SummaShare | The Income Inequality Mirage

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Introduction

Trying to understand and rectify the causes of poverty is very important, but focusing on income inequality, as measured by the Gini coefficient, is counterproductive if not downright destructive. Although other methods of measuring inequality exist, the Gini Coefficient is clearly the most important because it is used in virtually every study of the fairness of income differences and is most often quoted by world leaders. Yet its importance is due to its political power, not its intellectual accuracy.

Income inequality seems simple. It is supposed to tell us how the haves and have-nots are faring in different countries and whether economic systems in different countries are fair or unfair. It is based on the basic premise that the rich get richer because the poor get poorer and because the rich have a built-in money-making engine of established wealth to give them an insurmountable edge. Consequently, it is a favorite topic of world leaders who are looking for support from the poor.

But the whole concept of income inequality is based on a number of statistical fallacies including 1) failing to distinguish between the sad state of equal poverty and a much better state of unequal wealth, 2) ignoring the many causes of income inequality, some good and some bad, and 3) grouping together a wide range of people who have very different reasons for being in a particular income bracket. As a result, income inequality is a very poor yardstick, and any academic studies using it as an input will end up with grossly misleading conclusions that form a counterproductive basis for public policy. It labels equality an idyllic oasis, even if it is equal abject poverty. As a result, it lures unsuspecting leaders and the masses deeper into the waterless desert of government paternalism.

If one really cares about the poor and wants to improve their situation, one will have to look at better measures of economic progress and fairness than income inequality.

Reality of Income Inequality

It is obvious in free societies that people glean very different incomes from their work, investments, and government assistance. Since their incomes are not equal, it follows that “income inequality” is real. It is also obvious that some differences are fair while others are not.

Few people object to professional athletes and movie stars making more than average, and they are seldom singled out as a cause of income inequality. It is also commonly agreed that doctors, with more than 24 years of formal education, can justly make more than most high school graduates. Still, many wealthy business founders who never attended or graduated from a university are far “richer” than top doctors, such as J.C. Penny who started work after high school as a store clerk to help support his family after his father’s death.

Conversely, most people DO object to inequality that is the result of corruption and manipulation of power. When big banks gamble, lose, get bailed out, and pay big bonuses to those who did the gambling, people are rightfully resentful. Similarly, when CEOs of big companies go home with massive pay and benefits because of lucrative government contracts, monopoly protection, or other privileges that are the result of their “connections” in the Congress or the White House, people recognize that something is very wrong. These are the takers who steal wealth.

But most people don’t understand how entrepreneurs and honest business men and women improve their lives, and why they may end up making a great deal of money. These are the makers who create wealth that benefits others before they get to keep anything for themselves. They are an integral part of the engine of prosperity.

Because the Gini coefficient lumps all of the above together, it produces very misleading ideas about wealth and poverty that lead to policy conclusions which destroy prosperity instead of improving the lives of the poor.

Is Income Inequality Relevant?

Income Inequality and Growth

A Harvard study of the relationship between income inequality and economic growth “shows little overall relation between income inequality and rates of growth and investment.” If anything, “inequality retards growth in poor countries but encourages growth in richer places.”

The graphs in this study show an essentially random distribution of inequality, as measured by the Gini coefficient, and growth or GDP. This means that there is no relationship between income inequality as measured by the Gini coefficient and economic growth.

Income Inequality by Country

The most striking observation in a study of income inequality in multiple countries is that there is NO relationship between income inequality (as measured by the Gini Coefficient) and economic freedom, government corruption, productivity or economic prosperity! No pattern emerged, such as “countries with low inequality are economically prosperous” or “countries with high inequality are economically free.” Consequently, comparing “income inequality” between countries tells us nothing about prosperity or the justice and fairness of a political or economic system. Nor does it tell us anything about the condition of the poor. Countries where everyone is equally poor receive very favorable income inequality scores while countries where people are much better off but are unequal receive unfavorable scores.

Statistical Fallacies

World leaders say the “the sheer magnitude of inequality … is unacceptable”, the “gap between rich and poor is … the biggest single risk to the world”, “increasing inequality is … the defining challenge of our time”; and use income inequality to justify greater government control and punitive taxes on the rich. But these faulty conclusions are based on shaky Gini coefficient quicksand without any recognition of its limitations. Policies based on this errant data will not only be wrong but very destructive because the whole concept of income inequality is a maze of statistical fallacies including 1) failing to distinguish between poverty and wealth, 2) ignoring the causes of income inequality, some good and some bad, and 3) statistical analysis that groups together a wide range of people who have very different reasons for being in the same income bracket.

