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ROHAC: Income inequality doesn’t matter

The poor benefit most from removal of economic obstacles

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Liberal pundits are alarmed that income inequality in the United States is higher than in Pakistan or Ethiopia and - as a recent Organization for Economic Cooperation and Development study shows - higher than at any time since the Great Depression. But should this be a cause for concern?

If one cares about the welfare of the poorest and the most vulnerable, income inequality is not a useful measure. Measures of inequality tell us nothing about the living conditions of the poor, their health and their access to economic opportunity.

Income inequality can easily increase in societies in which everyone, including the very poorest individuals, is becoming better off. In the United States, as well as in Europe, indicators of income inequality have grown during the past 30 years. Yet this rise is just an artifact of the inappropriate use of income as a measure of welfare. In real terms, the poorest members of Western societies are better off than they were 30 years ago.

Much of that has to do with the rise of cheap imports from countries such as China and new forms of large-scale retailing, epitomized by Wal-Mart and Sears, which have given the low-income groups access to goods that previously were enjoyed only by the rich. In terms of the actual material conditions of living, developed countries appear to be more equal than ever before.

Data reveal that inequality in subjective life satisfaction is not on the rise, either. Bill Gates' net worth might be higher by a factor of 5 million compared to that of the average American family. However, in spite of his wealth, he certainly is not 5 million times happier than a typical American.

Most measures of inequality are based on the country level as the relevant unit of analysis. However, as Branko Milanovic, a World Bank inequality analyst, points out, that obscures the most significant differences in the standards of living. On a global level, income disparities between countries dwarf the disparities within countries.

Therefore, if one cares about the well-being of the least-well-off human beings, one should think primarily about lifting developing countries out of poverty rather than about reducing income disparities in wealthy countries.

Should we be bothered at all by income inequality at a national level? In their influential book "The Spirit Level" (Bloomsbury Press, 2009), British academics Richard Wilkinson and Kate Pickett tried to demonstrate the social costs of inequality. If the United Kingdom were to cut income inequality in half, the argument goes, "murder rates would halve, mental illness would reduce by two-thirds, obesity would halve, imprisonment would reduce by 80 percent, teen births would reduce by 80 percent, and levels of trust would increase by 85 percent."

However, the thrust of "The Spirit Level" is junk science, cherry-picking the evidence and relying on simple correlations between inequality and numerous social ills. By doing that from the outset, the authors disregard various other factors that may have affected health outcomes, homicides, drug use or child pregnancies while assuming what they were supposed to prove: that inequality is the only relevant factor driving these outcomes.

To be sure, rising income inequality can be symptomatic of underlying injustice or institutional flaws. American data reveal that development for those with the highest incomes is completely dissociated from that for lower-income earners. While skills-based technological change might have been part of the reason for rising nominal income inequality, the evolution of very high incomes seems to be driven by other factors.

In particular, the growth of executive remuneration in the financial industry cannot be dissociated from a cozy relationship that has long existed between policymakers and bankers. The implicit guarantees to the banking sector have led to excessive risk-taking and leverage, translating into high bonuses in good economic times and bailouts in bad economic times.

Putting in place restrictions on executive bonuses, taxing financial transactions and corporate profits does little to mitigate the flawed incentives that have led to exuberant financial booms. A genuine solution would consist of eliminating bailout guarantees to the banking sector, thus reducing the existing incentives for gambling with other people's money.

As a rule of thumb, poor people are not harmed by economic inequality. They are harmed by bad institutions, corruption, barriers to entrepreneurship and privileges enjoyed by the select few at the expense of everyone else that result in income inequality. Focusing on income inequality rather than drivers of poverty, obstacles to economic opportunity and systematic injustice obscures what really works and what does not in the realm of economic policy, and ultimately, harms the poor and the vulnerable.

Dalibor Rohac is a research fellow at the Legatum Institute and the author of "Does inequality matter?" - a report published by the Adam Smith Institute.

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