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Blogs review: Inequality and the recovery

What’s at stake: Inequality is again a hot topic in the blogosphere. While the early focus of that debate was about the role of inequality in fos

Publishing date
01 February 2013

What’s at stake: Inequality is again a hot topic in the blogosphere. While the early focus of that debate was about the role of inequality in fostering financial crises (see this review from 2011), the debate moved away from short-term macroeconomic issues for some time with the discussion about capital-biased technical change and the rise of robots (see here). That time was short, however, as the latest round of discussion has been about the role that inequality might play in holding back the recovery.

Distribution and demand: the under-consumption hypothesis

Joseph Stiglitz started off the debate arguing that rising inequality and the sluggish recovery are intertwined. Stiglitz argues that the lack of growth in middle class incomes means that too little money is flowing to people with a higher consumption propensity. While the top 1 percent of income earners took home 93 percent of the growth in incomes in 2010, the households in the middle — who are most likely to spend their incomes rather than save them and who are, in a sense, the true job creators — have lower household incomes, adjusted for inflation, than they did in 1996. There is thus not enough support for consumer spending, the usual driver of US growth.

Paul Krugman writes that given his political views and general concerns about inequality, he would love to blame slow growth on inequality. But he couldn’t convince himself that the theory and evidence support that view. It is indeed perfectly possible to have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs. You don’t have to like it, but economics is not a morality play, and I’ve yet to see a macroeconomic argument about why it isn’t possible.

In a simple model of the IS-MP type, a decrease in the MPC would translate into a steeper IS curve. To the extent that the IS curve would also shift inward (it is not clear from the Stiglitz argument why it should, but still), that would generate a negative output gap. Add to this an inflation adjustment mechanism (i.e. a Phillips Curve) to close the model, and there is no reason why the economy should remain with depressed demand.

Mattew Iglesias conjectures that high levels of inequality greatly complicate the political economy of expansionary policy (which happens in the model outlined above since there is disinflationary pressure from the negative output gap). So to the extent that you have a lot of inequality, your politics is naturally going to be more focused on questions of distribution than expansion. I think you saw that in liberal hostility to even temporary expansion of the Bush tax cuts and even more clearly in things like the GOP turn against Making Work Pay and the payroll tax cut.

Inequality, tax receipts and fiscal fears

Joseph Stiglitz also argues that inequality also has negative fiscal consequences, fuelling fiscal fears: top earners are good at avoiding taxes and lobbying for lower tax rates. A lack of government revenues holds up government investment in education, infrastructure, research and health. Returns from Wall Street speculation are taxed at a far lower rate than other forms of income. Low tax receipts mean that the government cannot make the vital investments in infrastructure, education, research and health that are crucial for restoring long-term economic strength.

Paul Krugman argues that the idea that rising inequality depresses tax receipts is also dubious. The American tax system is mildly progressive, so receipts should go up when inequality rises, not down. Dean Baker notes that the tax system is, indeed, progressive, but the broader tax-and-transfer picture may well not be. The fiscal balance will probably worsen when inequality rises, as slightly risen tax receipts will not compensate for higher expenditures in means-tested welfare programmes such as food stamps or Medicaid. In a response to Baker, Krugman concedes this point, but doubts that even so the effect can be large. But Bajer is right: it’s always a good idea to remember that we have a tax-and-transfer system, not just a tax system.

Middle class stagnation revisionism

Donald Bourdreaux and Mark Perry argue that despite their wage stagnation, the welfare of nonsupervisory workers in the US has actually improved. They give several reasons. First, the Consumer Price Index overstates inflation by ignoring improvements in product quality. Second, fringe benefits have grown considerably in the past decades. Life expectancy has also risen for the middle class and fast travel has become much more affordable. Spending on “basics” has, according to BEA data, fallen from 53% of disposable income in 1950 to 32% today.

Jim Tankersley points out that the Boudreaux-Perry definition of “basics” is more than a bit dubious: Bourdreaux and Perry count food, clothing, shelter and cars as basics. The income fraction spent on that has indeed declined. But if one includes gasoline, healthcare and education, then there has been hardly any change in the income share of basics since the 1970s.

Paul Krugman writes nobody questions the fact that America has grown richer over the past several decades. The question is whether that growing wealth has trickled down to ordinary families, or gone mainly to a small elite. Yet when Boudreaux and Perry invoke consumer data, it’s data for all households — in effect, mixing the top quintile (and the top 1 percent) with the middle class. that nobody is saying that America has become richer. Disaggregating basics spending using the Consumer Expenditure Survey data, it is easy to show that the decline in the basics spending share since the 1980s is driven by the top quintile, whilst the middle quintile basics spending share has remained constant. B&P’s evidence that purports to prove that the middle class faces no stagnation indeed really shows that a growing income share is going to the very rich, who unsurprisingly spend only a low share of it on basic necessities.

Income vs. consumption inequality

Real Time Economics writes that while economists agree that income inequality in the U.S. has steadily increased, there has been debate over whether that has also translated to an increase in consumption inequality.

Mark Thoma reports that Kevin Hassett and Aparna Mathur are among the prominent figures who argue that consumption inequality has not increased along with income inequality. But Thoma debunks their arguments pointing that these authors are citing what is now dated work. They either don't know about the more recent work, or simply chose to ignore it because it doesn't say what they need it to say. The recent research in this area – see here or here - says the data (from the Consumer Expenditure Survey) they use must be corrected for measurement error or you are likely to find the (erroneous) results they find. When the data are corrected, consumption inequality mirrors income inequality. They don't say a word about correcting the data.

About the authors

  • Jérémie Cohen-Setton

    Jérémie Cohen-Setton is a Research Fellow at the Peterson Institute for International Economics. Jérémie received his PhD in Economics from U.C. Berkeley and worked previously with Goldman Sachs Global Economic Research, HM Treasury, and Bruegel. At Bruegel, he was Research Assistant to Director Jean Pisani-Ferry and President Mario Monti. He also shaped and developed the Bruegel Economic Blogs Review.

  • David Saha

    David C. Saha is a PhD student at the Freie Universität Berlin. David specializes in public economics and worked as research assistant at Bruegel in 2008. He holds an MSc in Economics from the LSE and an MA in Political Science from Columbia University. [email protected]

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