Understanding Income Distribution

In Economics there are two things that are used to measure income distribution: Lorenz Curves and Gini Coefficients. The way it works is the United States is broken into 5 income levels (a quintile), and then we determine the percent of the wealth that lies in each quintile. From these numbers, we plot it on a graph and get a Lorenz Curve. Here is an example:

The 45 degree line represents a country that each person owns exactly the same amount of wealth, and a perfectly vertical line down the far right of the graph would represent a country where 1 person owns 100% of the nations wealth. When plotting the Lorenz Curve for a country, it typically falls somewhere in the middle. The closer the curve is the the 45 degree line, the more equal its income distribution is.

Gini Coefficients

Gini Coefficients are calculated as the area between the Lorenz Curve and the 45 degree line. We use this number to compare each country (as well as populations within a country). As a general rule, countries the have a Gini Coefficient between a .50-.70 are considered to have a high level of inequality whereas a country who’s Gini Coefficient falls between a .20 and a .35 is said to have a rather equal distribution.

If a country has a Gini Coefficient below a .20 you run into a problem where there is not a lot of competition and there is not a great incentive to work. There needs to be some incentive for workers to want to do better, to want to move up and accumulate more wealth. If that condition does not exist, a country will run into big problems. Typically you see low Gini Coefficients in communist societies or very socialist societies.

If a country has a higher Gini Coefficient, there are several problems that could develop:

- The rich tend to save more and not invest it
- There is an inefficient allocation of assets
- High crime rates and greater need for private property protection
- Social unrest

The higher the Gini Coefficient, the more likely the above problems are to occur. Gini coefficients have a tendency to creep higher as time progresses.

The United States: Now and Then

We often hear in the media that income distribution in the United States has become out of line and you hear calls for higher taxes on the wealthiest Americans. Then you hear claims that raising taxes is class warfare, so what is the truth?

Below is a graph of several historical Lorenz Curves for the United States:

As you can see, the curves have been moving outward for the last 30 years. Here are some historical Gini Coefficients:

1970: .394
1980: .403
1990: .428
2000: .462
2010: .469

Note: Data come from the US Census Bureau

Looking at this trend, it is in line with the Lorenz Curves and does show that income inequality in America is growing. When looking at the data, the majority of this growth of the income inequality happened during the 1990’s and the tech boom. Over the last 15 years or so we have seen this trend slow down.

How to Fix the Problem

The solution to income inequality is a progressive tax system (which the United States currently has). That tax system should reduce the distribution at the upper levels and increase the distribution at the lower levels through transfer payments (social safety nets for food, health, and education).

Now, before you start saying that I am calling for massive income redistribution in the United States (which I am not by any means), there are several requirements:

- you want to target the poorest members of society
- with any welfare type system you do not want to create dependency, it defeats the purpose
- There must not be an incentive to leave the work force to receive government aid
- The distribution cannot be so large that it upsets those not deemed poor

The United States does a fairly good job at this overall. Though I think we do need to look at our Tax Code and consider some major changes to it, yhowever calls for massive overhauls of the tax system — the Fair Tax, a Flat Tax, Herman Cain’s 9-9-9 Plan — are not necessary and will only hurt the economy. Those types of tax systems put a heavier burden on the lower quintiles and will only make income inequality worse.

The tax code is currently based on wide brackets, and as you move from one bracket to the other, there is a jump in the marginal tax rate (which can sometimes cause people to limit how much they make to prevent a jump from, one bracket to another). I think that the tax code should be a smooth curve where every extra dollar made pays a very small increase in federal tax rate that way it captures more of the income and does not discourage people from accumulating wealth into a higher tax bracket. I think the United States should target a Gini Coefficient around .40 and then write the tax code to reflect that. It should be adjusted in small increments so that there is not a huge change all at one time so that gradually we reduce the Gini Coefficient. I think the tax code needs to be looked at as a whole, we have a corporate tax rate that is much higher than that of every other developed country and we also need to re-write the personal income tax system so that it is easier to understand and no complicated to fix, and we should include a seperate tax rate for small businesses. Currently we change the tax code by writing it into bills to tax this group for this, etc…A better solution would be to re-write the entire tax code and keep these principals, or those like it in mind.

US vs The World

A look at Gini Coefficients around the world so you can understand where the United States stands:

United States: .469
Brazil: .567
Mexico: .479
China: .470
Russia: .415
Japan: .381
United Kingdom: .340
France: .327
Germany: .270

Note: US data is from 2010, all other countries are from 2005-2007 (From the CIA World Factbook)

1. econ4dummies posted this