How much is money worth at different income levels?

One of the more important questions about income inequality and redistribution is the value of an extra dollar depending upon the income level of the recipient. An extra dollar might be more efficient and useful to society depending upon the income level of the individual it goes to. A new National Bureau of Economic Research working paper by economist Nathaniel Hendren of Harvard University attempts to answer this question by creating a new metric called the “inequality deflator.”

Hendren’s new statistic may help economists and policy makers better understand the distributional effects of a variety of policy areas from taxes to trade policy to mergers and acquisitions. This in turn should help economists better understand how high levels of inequality interact with economic growth to create higher living standards.

The key insight of Hendren’s new measure is this—the social value of an extra dollar depends upon who receives it. Compensating the losers of a change to economic circumstances, also known as redistribution, has some costs. Taxing the winners will distort their decisions, such as how much to work, which would have an effect on total economic output—particularly if they are higher-income individuals. So if the surplus the winners accrue goes to those at the top of the income ladder then a fair amount of distortionary redistribution might be necessary to make everyone better off.

Hendren argues that economic surplus is worth more to those at the bottom of the income distribution. His reasoning: When the surplus flows directly to low-income people the need for distortionary taxation is reduced and everyone would be better off. In other words, inequality has a cost because rectifying it would be costly.

Hendren’s inequality deflator varies across the income distribution and ends up being a single number for each point in the distribution that tells you is how much surplus the average person would receive if the surplus for a person at a particular income is increased by $1. According to Hendren’s calculations using U.S. tax data, giving $1 of surplus to a person at the 20th income percentile would increase average surplus per person for everyone by about $1.10. Compare that to the deflator of an income at the 90th percentile, which would result in everyone accruing only about $0.80 for each $1 of surplus.

The deflator can be used in several ways, but one particularly interesting application is for comparing income distributions across countries. The United States has the highest per capita output of all major industrialized countries, but also the highest levels of overall income inequality. Using the deflator, Hendren adjusts this output per capita for the income distribution and finds that the U.S. level doesn’t look so great anymore.

In fact, using Hendren’s new deflator, the United States is now below Canada and Denmark when it comes to output per person and closer to the level of Austria and the Netherlands. At the top of this ranking of select developed economies is Denmark and at the bottom is France.

Hendren’s work is, of course, a preliminary working paper and offers a new way of thinking about the equity-efficiency trade-off. We should be careful not to be wedded to the specific take-aways from this paper. But he has contributed a very interesting way of thinking about how we value economic surplus.

August 4, 2014


Economic Inequality

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