6SSMN966 Lecture 8 Part 1

Income Inequality Measure Income Inequality Empirical Facts on Income Inequality Wealth and Labor Income Readings
Public Economics.
7. Income Inequality
Simona Grassi
King’s College London
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Outline
1 Income Inequality
2 Measure Income Inequality
3 Empirical Facts on Income Inequality

Evolution of Top-Incomes
4 Wealth and Labor Income
5 Readings
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Recall: Two General Rules for Government Intervention
1 Market Failures: Government intervention can help if there are market

failures
2 Redistribution: Free markets might generate inequality. Public cares

about economic disparity. Govt taxes and spending can reduce
inequality
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Redistribution
Even with no market failures, free markets outcomes might generate

substantial inequality
Inequality matters because people evaluate their economic well-being
relative to others, not in absolute terms ⇒ Public cares about inequality
Govt uses taxes and transfers to redistribute:
⇒ Generates an efficiency and equity trade-off (size of economic pie vs.
distribution of the economic pie)
If govt intervenes to redistribute the economic pie more equally, the more
equally divided pie is smaller!
4/40
Inequalities and Riots in Baltimore 2015

City of Baltimore: Riots in 2015 in the poor inner city.
Figure: Inequality in Life Expectancy
Source: Gruber, 5th edition, ch. 17

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Inequalities and Riots in Baltimore 2015
In Sandtown-Winchester, the average life expectancy is 67 years; just 3

miles away in the wealthy Baltimore neighborhood of Roland Park, life
expectancy averages 84 years.
The life expectancy in Freddie Gray’s neighborhood is well below that in

North Korea, one of the poorest countries in the world and at about the
same level as the U.S. average in 1948.
This is not an isolated example: 15 Baltimore neighborhoods have a life

expectancy below that of North Korea.
This enormous discrepancy represents huge underlying differences in

economic resources in these different neighborhoods.
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Inequalities and Riots in London 2011
London:
Sir Michael Marmot, Chair of the Commission on Social Determinants of

Health -WHO:
"In summer 2011 in London, there were riots. They started in Tottenham in
North London. ... the precipitant was the killing of a black man by the police.
As with Baltimore, the underlying cause was inequality. I had been pointing to
figures on health variations in London. For men, life expectancy in the most
down at heel part of Tottenham was 17 years shorter than in the richest part
of Kensington and Chelsea."
Source: http://www.abc.net.au/radionational/programs/boyerlectures/boyer-
lecture-health-inequality-and-the-causes-of-the-causes/8172022
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Income Inequality: Labor vs. Capital Income
Individuals derive market income (before tax) from labor and capital:
z = wN + rk where w is wage, N is labor supply, k is capital, r is rate of
return on capital
1 Labor income inequality is due to differences in working abilities
(education, talent, physical ability, etc.), work effort (hours of work, effort
on the job, etc.), and luck (labor effort might succeed or not)
2 Capital income inequality is due to differences in wealth k (due to past
saving behavior and inheritances received), and in rates of return r
Capital Income (or wealth) is much more concentrated than Labor Income; it
is based on interests, rents, dividends.
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Macro-aggregates: Labor vs. Capital Income
US data 2010
Labor income wN ' 75% of market income z
Capital income rk ' 25% of market income z
Capital stock k ' 400 − 500% of market income z
Rate of return on capital r ' 5 − 6%
In GDP, gross capital share is higher (35%) because it includes

depreciation of capital
National Income = GDP - depreciation of capital + net foreign income
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Income Inequality Measurement
Commonly used are the Lorenz curve and associated Gini coefficient.
Lorenz curve: L(p)

