The Right Level of Income Inequality

2011 February 27 by Frank Monaldo.

Overtime, income inequality in the US has experienced an increase, at least in comparison to other Western countries. Some of this has been the consequence of high income women marrying high income men spreading the household income distribution, as well as the move away from heavy industry to a emphasis on new high-tech skills sets. The question posed here is: If people are freely able to sell their labor at whatever price others freely accept - a natural meritocracy - what would be the level of inequality?

One traditional measure of inequality is the Gini index. The index varies from 0 to 1 where 0 is total equality, everyone makes the same income and 1 is one person making all the income. The index is not linear and one can find its definition here.

There must be a natural Gini index associated with a open meritocracy. If the actual Gini index is much higher or lower than this natural value, it takes an outside force like that of the government to compel a different result. At one end, a government could claim all income and distribute it equally, yielding a Gini of 0. At the other extreme, a government could force most people to receive little income and a bulk of the income could be distributed to a few people, probably with political pull. A government could also force an intermediate result.

The US Gini index for income was stable, a little less than 0.40 from the end of World War II until about 1980. From that point, there has been a steady increased to about 0.47 in 2006. More recently there has been a small dip in the Gini index.

The US is always compared unfavorably to our European friends for having a higher Gini index. Their Gini indices tend to be in the 0.30 to 0.35 range, with notable exceptions like Sweden in the 0.25 range. However, that complaint begs the question. What would the optimum Gini index be? The actual Gini index is a complex function not only how much the government determines wages, but of the age and cultural distribution of a society, of the variety of different industries, of geographical diversity, and whether there exist new industries growing rapidly with the need for specialized labor. A growth in the Gini index could be a positive or negative result depending on the cause.

One way to estimate the natural Gini index is to look at sports, which is as close to a meritocracy as we can expect. For Major League Baseball with no salary cap and with free agency, the Gini index is about 0.50, far more unequal than the US general population. In individual sports like golf and tennis the inequality can be greater. Indeed, in some studies the more unequal the distribution in a team’s payroll, the better its performance.

The point here is not to argue exactly what the level of inequality there should be in a society, but simply to caution that it is not necessarily true that the narrower income distribution the more equitable or more optimal.

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