Between Poverty and Wealth

As a measure of the state of the poor and middle class, the Gini coefficient is very misleading because it gives better marks to equal poverty than unequal wealth. Although the Gini coefficient makes no explicit value pronouncements, it is incessantly used for that purpose by world leaders. It compares only relative income, not real income and makes bad look good and good look bad. For instance:

If everyone was equally poor (everyone had an annual income of $1,000), the Gini-coefficient would be zero, indicating perfect equality (no inequality), which is considered very good by those who value equality above all other virtues.
On the other hand, if everyone in the bottom 90% of the population had an income of $50,000 to $100,000 per year, while the top 10% had incomes of $500,000 or more per year, the Gini-coefficient would be high, indicating great inequality. This would be considered very bad by people who consider material equality to be the most important measure of fairness – in spite of the far greater prosperity for the “poorest” people.

Which society would you rather be “poor” in?

Causes of Income Inequality

Another major failing of the Gini coefficient is that it doesn’t take the causes of income differences into account.

Differences in income can be due to natural facts of life such as heredity, upbringing and individual ability or willingness to work hard, postpone immediate satisfactions, invest time and money, take risks, and sometimes just plain luck. On the other hand income differences can be due outright theft or abuse of power through rent/favor seeking by special interests that manipulate government and get it to steal for them. Discrimination that reduces the opportunities of specific groups also creates greater income inequality.

But, the Gini coefficient doesn’t differentiate between any of these fair and unfair causes of income inequality. All it measures is the difference in income. It says nothing about whether that difference is fair or unfair. But that doesn’t stop politicians from using it to claim that high income inequality is evil in and of itself.

Grouping Unlike People

The Gini-Coefficient, like almost all other political statistics, suffers from the fallacy of grouping together very different people under one broad common heading. For instance the “bottom 20% of people” based on income lumps together college students, retired people, recent immigrants, single parents and welfare recipients, even though they all have very different reasons for being in a low income bracket and totally different prospects for rising in the future.

The college students are poor because they are postponing work to get an education, while the welfare recipients may be unable or simply unwilling to work. Some will move out of these groups while others will in turn join them, because individuals are constantly moving up and down between income groups. A poor student today may be an aspiring small business owner tomorrow, but is counted as poor when she is in school and rich when she is working and creating jobs. A current business owner’s business may fail, moving her back into the poor category while she starts over.

Trying to draw conclusions about economic fairness by analyzing comparisons between meaningless groupings of diverse individuals will always produce misleading and deceptive results. The only things than can be gained from such analyses are skewed, meaningless, political sound bites.

Results Based on Bad Data

Garbage In, Garbage Out

The reason for the almost complete lack of relationship between income inequality and measures of growth and prosperity is the first law of statistics: “Garbage In, Garbage Out.” The Gini coefficient is a completely misleading metric based on meaningless groupings of individuals without considering whether the people it is measuring live in poverty or wealth, and without accounting for the innumerable causes of income inequality. It creates a statistical mirage of perfect equality that defies reality. Consequently, any analysis used the Gini coefficient as input will end up with grossly inaccurate and misleading conclusions that form a counterproductive basis for public policy.

A better measure of economic fairness is needed as a guide to public policy if we are serious about trying to solve the problem of poverty.

Piketty Example

Thomas Piketty, whose career has revolved around the study of income inequality, began with the premise that rising income inequality as defined by the Gini coefficient was bad, and then compiled a mountain of data to explain the factors affecting income inequality. His book, Capital in the Twenty First Century concludes that rising income inequality is due to the “fact” that return on capital (return on investment) is higher than the growth rate, boiling down all the complexities of income inequality into a simple mathematical equation, “r>g” where “r” is return on capital and “g” is the growth rate. It would be nice if it was that simple, but clearly it is not. If the object was an investigation into the causes of poverty, Piketty’s analysis is meaningless because it is based on bad data generated by the Gini coefficient, and you can’t start with garbage and end up with a gourmet steak dinner.

Unfortunately Piketty seems to lack a basic understanding of how wealth is accumulated and maintained in a free society where people can’t use personal or government power to steal from others. See “Making Capital Grow” in Engine of Prosperity to learn why just having capital is not enough to make it grow.

