Oversimplifying income inequality

Writer H.L. Mencken noted that "there is always an easy solution to every human problem that is neat, plausible, and wrong."

There may be no greater contemporary illustration of Mencken's warning than the debates surrounding inequality. People on both sides of the political spectrum repeatedly get this issue wrong, which risks solutions that could make matters worse.

Let's begin with those who consider themselves more conservative or libertarian. Their overwhelming response is to deny or ignore inequality as an issue. Their operative assumption is that much of the inequality observed is temporary and, at its root, a function of economic success. They are certainly correct on the former but view inequality too narrowly on the latter.

According to Statistics Canada, one-quarter of those who started in the lowest income quintile (bottom 20 per cent) in 2008 moved to a higher quintile within a year. When the period is extended to five years, 43 per cent of those in the lowest quintile had moved to a higher quintile. One could say that the solution to much of today's inequality is tomorrow's income mobility. The worst possible solution, then, would be to implement policies that impede such mobility.

Inequality, however, is not always a result of successful entrepreneurs and businesses providing citizens with goods and services they want at a price they're willing to pay. Indeed, inequality that results from hard-won economic success is not all that troubling. In fact, substantial amounts of inequality are a result of government protection (monopolies and trade restrictions) and other special privileges (cronyism) bestowed on individuals and businesses by government.

Conservatives make a terrible mistake when they are complacent about inequality arising from such special privileges. No less an authority than Adam Smith, intellectual father of modern economics, warned sternly against the dangers such abuse of government power entails.

While the dismissiveness of inequality by those on the right is unacceptable, the over-simplification of inequality by the left is potentially much more damaging.

Those who want more redistribution of income and wealth tend to put every inequality statistic to work in the service of this goal. Inequality is not at all simple, but is rather terribly complicated. If we don't go to the trouble of understanding how it works, our solutions will be ineffective at best, and deeply damaging at worst.

Consider just a few of the many complications that exist in analyzing inequality. First, many of the inequality comparisons used are based on income before the effects of taxes and transfers are factored in. Yet the whole edifice of transfers, and the progressive tax system that finances it, is one of the most important ways in which inequality is tackled. Not taking account of such policies when measuring inequality is a mistake that obscures rather than informs.

Another problem occurs because much of the inequality data is taken from surveys, which suffer notoriously from under-reported and unreported income. For example, one study reports that roughly 20 per cent of employment insurance and 40 per cent of social assistance income is under-reported.

A related issue is the underground economy. Income from both legal and illegal activities may go unreported for many reasons, such as tax evasion or fear of prosecution. The 2007 estimate for the size of the underground economy in Canada was 15.7 per cent of GDP, which represents a lot of income likely not captured by official figures.

Some of these incomes, such as social assistance, are disproportionately earned by those in lower-income brackets; at the very least, the uncertainty created by such potentially significant differences in real incomes at the low end of the income scale muddies our understanding of actual income inequality.

If the concern with income inequality is that it measures the inability of low-income households to secure basic necessities, the real issue becomes not income, but consumption: can people get the housing, food, transport, appliances, education and other goods and services they need?

Consumption inequality is always lower than income inequality. In 2008, the most recent year of data, consumption inequality was a little over 30 per cent less than the inequality calculated using income.

Another complicating factor is the changing nature of households. Statistical measures of income and thus income inequality are based on households rather than individuals. One of the main factors to consider in the changing nature of households is the increased rate of single-parent and single-income households. When the statistics are properly adjusted to compensate for the changing nature of households over time, both income and consumption inequality are reduced by roughly 30 per cent.

Ignoring important issues such as these all result in oversimplifying the complicated social phenomenon that is inequality.

Not all understandings of inequality are created equal. And therefore many "solutions" to the problem of inequality deserve a healthy dose of skepticism.

Jason Clemens is the director of research at the Ottawa-based Macdonald-Laurier Institute and the author of the recently released Income Inequality: Oversimplifying a Complicated Issue, available at www.macdonaldlaurier.ca.

Republished from the Winnipeg Free Press print edition July 1, 2012 A14