Order all income unit from the poorest to the richest
Divide the units in equal groups, e.g. deciles, and compute the
proportion of the total income received by each tenth of the population
The Lorenz Curve maps the cumulative percentage of the total income
against the cumulative percentage of the population
e.g. the point on the curve corresponding to x=50% will tell the p% of
total income owned by the poorest 50% of the population
If all have the same income, then the poorest 50% of the population
must have 50% of the total income!
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Income Inequality Measurement
Gini coefficient
Gini = 2 * area between 45 degree line and Lorenz curve
Notice: area below 45 degree line is 0.5
Gini=0 means perfect equality
Gini=1 means complete inequality (top person has all the income)
0 ≤ Gini coeff. ≤ 1
11/40
Gini Coefficient California pre-tax income, 2000,
Gini=62.1%
100%
90%
Lorenz Curve
80%
70% 45 degree line
60%
50%
40%
30%
20%
10%
0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Source: Annual Report 2001 California Franchise Tax Board

Empirical Facts on Income Inequality
In the news
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In the news
13/40
In the news
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Key Empirical Facts on Income Inequality
1 In the US, top income shares dropped dramatically from 1929 to 1950
and increased dramatically since 1980 [Piketty and Saez, 2003]
2 US: Top incomes used to be primarily capital income. Now, top incomes
are divided 50/50 between labor and capital income (due to explosion of
top labor incomes with stock-options, bonuses, etc.)
3 In the US, labor income inequality has increased substantially since

1970: debate between skilled biased technological progress view vs.
institution view (min wage and Unions) [Autor-Katz’99]
4 Fall in top income shares from 1900-1950 happened in most OECD

countries. Surge in top income shares has happened primarily in English
speaking countries, not as much in Continental Europe and Japan
[Atkinson, Piketty, Saez JEL’11]
Next graphs: Source mainly Piketty and Saez 2003 Quarterly Journal of
Economics.
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Figure 1: Gini coefficient
0.50
● ●
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●
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●
●● ●
0.45 ●●● ●
● ●
●
● ●●● ●
●
●●
●
●
Gini coefficient
● ●●
●●
●● ●
0.40 ●● ●
● ●●
●
●
●
● ●●
● ● ●●●● ●●●
●
●●
● ●● ●
● ●
●
0.35
● All Workers
Men
Women
0.30
1940 1950 1960 1970 1980 1990 2000
Source: Kopczuk, Saez, Song QJE'10: Wage earnings
Year
inequality
Top 10% Pre-‐tax Income Share in the US, 1917-‐2013

50%
Top 10% Income Share
45%
40%
35%
30%
25%
1917
1922
1927
1932
1937
1942
1947
1952
1957
1962
1967
1972
1977
1982
1987
1992
1997
2002
2007
2012
Source: Piketty and Saez, 2003 updated to 2013. Series based on pre-tax cash market income including realized
capital gains and excluding government transfers.
Decomposing Top 10% into 3 Groups, 1913-2013
25%
Share of total income for each group
20%
15%
10%
Top 1% (incomes above $392,000 in 2013)

5%
Top 5-1% (incomes between $165,500 and $392,000)
Top 10-5% (incomes between $116,500 and $165,500)
0%
1913
1918
1923
1928
1933
1938
1943
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
2013

Source: Piketty and Saez, 2003 updated to 2013. Series based on pre-tax cash market income including realized
capital gains and excluding government transfers.
US Top 0.1% Pre-‐Tax Income Share and Composi:on
12%
Capital Gains
10% Capital Income
Business Income
8%
Salaries
6%
4%
2%
0%
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
2011
Source: Piketty and Saez, 2003 updated to 2013. Series based on pre-tax cash market income
including or excluding realized capital gains, and always excluding government transfers.
Europe is UK, France, Germany, Sweden
16/40
Top 1% Income Share (in %)
0
5
10
15
20
1910
1915
1920
1925
Canada
1930
1935
United States
United Kingdom
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Top 1% share: English Speaking countries (U-shaped)
2010
Source: THE WORLD TOP INCOMES DATABASE
Evolution of Top-Incomes
Evolution of Top-Incomes: follow section 2, 4, 6 of
Atkinson, Anthony B., Thomas Piketty, and Emmanuel Saez. Top

Incomes in the Long Run of History. Journal of Economic Literature 49.1
(2011): 3-71.
17/40
Top Incomes in the Long Run of History
The analysis of top incomes dynamics has some limitations

Only top incomes
Only pre-tax incomes (so we don’t know if govt corrected inequality)
Definition of income is not perfectly comparable among countries and is
based on tax return
Tax evasion not taken into account because use tax records
18/40
Why do we care about increase of top incomes?

