Sunday, September 27, 2015

Income averaging over a lifetime, masked as income redistribution

I have long argued that disputes over income inequality, where they are not simply a function of intra-elite envy or ideological animus, are for the most part, simply a political cudgel wielded for rhetorical effect but to no good policy ends.

I have argued that we suffer two forms of ignorance. The first is the broader one. We do not have good language or numeric capacity to conduct a reasoned and informed discussion at the national level about income inequality because most people simply do not have access to the customs of thinking and the information which is available to actually reason towards some logical outcome.

The more critical aspect, though, is that the same can be said about the actual informational practitioners. Inequality is a function of policy and circumstance and economics and sociology and custom and culture and demographics and technology, etc. Even those who are supposed to be close to the issue, usually only touch one or two parts of the elephant. Not only does no one have a good picture of the entire issue, but we still are not very well developed in our measures of inequality. The Gini Index, one of the most common measures, is fairly crude and is loaded with its own in-built biases.

I think it might be Thomas Sowell who uses the example of the impact of demographics in confusing the issue. The example he gives (and I am making up the numbers) is that adult Hispanics earn $20,000 a year whereas adult Japanese Americans earn $40,000, demonstrating dramatic income inequality. The issue, however, is that the average age of Hispanics is 25 (at the very beginning of a career) whereas the average age of Japanese Americans is 45, at the peak of one's earning years. So comparing Hispanics and Japanese Americans to highlight income inequality is wrong because it does not control for critical measurable differences between the demographic groups.

Who gets counted as in poverty is also part of the set of issues. Is it right to include the 19 year old student in college and from a solidly middle income family as poor because they are only earning a few thousand dollars a year in waiting tables, life-guarding and similar student jobs? We all know that they are not poor, they are simply cash flow constrained. When they graduate into white collar jobs, they will no longer be poor. There is nothing that needs to be done for them from a policy perspective, and yet they are a not immaterial portion of the population measured as poor.

This is not to say that inequality is irrelevant. It is to say that we do not yet understand it well at an academic level (for example, at the macroeconomic level, to the surprise of most economists and certainly all left leaning politicians, there is, within reasonable boundaries, no evidence that inequality has any impact on national productivity) much less at a level to argue policy.

There is further evidence of the complexity of the topic from Why Britain is not so unequal after all from The Economist. Britain, despite Margaret Thatcher, has had a strong redistributionist inclination for decades now. However, a new paper indicates that the net result of most inequality reducing policies is not to actually redistribute money from rich to poor, but to function as a scheme of forced savings, smoothing income swings over a lifetime.
One of the key aims of taxation and public spending is to redistribute income from rich to poor. The way most statisticians, economists and policymakers think about this is in terms of a cross-sectional snapshot: what the distribution of wealth or income is between different people in a population in a single year. But we might care more about lifetime incomes: in the modern labour market, many people now have very high incomes in certain parts of their lives, and much lower ones at other times.

A new paper by the Institute for Fiscal Studies (IFS) shines a new light on how well the British tax system redistributes incomes over people's lifetimes, in addition to using the cross-sectional approach. It presents several interesting findings. For a start, it finds that lifetime inequality in Britain has always been much lower than cross-sectional inequality (see first chart). This is because the poorest in any given year are not always poor for their entire lives; the IFS's simulations suggest that those who, over the whole of their life, are in the lowest 10%, only spend an average of a fifth of their lifetimes at the bottom.

More startlingly, policies that increased or cut welfare expenditure appear to have had very little impact on lifetime inequality. For instance, while the benefit cuts of the late 1980s reduced benefits and increased cross-sectional inequality, it had a much more muted effect on lifetime inequality. And, similarly, although Gordon Brown's massive expansion of means-tested tax credits in the 2000s reduced cross-sectional inequality, they had very little impact on cutting lifetime inequality.

The paper also finds that the redistribution performed by the British welfare state is, to a great extent, smoothing incomes over people's lifetimes rather than in a given year. Whereas 36% of individuals receive more in benefits than they pay in tax in any given year, only 7% do so over their lifetimes. Over half of all redistribution is simply across peoples' lifespans; the young pay in while they work, and take out when they retire (see second chart).
To me, this is further support to the idea that the policy focus ought not to be on redistribution, it ought to be on equipping citizens with the cognitive and non-cognitive skills which will increase their productivity (and therefore income) over a lifetime.

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