Karl Marx's Vision

Corrado Gini was a fascist theoretician who wrote the “Scientific Bases for Fascism.” Why would a fascist (national socialism) decry income inequality regardless of whether people were rich or poor. The answer can be found in the basic tenants of fascism, which are very similar to those of communism. Examining communist ideology regarding inequality can help us understand the problem.

Good is Bad

The fascist fallacy of measuring the well-being of the poor or middle class based on the comparative distribution of income, described above, is also clearly illustrated by the economics of Karl Marx. For Marx, the more a worker earns and the more his life improves under “capitalism”, the more he is being exploited! A rise in wages is said to increase the misery of the worker, because, as Marx put it, “… although the enjoyments of the worker have risen, the social satisfaction they give has fallen in comparison with the increased enjoyment of the capitalist ...” Because the business owners, who created the opportunity for the worker to increase his productivity and income, make more than the worker; the worker, being jealous of the business prosperity, can’t enjoy his own better state of existence. It's the pure destructive politics of envy.

So in Marx’s view the fact that the worker is better off, has a better home, better food, medical care, etc. is irrelevant because the free market businessman got even more. This view is perfectly reflected in the Gini-coefficient.

(Marxism Philosophy and Economics by Thomas Sowell, chapter 7, particularly the “Increasing Misery” of the Proletariat starting on pg 132 with quotes from pg 135).

Envy and Inequality

For Communist Karl Marx and Fascist Corrado Gini, it is ultimately all about envy, not material well-being. They care more about attacking the successful than helping the poor become more prosperous. If everyone were equally poor and starving to death, the Gini-coefficient would register perfect equality (fairness).

Based on the politicians' view of world inequality, and their use of the Gini Coefficient, it appears that they also think you would be happier and better off sharing equal misery than you would be with a higher standard of living in an unequal environment - because no matter how much you have, there would be others who have more – and your envy of and anger at those with more will make you miserable.

Are Marx, Gini and world leaders right? Would you rather not have an i-Phone because Steve Jobs became a billionaire creating it for you? Are you really as driven by envy as politicians think you are? Or should they start looking at the real rather than the relative quality of life, and how fair income inequality rises when the wealthy work to improve the lives of others - while unfair income inequality rises when the powerful use unjust influence and “rent/favor seeking” to siphon the wealth from taxpayers and consumers and give it to their friends and supporters.

Lesson

Although there are obvious differences in people’s incomes, the concept of “Income Inequality” as defined in 1912 by an Italian fascist named Corrado Gini is very dangerous because it says that the world would be better off if everyone were equally poor rather than unequally rich(er). His Gini coefficient is a mirage that only measures relative inequality of mismatched groups of people without any consideration of their actual standard of living or the causes of their differing incomes, completely ignoring the differences between fair and unfair income inequality.

Income Inequality, based on the Gini coefficient, is worthless as a basis for scientific study of the causes of poverty because meaningful results cannot come from flawed data. It’s sad that so much money and effort has been devoted to the analysis of income inequality using the Gini coefficient, as in the life’s work of Thomas Piketty, who recently published the New York Times best seller Capital in the Twenty-First Century.

Income Inequality is important, not because it is an accurate representation of anything in the real world, but because it can be used by politicians and elite world leaders to stir up envy and hatred that can be used to increase their power, which they claim they will use to make the world “fair”. Although some of these elites may sincerely misunderstand what they are doing, many are likely seeking increased power for their personal benefit.

If you really care about the world’s poor, pray that the political elite don’t get their way and crush all income inequality except their own. Although the causes of unfair income equality need to be addressed, policies that approach income inequality as an evil in and of itself will actually destroy prosperity instead. Corrado Gini and Karl Marx considered income and wealth inequality as a significant evil. In keeping with Marx’s view that an increase in the pay and standard of living for a worker is an indication of greater and more evil exploitation (because the business owner who created the higher paying jobs made even more than the workers), Gini created a mathematical tool to measure income equality that creates an alluring mirage of an idyllic oasis where everyone is equal, without telling you that they are also poor. The danger of this mirage is that it has the power to lure the masses into the waterless desert of government paternalism.

If one really cares about the poor and wants to improve their situation, one will have to look at a better measures of economic progress and fairness than Gini’s income inequality coefficient.

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