Consumption and Income Inequality

From the NY Times opinion page:

You Are What You Spend, by W. Michael Cox and Richard Alm, Commentary, NY Times: With markets swinging widely, ... and the word “recession” on everybody’s lips, renewed attention is being given to the gap between the haves and have-nots in America. Most of this debate, however, is focused on the wrong measurement of financial well-being.

It’s true that the share of national income going to the richest 20 percent of households rose from 43.6 percent in 1975 to 49.6 percent in 2006, the most recent year for which the Bureau of Labor Statistics has complete data. Meanwhile, families in the lowest fifth saw their piece of the pie fall from 4.3 percent to 3.3 percent.

Income statistics, however, don’t tell the whole story of Americans’ living standards. Looking at a far more direct measure of American families’ economic status — household consumption — indicates that the gap between rich and poor is far less than most assume, and that the abstract, income-based way in which we measure the so-called poverty rate no longer applies to our society.

The top fifth of American households earned an average of $149,963 a year in 2006. As shown in the first accompanying chart, they spent $69,863 on food, clothing, shelter, utilities, transportation, health care and other categories of consumption. The rest of their income went largely to taxes and savings.

The bottom fifth earned just $9,974, but spent nearly twice that — an average of $18,153 a year. How is that possible? A look at the far right-hand column of the consumption chart, labeled “financial flows,” shows why: those lower-income families have access to various sources of spending money that doesn’t fall under taxable income. These sources include portions of sales of property like homes and cars and securities that are not subject to capital gains taxes, insurance policies redeemed, or the drawing down of bank accounts. While some of these families are mired in poverty, many (the exact proportion is unclear) are headed by retirees and those temporarily between jobs, and thus their low income total doesn’t accurately reflect their long-term financial status.

So, bearing this in mind, if we compare the incomes of the top and bottom fifths, we see a ratio of 15 to 1. If we turn to consumption, the gap declines to around 4 to 1. A similar narrowing takes place throughout all levels of income distribution. The middle 20 percent of families had incomes more than four times the bottom fifth. Yet their edge in consumption fell to about 2 to 1.

Let’s take the adjustments one step further. Richer households are larger — an average of 3.1 people in the top fifth, compared with 2.5 people in the middle fifth and 1.7 in the bottom fifth. If we look at consumption per person, the difference between the richest and poorest households falls to just 2.1 to 1. The average person in the middle fifth consumes just 29 percent more than someone living in a bottom-fifth household.

To understand why consumption is a better guideline of economic prosperity than income, it helps to consider how our lives have changed. Nearly all American families now have refrigerators, stoves, color TVs, telephones and radios. Air-conditioners, cars, VCRs or DVD players, microwave ovens, washing machines, clothes dryers and cellphones have reached more than 80 percent of households. As the second chart, on the spread of consumption, shows, this wasn’t always so. ...

While foreign competition may have eroded some American workers’ incomes, looking at consumption broadens our perspective. Simply put, the poor are less poor. Globalization extends and deepens a capitalist system that has for generations been lifting American living standards — for high-income households, of course, but for low-income ones as well.

Paul Krugman responds:

Income and consumption inequality, by Paul Krugman: So Cox and Alm have a piece in today’s Times arguing that consumption inequality is much less than income inequality, so nothing to worry about.

Now, there’s no question that consumption inequality at a point in time is less than income inequality. But the CEX study on which they rely is widely believed to be seriously flawed, especially for tracking recent trends. For whatever reason, the survey seems to be missing a lot of consumption growth among the affluent. There’s a good summary of that discussion in Gordon and Dew-Becker.

You probably should also know that Cox and Alm previously tried to make the case that there is huge income mobility in America — unconvincingly. In fact, they repeated in full arguments that had been thoroughly debunked years earlier. (Also see Gordon and Dew-Becker on this.)

So my basic reaction to the piece was, there they go again. There’s some truth in what they say, but no news.

