Saturday, January 25, 2014

Back of the envelope estimation of the income-inequality impact - 2.3% reduction

Two of the critical questions in the Decision Clarity decision-making methodology are, for any proposition, 1) Is it real? and 2) Do we know what causes it? They seem such easy questions but for most problems or arguments, they are quite hard to answer. Only once you have answered them can you move on to other important questions such as 3) Is it important?, 4) Can we change it?, and 5) Is it worth it?

Much of the current discussion of income and wealth inequality and mobility is simply so much cognitive pollution, wielded for political advantage rather than to address real world issues. Income inequality/mobility is one of those issues that is causally dense, complex (many parts with hidden feedback mechanisms), chaotic (sensitive to initial conditions), and non-linear in nature. Any pretense that we are either effectively measuring it or understand what causes it is delusional. We are at the edge of the knowledge shore, our feet wet, but with no demonstrated capacity to swim. We simply, for the time being, do not really know what we are talking about.

For those that wish to make an issue of income inequality, much of the inequality is attributed to simple luck (right place and right time) or to genealogical luck (born with the silver spoon in their mouth). It is critical that inequality not be the outcome of individual decision-making and effort.

As Mankiw summarizes in this post, How much income inequality is explained by varying parental resources? by Greg Mankiw, the popular view on income inequality among some might be characterized as follows.
When people think about inequality of incomes, a key issue is inequality of opportunity. Some people are born to rich parents who can afford private schools, summer camp, SAT tutors, etc., while others have poorer parents who cannot easily afford such things. One might wonder how much of the income inequality we observe can be explained by differences in the resources that people get because of varying parental incomes.
Citing a recent paper, Is the United States Still a Land of Opportunity? Recent Trends in Intergenerational Mobility by Raj Chetty et al, Mankiw skips much of the interesting discussion of how do we measure income inequality, whether those measures are meaningful, whether decreasing income mobility is real, much less whether we actually know what causes income inequality (however it is measured).

Instead he simply asks question 5 - Is it worth it? What is the size of the prize. If it is big, that makes it worthwhile to go back and do the hard slog through 1) Real? and 2) Causes?
The recent paper by Chetty et al. finds that the regression of kids’ income rank on parents’ income rank has a coefficient of 0.3. (See Figure 1.) That implies an R2 for the regression of 0.09. In other words, 91 percent of the variance is unexplained by parents’ income.

I would be willing venture a guess, based on adoption studies, that a lot of that 9 percent is genetics rather than environment. That is, talented parents have talented kids partly because of good genes. Conservatively, let’s say half is genetics. That leaves only 4.5 percent of the variance attributed directly to parents’ income.

Now, if you let me play a bit fast and loose with the difference between income and income rank, these numbers suggest the following: If we had some perfect policy invention (such as universal super-duper pre-school) that completely neutralized the effect of parent’s income, we would reduce the variance of kids' income to .955 of what it now is. This implies that the standard deviation of income would fall to 0.977 of what it now is.

The bottom line: Even a highly successful policy intervention that neutralized the effects of differing parental incomes would reduce the gap between rich and poor by only about 2 percent.
That is not to argue that nothing should be done - rather it is a caution against expectations and investment risk. It is also a catalyst to deep thinking - What are the real (as opposed to politically useful) causes of inequality, and what can we do about them?

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