1. Fairness
2. Impact on growth and resources:

the top 1 percent is small share of the population, but captures more
than a fifth of total income -23.5 percent in the United States as of 2007
–> should tax policies reflect this?
average real incomes per family in the United States grew by 32.2
percent from 1975 to 2006 while they grew only by 27.1 percent in
France
did US do better than France? Excluding the top percentile, average
U.S. real incomes grew only 17.9 percent during the period while
average French real incomes still grew at much the same rate
3. Impact overall inequality
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4. Affect world inequality
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Explain Evolution of Top Incomes
Factors explaining evolution of top incomes
1. Wars. Most countries top incomes fall during the world wars -mainly loss of
capital incomes. Why?
Physical capital destruction due to the wars (very large in France where
2/3 of it went destroyed during WW2)
Very high inflation eroding the value of nominal bonds
Loss of territories (England lost colonies)
Increase tax on wealth during wars
War economy imposed wage controls, so also wage incomes became
more equal
21/40
2. Political variables. The type of political regimes can affect top income
inequality
Top income share started to increase in UK and USA during Thatcher
and Reagan administrations
Type of welfare states: liberal (Anglo-Saxon) vs
corporatist-conservatives (continental Europe) vs social democratic
welfare states (Scandinavian countries)
22/40
3. Macroeconomics and financial crisis: In Australia, France, the Netherlands,

USA, UK the Great Depression (1928-1931) reduces inequality at the top
4. Globalization
5. Progressive taxation:
Piketty (2001, 2003) highlighted the role of progressive income taxation
in France: "how can one account for the fact that large fortunes (pre-tax
incomes) never recovered from the 1914-45 shocks, while smaller
fortunes did recover perfectly well? The most natural and plausible
candidate for an explanation seems to be the creation and development
of the progressive income tax."
23/40
5. Progressive taxation:
Sweden: Roine and Waldenstrom ("The evolution of top income sin an
egalitarian society: Sweden, 1903-2004", Journal of Public Economics,
2008) conclude that "given that much of the fall in top incomes happens
before (progressive) taxes reach extreme levels and largely as a result of
decreasing income from wealth, an important effect of taxation in terms
of top income shares has been to prevent the accumulation of new
fortunes" (p. 382).
24/40
On Wealth and Income
For Wealth and Income, follow

Thomas Piketty, Emmanuel Saez, Inequality in the long run, Science, 23
May 2014: Vol. 344, Issue 6186, pp. 838-843
Can skip the model of wealth concentration over time (page 841)
Next: why labor income and capital income compositions differ over time and
space.
25/40
Wealth Inequality: Europe vs USA

Europe: UK, France, Germany, Sweden
26/40
Wealth inequality: Europe vs USA
Wealth concentration always much higher than income concentration