Let me add this from the Minneapolis Fed. This is from an earlier post I did on this topic (with new comments at the end):

Poverty Rates in Recent Years, by Mark Thoma: In a recent commentary in the Washington Times, Alan Reynolds says:

No economist who hopes to avoid professional ridicule would try to deny that consumption is a better measure of long-term living standards than the most widely cited income distribution figures, which do not even add transfer payments or subtract taxes.

It's clear why the administration's defenders are pushing this point. Here's a graph of income and consumption based measures of poverty taken from a recent article from the Minneapolis Fed on measuring poverty:

The green line is income based poverty and it has been increasing since 2000. The consumption based measure shows more progress and that's why it is being pushed on some editorial pages. But even with the consumption based measure, poverty is little changed between 1998 and 2003 and the total decline since 1998 has been less than 1%. Thus, while the consumption based measure does not show the increase in the poverty rate that income based measures show, it is still evident that progress has stalled in recent years as compared to the decline from 1993 through 1998.

As Paul Krugman notes in comparing the change in poverty in the U.S. and in Britain:

And Britain’s poverty rate, if measured American-style — that is, in terms of a fixed poverty line, not a moving target that rises as the nation grows richer — has been cut in half since Labor came to power in 1997.

For the same time period, and using the best case consumption based measure, the rate has only fallen by a little over a percentage point over the same time period in the U.S. (see graph). Thus, while it's easy to see why the administration prefers the consumption based measure, even using this measure the U.S. has not done as well as Britain has over the same time period. As Paul Krugman also notes, this is partly due to a difference in the priorities of the two administrations.

I want to defend my colleagues against the claim made by Reynolds that they will face ridicule if they question Reynold's preferred consumption based measure of poverty.

Actually, I'll let who economists who work in this area speak for themselves. This is from the article containing the graph shown above. See if you think these economists ought to receive the "professional ridicule" Reynolds says they deserve rather than the respect accorded to colleagues engaged in serious research on important issues:

Poor by what standard?, FedGazette, Minneapolis Fed: ...Not foolproof Add it all up, and a different pattern emerges regarding poverty. A 2003 Census report on material well-being noted, “As many (studies) show, the levels of poverty and inequality tend to decrease using consumption-based figures, in comparison with income-based measures.”

Recent studies have reinforced that notion. In a 2006 working paper for the NBER, economists Bruce Meyer (University of Chicago) and James Sullivan (Notre Dame) pointed out that the official poverty rate “suggests that poverty has changed very little over the past three decades,” rising with recessions and then subsequently falling. In contrast, “Consumption-based poverty rates often indicate large declines, even in recent years when income-based poverty rates have risen” (see chart).

Responding to questions via e-mail, Sullivan said that consumption “is a more consistent measuring stick over time and that it is a better measure of the well-being of the worse off.” He added, “Over the past three decades, consumption poverty tells a more optimistic story than does income poverty ... suggesting we are winning the war on poverty.”

Some economists prefer to look at consumption because it is less volatile than income on an annual basis for most households. People smooth their consumption based on long-term income expectations. Such a phenomenon is readily apparent among those who lose a job. While their income might plummet, consumption tends to fall much less dramatically. Such households tend to either dip into savings or take on additional debt with the expectation that higher income will return in due time.

All this is not to say that consumption wins the best-measuring-stick debate hands down, even among advocates. Sullivan, for example, acknowledged “some important practical concerns with switching to consumption,” including the fact that consumption surveys are much smaller in scale than income surveys, making it difficult to analyze local patterns because of sampling problems.

The consumption model has other blind spots. For example, it can only measure total costs; it has no ability to distinguish the quality of purchases or the utility of different types of purchases to a household. For example, a 2005 working paper by Thomas Deleire of Michigan State and Helen Levy of the University of Michigan found that higher expenditures among single-mother households during the 1990s “can be explained by a shift from food at home to food away from home.” While that is positive in some senses—less work cooking at home and more food “leisure”—an alternative explanation is that more meals were eaten outside the home out of necessity and at higher cost to the household budget, as more single mothers worked, either voluntarily or because of changes to the welfare system in the 1990s. Better off? Hard to say for sure.

