrics for measuring income 1.0 inequality. Here, the most commonly used measures— Norway (2015) US (2016) 0.8 the Lorenz curve, the Gini coefficient, decile ratios, the Brazil (2015) Perfect equality Palma ratio, and the Theil index—are discussed in relation 0.6 to their benefits and limitations. Equally important is the 0.4 choice of what to measure: pre-tax and after-tax income, Share of income consumption, and wealth are useful indicators; and 0.2 different sources of income such as wages, capital gains, 0 taxes, and benefits can be examined. Understanding 0 0.2 0.4 0.6 0.8 1.0 the dimensions of economic inequality is a key first step Share of population toward choosing the right policies to address it. Source: Author's own compilation based on data from PovcalNet. Online at: http://iresearch.worldbank.org/PovcalNet/home.aspx KEY FINDINGS Pros Cons The Lorenz curve is a commonly used metric that If Lorenz curves cross they cannot provide a allows for the quick and visual comparison of conclusive ranking between distributions. inequality across countries. The Gini coefficient values change depending on The Gini coefficient uses information from the what is measured—wages, before- or after-tax entire income distribution and is independent of income, wealth, or consumption. the size of a country’s economy and population. Percentile ratios fail to use all information since Percentile ratios are easy to calculate and focus on they ignore incomes between percentiles. a specific region of the distribution. The Theil index is less intuitive and not directly The Theil index can decompose inequality into comparable across populations with different within- and between-group inequality. sizes or group structures. These commonly used measures are generally The evolution of inequality within a country can in agreement when comparing inequality across appear different depending on the metric used. countries. AUTHOR’S MAIN MESSAGE Despite the relative strengths and weaknesses of the available measures, empirical studies show that they are mainly in agreement when comparing inequality differences across countries. However, the evolution of inequality within a country or the effectiveness of a specific policy can be perceived differently depending on the specific metric under consideration, as well as what variable is being measured. For instance, if policymakers care more about what happens to the poor they should use the Palma ratio instead of the Gini coefficient as their inequality measure and focus on consumption instead of income data. Measuring income inequality. IZA World of Labor 2019: 462 11 doi: 10.15185/izawol.462 | Ija Trapeznikova © | July 2019 | wol.iza.org IJA TRAPEZNIKOVA | Measuring income inequality MOTIVATION There are many reasons why policymakers and researchers alike are concerned with a country’s degree of economic inequality. Recent studies show that persistent income disparities among individuals are associated with poverty and deprivation, mental illness, social unrest, and crime, as well as lower levels of education, employment, and life expectancy [1]. Many public policies such as taxes, welfare benefits, provision of education and health services, price, and competition regulations have distributional implications for income. How equally is income distributed across individuals in countries with different social institutions, education systems, capital, and labor markets? How has inequality evolved over time? How have income distributions changed after tax reforms or financial crises? To be able to answer these important questions, a consistent measure of inequality is needed. DISCUSSION OF PROS AND CONS Dimensions of economic inequality Before choosing a particular metric, a decision must be made about the dimension of economic inequality to be measured. This choice is important, not only from a conceptual point of view, but also because it determines what instruments are available to policymakers trying to correct a given distribution. The discussion in this article focuses on inequality in outcomes, as opposed to inequality of opportunities (such as access to education, skills, and other limitations imposed by parental circumstances or belonging to a low socio-economic class). While the latter is undoubtedly important for understanding the factors behind economic inequality, especially in the context of social mobility, this article relies on more readily observable indicators of living standards, such as income and wealth. Many of the measuring techniques described below, however, can be applied to inequality in education, health, happiness, and life satisfaction in general. When looking at disparities in income among individuals, it is necessary to distinguish between income, wealth, and pay inequality. “Pay inequality” refers to differences in wages paid to different people. This inequality can reflect differences in productivity of workers (e.g. between low- or high-skilled workers), labor market discrimination between groups, or differences in the nature of the job (e.g. miners and sales assistants). “Income inequality” is the extent to which income is distributed unevenly across people or across households. Income encompasses labor earnings (such as wages, salaries, and bonuses), capital income derived from dividends, interest on savings accounts, rent from real estate, as well as welfare benefits, state pensions, and other government transfers. In addition, it is possible to distinguish between individual versus family income, pre-tax versus after-tax (disposable) income, and labor earnings versus capital income. The third dimension of economic inequality is differences in “wealth” distribution. While income refers to the flow of money over a given period (say, a year or a month), an individual’s wealth represents the stock of all assets that a person holds. These include financial assets, such as bonds and stocks, property, and savings. Income and wealth are not perfectly correlated. For instance, a high earner might be in the upper end of the income distribution while being relatively poor in terms of assets; likewise, an elderly IZA World of Labor | June 2019 | wol.iza.org 2 IJA TRAPEZNIKOVA | Measuring income inequality worker might have accumulated substantial wealth (e.g. owning a house) but have low labor earnings. Different policies ranging from income and inheritance taxes to government schemes for first-time home buyers will affect different groups of individuals and might have opposing effects on wealth and income distributions. Consumption versus income inequality Some economists argue that “consumption” is a more appropriate indicator of persistent inequality as it is closely related to permanent income [2]. Consumption inequality is typically lower than income inequality because individuals can smooth temporary shocks to income (such as a temporary layoff or the end of a seasonal job) through saving and borrowing. Disparities in consumption better reflect differences across individuals in the accumulation of assets, access to credit, or the social safety net. Recent studies use the link between income and consumption variation to quantify the role of assets, taxes, transfers, and family labor supply in insuring against permanent income shocks [3], [4]. In practice, the choice between income or consumption measures is often determined by data availability. Advanced economies tend to collect high-quality income data, especially those drawn from administrative tax records. Consumption data are particularly relevant for developing countries, where it is difficult to obtain reliable estimates of income because a large part of the population is self-employed, producing for their own consumption (especially in agriculture), or being paid in kind. For this reason, World Bank Development Indicators on inequality for the least developed countries are typically estimated on household consumption expenditures. Studies that look at the joint analysis of consumption and income data suggest that, while the level of inequality in consumption is typically lower than in disposable income, the overall ranking of countries is similar under both measures [5]. At the same time, the question of whether consumption inequality tracks income inequality over time has been a subject of debate, with mixed empirical results that differ depending on the data sources and methodology used (see [2] for a literature survey based on US data). Unit of measurement Another important issue for inequality statistics is the unit of measurement—whether it is an individual, a tax-paying unit, a family, or a household. Given that income is often shared within a family or a household, it might be more appropriate to look at disparities in household income, as opposed to individual income. Typically, earnings dispersion among households is lower than among individuals because of income pooling within the household, as well as the fact that families can provide insurance against individual risks (e.g. a worker increasing their labor supply in response to the job loss of their partner). The role of this family insurance mechanism has increased
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