Income Inequality and Behavioral Economics

This post is co-authored by Julian Jamison, economist with the Federal Reserve Bank of Boston (*), and Austin Frakt.

Bruce Bartlet reacted to last week’s The American Prospect article on income inequality by Dalton Conley thus:

I have never understood how I am worse off if the top 1% of households increase their share of national wealth or income as long as the absolute level of wealth and income of the other 99% is unchanged. It may be aesthetically displeasing, but it doesn’t impose any actual costs on anyone as long as the pie is not fixed.

Kevin Drum, whose post brought this latest blogosphere skirmish over the issue to my attention, thinks the real problem is stagnation of middle class wages:

Rising inequality, then, is just a symptom of the real problem: sluggish middle class wages in a country that’s been growing energetically for decades.  That’s the core problem.  Get median wages growing at the same rate as the country itself and inequality will take care of itself because there will automatically be less money left over for the rich.

As these quotes suggest, much of the focus in debates over income inequality is on its extent and causes, its socio-economic consequences, and what if anything can and should be done about it. But I think there’s something missing: why does income inequality bother some of us at all and others not in the least? One is tempted to answer, “It doesn’t bother the ‘haves’ because they’re on top. It bothers the ‘have nots’ (or the ‘have less’) because they, well, have less and want more. Don’t we all?” But I think the “have less” can get more (and some argue they have) and still be dissatisfied, and justifiably so. More doesn’t necessarily make us happy, even if neo-classical notions of rationality suggests it ought to.

For the moment let’s ignore income inequality entirely and ask whether more money (or GDP/capita) makes people happier. The neo-classical answer is yes, always. The recent stereotypical answer is: yes, very much up to some minimal level, but very little after that. Maybe it helps in the short-run, but people adapt very quickly to higher income. Furthermore, people don’t correctly predict this adaptation, so again they overestimate the effects of increased wealth. So this is a real problem with normal comparisons of who’s doing well.

Separately, behavioral economics studies also show that relative income seems to matter, and there are good evolutionary reasons for why that might be the case. It’s important for us social animals to be respected and held in high regard by our peers and potential competitors. Also, there’s the sense of schadenfreude when someone else does poorly, but this is probably not something we should promote in policy.

So again, this suggests that an unevenly rising tide might not be a great thing overall–not for ethical reasons (which are fine as well) but for purely utilitarian ones. Of course it also depends how one defines one’s reference group: community or country? people in your church or your workplace or who you grew up with? Can government change your framing so as to induce you to compare yourself to a different group and thus be happier? Would that be a reasonable policy goal? Would it need to be secret to work?

These questions are suggested by appeals to behavioral economics but are rarely considered in discussions of policy (as far as we know). Why not? Shouldn’t policy debates concerning income inequality be sensitive to the teachings of behavioral economics? After all, neo-classical notions of welfare, utility, and rationality do not have unique claims to legitimacy. They’re tradition, and in many instances they’ve been shown to be at odds with how we really feel, think, and behave. A sufficiently large degree of income inequality rubs (some of) us the wrong way because that’s the way we are. Of course it is hard to go from that statement of reality to policy prescriptions. But if we were to try, what would we come up with? What’s the behavioral economist’s solution to the problem of income inequality? By now at least that should be viewed as a legitimate question.

(*) The views and opinions expressed in this post do not necessarily represent those of the Federal Reserve Bank of Boston or the Federal Reserve System.

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