The Myth of Income Inequality

Income inequality is just 25% of its reported value. The Census Bureau uses the a deeply flawed definition of the measure, misleading you, me, and policymakers alike.

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"It's not what you don't know that gets you in trouble, it's what you know that ain't so." Ironically, despite 24/7 news, Mark Twain's warning is more relevant today than when he said it 120 years ago. Even on consensus issues, there's so much we know that just ain't so.

Take inequality. A 2020 Economist article spoke everyone's mind when they commented, "It's a truth universally acknowledged that inequality in the rich world is high and rising." Wealth inequality, of course and that's another story. But income inequality? Not so much. The Census Bureau reports income equality at 16:1, meaning the too 20% of households in the US have an income 16x what the lowest 20% of households. That is wrong. Income inequality in the US has been between 3-6% over the last two decades.

The reason for the inflation is arguably the most misleading definition I've heard. In their book The Myth of American Inequality: How Government Biases Policy Debate, Phill Gramm, Robert Ekelund and John Early reveal that the Census Bureau defines income inequality as pre-taxed, earned income.

Pre-tax income inflated the ratio of inequality because we have a progressive tax system where higher income earners pay more in taxes. IMO it's also misleading as it masks increases in W2 taxes that eat into your net income.

The second problem is earned income. The Census Bureau doesn't account for over $1.9 trillion dollars of transfer programs we pay to the poorer amongst us. Medicare, Medicaid, SNAPs and other programs that are designed to create more equality by taxing the rich aren't counted in the very measure they were designed to mitigate. That's like giving slower runners a head start in a marathon to ensure more equitable finishes, then use speed to rank runners rather than finish times. Taxes and welfare reduce our official income inequality metric by 75%!

This all sounds so preposterous, I remained doubtful. So I looked into it. From the Tax Policy Center, I collected all types of income; earned, transfer payments, and taxes. Turns out, Gramm, Ekelund, and Early were exactly right.

Since the Census Bureau provides the OECD with our measure of income inequality, their folly makes us look bad on the world stage too. Judged by the Gini Index, the US is reported worst among all G7 countries in income inequality. However, when accounting for taxes and transfer payments, we move into the middle of the pack. We're so much better than advertised!

This revelation completely changes how we should approach income inequality policy. Consider this. In the US, the top 10% of households account for ~42% of all wages. Do you think they:

a) Pay a lower share of total taxes

b) Pay an equal share of total taxes

c) Pay a higher share of total taxes

The answer is c. The top 10% of income earners pay 62% of all payroll taxes. This ratio of 1.4 is the highest of any G7 country. Stated differently, we have the most progressive tax system in the developed world.

As we already tapped the well dry on redistributive measures of combatting income inequality, further efforts should focus on the largest contributor to income inequality today--earned income. Thankfully, policies exist that'll provide the freedoms and resources for people with lower incomes to create better lives. Below are three such policies that will get more people working, create more local businesses, and educate those most in need of an early education.

1) Mandate welfare recipients are actively seeking work or advancing their education

2) Decrease unnecessary licensing requirements

3) Allow for school choice