Bottom half of the population owes any wealth (less than 1/10 of
average wealth), whereas they hold appreciable income (half of average
income)
USA top decile wealth share was about 70 to 80% from 1870 to 1910,
still around 70% now
In USA 20 to 30% of wealth did not belong to top decile; bottom half
ownership’s of share of capital always negligible; exists wealth middle
class (middle 40%)
Europe middle wealth class missing before WWI; nowadays wealth
middle class in Europe wealthier than in the US, but trending to getting
small.
Today inequality in US is mainly due to large rise of top labor income
rather than on extreme wealth concentration of patrimonial society of the
past
In 1913 Europe, top incomes were mainly top capital incomes (rent,
interests, dividends)
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Wealth to Income Ratio
28/40
Europe is UK, France, Germany, Sweden
29/40
Europe vs US
US: U-shape for income inequality (booming top labor incomes) (see
Figure Top 10% Pre-tax Income Share in the US, 1917-2013)
Europe: U-shape for aggregate wealth to income ratio (booming wealth)
30/40
Why capital is back in the second half of the XXI century?
According to Thomas Piketty and Gabriel Zucman, the reason why capital is
back is due to low growth rate of the economy.
They propose a model to explain the observed data:

Given share of capital income over national income is α = rK /Y = r β, r
average annual real rate of return on wealth
β = gs ; Y grows for population growth and productivity growth.
Data show extreme capital concentration in society with high β and α
Example: saving rate s = 10% and a growth rate g = 3%, then
β = 300%. But if g = 1.5%, then β = 600%.
High wealth concentration in historical series is due to low growth rate
with respect to r. In short: Capital is back because low growth is back.
In a low-growth society, the total stock of capital accumulated in the past
can become very important. With zero population and productivity
growth, income Y is fixed; if s > 0, the accumulated capital K will go to
infinity and β = K /Y would rise indefinitely.
31/40
Explain wealth inequality

r − g in history
32/40
Explain wealth inequality
Large gap r − g in historical perspective explains reasons why

wealth highly concentrated until WW1
US has always had higher g because of large immigration and economic

growth, hence lower wealth concentration
in the last century, high population growth, lower rate of return to capital
due to capital shocks (destruction), rise of taxation explain reduced
wealth concentration compared to past centuries
Future: if we expect lower population growth and after tax rate of return
to capital rise due to changing technology and international tax
competition to attract capital, then in the current century r − g will go up
again –> new rise of wealth concentration
33/40
Explain Labor Income Inequality

On Explain Income Inequality follow: Skills, Education, and the Rise of
Earnings Inequality Among the "Other 99 Percent" , David H. Autor. Science,
23 May 2014: 344 (6186), 843-851.
Focus is not on the top 1% but more on inequality among the other 99%
Explain labor income inequality: race btw education and technology

education increases supply of skilled labor
technology rise demand for skilled labor
if the first is faster than the second, inequality falls and vice-versa
Inequality rise due to higher demand for skilled labor due to globalization,
skill biased technological change...
According to Autor: in the US slow down of supply of skilled workers from

1980s–> effect is the sharp increase in college premium in the early 1980s
continuing for 25 years
and at the same time: successive waves of innovation have reduced the
demand for physical labor and increased the demand for workers with high
cognitive ability.
34/40
35/40
Autor shows that not just the top 1% incomes rose over time, but also
labor incomes among the other 99%
The rise in skill premium has contributed to the rise in income inequality
According to some studies, in the US the increase in the education wage
premium explains about 60 to 70% of the rise in the dispersion of US
wages between 1980 to 2005.
36/40
Does wage reflect skill?

The figure in the following slide shows the average percentage earning
differential btw full time workers ages 35 to 54 who differ by one
standard deviation in the Program for the Internationl Assessment of
Adult Competencies (PIAAC)
37/40
38/40
Readings
Slides should guide your reading of the following resources

Sections 1, 2, 6 Atkinson, Anthony B., Thomas Piketty, and Emmanuel
Saez. Top Incomes in the Long Run of History. Journal of Economic
Literature 49.1 (2011): 3-71
Thomas Piketty, Emmanuel Saez, Inequality in the long run, Science, 23
May 2014: Vol. 344, Issue 6186, pp. 838-843 (skip model page 841)
Skills, Education, and the Rise of Earnings Inequality Among the "Other
99 Percent" , David H. Autor Science, 23 May 2014: 344 (6186), 843-851
Jonathan Gruber, Public Finance and Public Policy, Fourth Edition, 2012
Worth Publishers, Chapter 18 (stop after 18.4 in edition 5)
39/40
Readings
Not mandatory readings:

