Inequality 101 lessons for Democratic candidates

U.S. inequality is egregious, but it’s far less egregious when measured correctly. But understanding our true degree of inequality is important, especially for the many Democratic presidential candidates now proposing tax, Social Security and health-care reforms to fix the problem.

Unfortunately, today's inequality “experts” focus on inequality measures that exaggerate the problem. In particular, they leave out our progressive fiscal system. This is no minor mistake. The question is why?

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Surely it's the fact that incorporating our roughly 30 incredibly complex, interconnected federal and state tax and transfer programs in all their important, but gory details is a job requiring decades, not months.

Fortunately, together with business and academic colleagues, I have spent the last 25 years engaged in this task, not simply to analyze U.S. inequality appropriately, but to incorporate fiscal policy in fine detail in my company's personal financial planning software.

To understand the measurement issues, take Donnie and Johnnie — two 40-year-olds. Donnie doesn’t work. He has $10 million in real estate he inherited from his dad. Johnnie has not a penny to his name, but he has a great job, paying $500,000 a year. He plans to start saving and to retire at 65.

Who’s richer? The answer is penniless Johnnie. The present value of his future earnings — his human wealth — is over $12 million (discounted at an assumed 3-percent rate).

Hence, if we focus only on net wealth, per Thomas Piketty, the French economist who has been heralded for his study of wealth inequality, we’ll get the wrong answer. He'll conclude that Donnie is richer than Johnnie, which he’s not. 

Now add Sallie to the mix. Like Donnie, Sallie was born with a silver shovel in her mouth. When she was 40, she too had $10 million. But now, at 80, she has some $3 million left in net wealth.

According to Piketty, Donnie is richer than Sallie. But this makes no sense. Sallie was just as rich as Donnie when she was 40, and Donnie will be just as poor as Sallie is when he’s 80.

In short, comparing the resources, net wealth plus non-human wealth, of two different age groups is comparing apples and oranges.

Indeed, if Donnie, Johnnie and Sallie each spend and save so that their consumption is the same in each future year as in the current year, Johnnie, who has the highest resources, will consume more this year and in each future year than will Donnie and Sallie.

Moreover, since Sallie is just an older version of Donnie, Donnie and Sallie will spend the same fixed amount this year and in each future year that they are both alive. So, based on current consumption, Donnie and Sallie are equally well off. 

Let’s add one last thing to this thought experiment. Suppose the government annually taxes Donnie’s wealth and Johnnie’s wages at a 99-percent rate and hands Sallie the proceeds in the form of Social Security benefits. Now, super-rich Donnie and even richer Johnnie will consume less than Sallie. 

To summarize, ranked by net wealth, Donnie, Sallie and Johnnie come in first, second and third, and the picture is one of extreme inequality, since Johnnie hasn’t a penny of wealth to his name. Ranked by resources — wealth plus human wealth — it’s Johnnie then Donnie then Sallie. 

But ranked by consumption, it’s Sallie followed by Johnnie followed by Donnie, with Sally getting to consume far more than Johnnie or Donnie. This is thanks to the highly progressive fiscal system I’ve assumed.

Should we use wealth, resources or consumption to assess inequality? Economics’ answer is consumption, both future as well as current consumption. Economics tells us to measure inequality based on remaining lifetime consumption and to do so separately for each age group.

Remaining lifetime consumption equals resources less lifetime net taxes. Resources, again, are the sum of net wealth plus the present value of remaining lifetime labor earnings.

And remaining lifetime net taxes equals current taxes net of current government benefits (transfers, including in-kind transfers, like Medicare benefits) plus the present value of of all future taxes net of all future benefits. 

In recent years, UC Berkeley's Alan Auerbach and I, together with company colleagues, have been studying inequality using the Federal Reserve's 2016 Survey of Consumer Finances (SCF) — the best source of data on U.S. wealth inequality.

Our work takes into account federal and state corporate and income taxes, federal payroll taxes, Medicaid, ObamaCare and Medicaid benefits, welfare benefits, food stamps, 11 Social Security benefits, Supplemental Security Income, state sales taxes, etc.

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Here's what we've found for 40-year-olds: The richest 1 percent of 40-year-olds account for 26.5 percent of all 40 year-olds wealth but only 12.9 percent of their age growth remaining lifetime consumption.

The poorest 20 percent of 40-year-olds account for only 0.3 percent of their cohort's total wealth but 7.6 percent of their cohort's total remaining lifetime consumption.

The bottom line? U.S. consumption inequality, which is our ultimate concern, is major. The fact that the top 1 percent of 40-year-olds get to consume 13 percent of what all 40-year-olds consume and that the bottom 20 percent get to consume only 7.6 percent is unfair by any reasonable standard.

So we need policies that address this inequality. But in searching for those policies, we should not assume that wealth inequality is, on its own, a useful guide to true underlying consumption inequality. It's a terrible guide. 

Laurence Kotlikoff is a Boston University economist, president of Economic Security Planning, Inc., a fellow of the American Academy of Arts and Sciences, a research associate at the National Bureau of Economic Research and was formerly on President Ronald Reagan's Council of Economic Advisers. Follow him on Twitter: @Kotlikoff.