Archive for July 8th, 2011

For politicians, rising inequality has been one of the hottest topics in recent years. Many newspaper articles, books, and political campaigns have targeted the divide between rich and poor. Most of the turmoil is based on statistics of income distributions. However, like so often with statistics, many people do not understand how to properly deal with numbers. Especially when they draw conclusions beforehand and just look out for some figures to support their already set conception.

Surprisingly, even many economists are not careful enough when dealing with income statistics. Thus it should be worthwhile for many readers to have a look at Thomas Sowell’s respective remarks in The Vision of the Anointed.

In great detail, the author explains why we should be very cautious when trying to draw conclusions from income statistics. First of all, he describes the particular difficulty of understanding or explaining the income distribution. Due to a large array of potential forces, it is basically impossible to explain what has caused income distributions to change over time. If we take a look at the income distribution of the United States for instance, we see that the poorest 20% have not gained any wealth since 1970s. Furthermore, we could say that the bottom half of the population has hardly benefited from rising GDP since the 1970s. Only the top 20%, and especially the top 5% have seen an enormous increase in paychecks.

Income Distribution of the United States, 1940-2005, source: Wikipedia

However, are we really able to draw these conclusions?

Simply put, we have no clue whatsoever about what has driven these statistics. Comparing income distributions of the 1970 with those of 2010 is like comparing apples and oranges. So many things have changed over the last decades that it is almost impossible to tell anything about those graphs above. There is just too much that we need to know but in fact do not know:

  • How were the underlying statistics collected?
  • How did the authors deal with unemployed workers?
  • How did they account for part-time workers?
  • How did they factor in changing demographics?
  • How did they incorporate immigration?

Just to mention a simple example, the share of part-time work has increased dramatically since the 1970s. Given that part-time workers usually earn less per hour than full-time workers, more part-time work would show up as more ‘poor workers’ in the figure above.

Furthermore, the fact that population in many Western countries ages has definitely had an impact on the graphs above. As we all know, income differences among 20-year olds are negligible. Income gaps usually widen as people grow older. Thus, demographics has almost certainly had an effect on America’s income distribution.

Thomas Sowell provides his readers with many more ways in which the figure above could be explained. But I guess you already got the message: Due to the plethora of potential explanations, we just don’t know what has caused the statistical figures we observe. Thus, it is nothing but ridiculous to say anything about whether or not the development we observe in the figure above is ‘fair’.

The second issue, Thomas Sowell beautifully points out is the illusionary idea of equality. In particular, he presents a simple model where all individuals start their career at age 20 with an income of $10,000. At age 30, all individuals then increase their salary to $20,000. Another ten years further in their career, they earn $30,000. These raises continue until individuals reach their 60s, while income drops to zero at age 70. In addition to this perfectly equal income distribution, Sowell further assumes that all individuals follow the same savings pattern. Each year every person uses $5,000 to pay for subsistence expenses and saves 10% of whatever is left.

A simple summary clarifies the situation:

  • Age / Income / Annual Savings (10%) / Accumulated Wealth
  • 20 / 10,000 / 500 / 0
  • 30 / 20,000 / 1,500 / 5,000
  • 40 / 30,000 / 2,500 / 20,000
  • 50 / 40,000 / 3,500 / 45,000
  • 60 / 50,000 / 4,500 / 80,000
  • 70 / 0 / 0 / 125,000

These numbers already show the enormous inequality that emerges. The richest people earn five times as much as the poorest and they possess more than 25 times as much wealth. And if all cohorts had the same size, we could infer that the richest 17 percent have 45 percent of all accumulated savings in the economy.

Keep in mind that we assumed identical incomes and saving patterns for all individuals. The only source of income variation in our example is age (something hardly blamed for inequality). Thus, even when having perfect equality in income paths, the result would be a very unequal distribution of income and wealth.

Thomas Sowell extends his analysis by also discussing other kinds of misleading income statistics. For instance, he describes how different demographics lead to racial income gaps. Or he points out that the whole notion of ‘income distribution’ is deceptive: income is earned and not distributed. Only by assuming income being property of the state (rather than the individual) one can talk about income¬†distribution.

To sum up, we ought to be very careful when dealing with income statistics. And if you ever paid any attention to those alarming statistics, I can only suggest reading Sowell’s book.

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