Luttmer, Erzo FP. Neighbors as negatives: Relative earnings and
well-being. Quarterly Journal of Economics 120.3 (2005): 963-1002
Piketty, Thomas, and Emmanuel Saez. Income inequality in the
United States, 1913-1998. The Quarterly Journal of Economics
118.1 (2003): 1-41
Piketty, Thomas, and Emmanuel Saez. How Progressive is the US
Federal Tax System? A Historical and International Perspective. The
Journal of Economic Perspectives 21.1 (2007): 3-24
Piketty, T., and G. Zucman, "Capital is Back: Wealth-Income Ratios
in Rich Countries, 1700-2010", Quarterly Journal of Economics,
2014, vol.129, no.3, p.1155-1210
40/40

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Income Inequality Measure Income Inequality Empirical Facts on Income Inequality Wealth and Labor Income Readings

King’s College London

2 Measure Income Inequality

3 Empirical Facts on Income Inequality

4 Wealth and Labor Income

Recall: Two General Rules for Government Intervention

1 Market Failures: Government intervention can help if there are market

2 Redistribution: Free markets might generate inequality. Public cares

Even with no market failures, free markets outcomes might generate

Inequalities and Riots in Baltimore 2015

Figure: Inequality in Life Expectancy

Source: Gruber, 5th edition, ch. 17

Inequalities and Riots in Baltimore 2015

In Sandtown-Winchester, the average life expectancy is 67 years; just 3

The life expectancy in Freddie Gray’s neighborhood is well below that in

This is not an isolated example: 15 Baltimore neighborhoods have a life

This enormous discrepancy represents huge underlying differences in

Inequalities and Riots in London 2011

Sir Michael Marmot, Chair of the Commission on Social Determinants of

Income Inequality: Labor vs. Capital Income

Macro-aggregates: Labor vs. Capital Income

Capital income rk ' 25% of market income z

Capital stock k ' 400 − 500% of market income z

Rate of return on capital r ' 5 − 6%

In GDP, gross capital share is higher (35%) because it includes

National Income = GDP - depreciation of capital + net foreign income

Income Inequality Measurement

Lorenz curve: L(p)

Income Inequality Measurement

Notice: area below 45 degree line is 0.5

Gini=0 means perfect equality

Source: Annual Report 2001 California Franchise Tax Board

Empirical Facts on Income Inequality

Key Empirical Facts on Income Inequality

3 In the US, labor income inequality has increased substantially since

4 Fall in top income shares from 1900-1950 happened in most OECD

Top 1% (incomes above $392,000 in 2013)

Europe is UK, France, Germany, Sweden

Evolution of Top-Incomes: follow section 2, 4, 6 of

Atkinson, Anthony B., Thomas Piketty, and Emmanuel Saez. Top

Top Incomes in the Long Run of History

The analysis of top incomes dynamics has some limitations

Top Incomes in the Long Run of History

Why do we care about increase of top incomes?

2. Impact on growth and resources:

Top Incomes in the Long Run of History

Explain Evolution of Top Incomes

Factors explaining evolution of top incomes

Explain Evolution of Top Incomes

Explain Evolution of Top Incomes

3. Macroeconomics and financial crisis: In Australia, France, the Netherlands,

Explain Evolution of Top Incomes

On Wealth and Income

For Wealth and Income, follow

Wealth Inequality: Europe vs USA

Wealth inequality: Europe vs USA

Wealth concentration always much higher than income concentration

Wealth to Income Ratio

Europe is UK, France, Germany, Sweden

Europe: U-shape for aggregate wealth to income ratio (booming wealth)

Why capital is back in the second half of the XXI century?

They propose a model to explain the observed data:

Explain wealth inequality