Sullivan and others also point out that income poverty has simple longevity on its side. “I think it is well understood that there are flaws in the official measure of poverty,” Sullivan said. “(But) we have been using the current measure for about 40 years, so we have a nice time series that is generally understood.” A 2005 article in the BLS's Monthly Labor Review noted that most studies of well-being are based on income data “partly because of history and also partly because of habit. Income data are accessible, comparable over time, and of high quality.” International comparisons are possible only through income because other measures like consumption are simply unavailable in most other countries.

Austin Nichols, a research associate at the Urban Institute, a nonpartisan economic and social policy research organization, has authored several recent reports on poverty trends. “I think a lot of folks use the official poverty line for the sake of convenience and comparability,” Nichols said via e-mail. That might sound like faint praise, but Nichols said that “convenience and comparability is not to be scoffed at.” Any new measure would not likely offer a view of poverty dating back to the 1960s and could have “equivalent or greater problems. ... At least the official poverty measure is understood by most people, as are some of its limitations.”

In the end, everything is relative. Not even researchers within the same organization agree on the best way to measure poverty. Gregory Acs is a senior research associate at the Urban Institute. Along with his counterpart Nichols, he has considerable experience with both poverty trends and the definition-measurement issue.

Acs and Austin tend to disagree over the utility of consumption-based poverty measures. According to Acs, “Ultimately, consumption is a better measure of well-being than income, but I think it is harder to measure, and income is not a bad proxy for consumption.” But Nichols responded, “I disagree that consumption is a better measure of well-being,” in part because researchers don't know how much consumption is financed by unsustainable borrowing. He added that consumption measures “have just as many problems as income-based measures.”

This scholarly head butting illustrates the general difficulty of pinning down who is poor and who is not. Said Acs, “I think Austin and I agree that there are pros and cons to all the poverty approaches,” both income and consumption.

The existing measure has stuck because “we have the most experience measuring income ... (and) researchers and policymakers are by now quite aware of its limitations,” according to Acs. “We want poverty to be an absolute measure of deprivation, and I think that's asking too much of any single statistic.”

However you measure it, we can do better.

To me, being poor isn't just about stuff, it's about being able to participate fully in society. The things on the list that almost all households now have, refrigerators, stoves, TVs, and telephones, are things you have to have to function in this society (the other things on the list such as VCRs and DVDs only have 80% penetration so they don't necessarily reach the poor). How do you make a doctor's appointment without a phone? Drop by in you spare time? A refrigerator and a stove are items a household has to have given how we bring food to the table in this society. I just don't see these things as doing anything more than providing the minimum necessary to function. Even something like a TV is necessary if you want to, say, keep up with the political debates (there's a presumption in our political discourse that you can watch campaigns on television and they are largely devoted to delivery over that medium - without a TV you cannot participate fully) or even talk to people around the water-cooler at work about the latest popular TV show. Yes, the poor might have been well-off in, say, 1821 given the societal standards of the time, or some other historical period one might choose to compare, but this isn't 1821 - things have changed and so have the minimum standards necessary to be part of the society. I'm sorry if there are people who don't want to share, an indication that even with all their wealth they don't think they have enough (if they did, why balk at sharing with the less fortunate, people who, according to the  Cox and Alm article, are "drawing down ... bank accounts" and selling other assets like cars just to keep up?). Giving people the things they need to be a full part of the society they live in is the decent and right thing to do. As our society elevates itself and the requirements for full participation increase, when things like computers are as necessary as a stove, our standards of decency - what we are willing to accept as a minimum standard of living - must also rise. Just meeting physical needs - food and clothing - is not enough to be a full part of the society we live in today. We can and should do better than that.