Tag: Taxation

In his most recent post, Matthew Kahn describes me as someone who believes that people want to keep up with the Joneses.  But I’ve never felt comfortable with that way of characterizing people’s concerns about relative income, because of its apparent implication that inequality wouldn’t matter if only people could learn to ignore negative emotions like envy and jealousy. Yet relative income matters for a host of reasons that have nothing to do with such emotions.  That’s because our ability to achieve important life goals often depends strongly on how much we spend in relative terms.

If you’re applying for a job, for example, you’re advised to look good when you go for your interview. But looking good is an inescapably relative concept. If other applicants spend more on clothing, your best bet may be to spend more as well, even though your likelihood of a callback won’t rise if all spend more.  Yet if others spend more and you don’t, your odds will fall.

Similarly, the relative amount you spend on housing affects your ability to send your children to good schools, because a good school is also an inherently relative concept. In almost every local environment, the good schools tend to be those located in more expensive neighborhoods. To send your children to one, you must outbid others for the relatively expensive housing in the neighborhoods they serve.

Failure to recognize the instrumental role of relative spending explains why many fail to recognize that rising income inequality has imposed large economic costs on middle-income families. The problem stems from a multi-step process that Adam Seth Levine, Oege Dijk, and I have called expenditure cascades. The first step occurs when people at the top spend more, which they’ve been doing simply because they have so much more money. When they build bigger mansions, they shift the frame of reference that shapes demands for those with slightly lower incomes, who travel in overlapping social circles.  The near rich respond by building bigger houses as well, which shifts the frame of reference for others just below them, and so on, all the way down the income ladder.

This cascade is the most parsimonious explanation for the striking fact that the median new single-family house in the United States, which stood at 1,570 square feet in 1970, had grown to more than 2,300 square feet by 2007.  That growth cannot be explained by growth in the median wage or median family income, which changed by much smaller amounts during those years.

What changed dramatically was the context in which the median family’s housing choice was made.  Any family that failed to rent or purchase a house near the median of its local price distribution would have had to send its children to below-average schools.  So a family that was determined not to see its children fall behind had little choice but to keep pace with what similarly situated families were spending on housing.

The figure at the top of this post (an updated version of one described in more detail here) shows how much more difficult keeping pace has become for the median family. Taking the implicit monthly cost of a house to be roughly one percent of its purchase price, it plots the number of hours each month the median earner would have needed to work to meet that cost during the last 60 years.  During the immediate postwar decades, when the income distribution was stable, the median burden of homeownership varied little, and was actually slightly lower in 1970 (41.5 monthly hours of work) than in 1950 (42.5 hours).  But as income inequality began rising sharply in the 1970s, the toil index rose in tandem. By 2010, the median worker had to work 82.9 hours a month—almost twice as many as in 1970—to put her family into a house of median price.

Housing is of course not the only expenditure that is sensitive to context.  Explosive income growth at the top has also spawned similar expenditure cascades for items such as clothing, gifts, birthday parties, and other celebrations to mark special occasions. In these domains as well, the median earner must now spend more than before or else endure significant adverse consequences of one kind or another.

Of course, Matthew Kahn would be correct to note that not all such spending has been purely wasteful.  Although the utility conferred by a diamond ring may depend largely on its relative size and quality, for example, even the lone resident of a desert island might take additional pleasure in the way an absolutely larger stone refracts the light. Yet surely much of the extra spending of recent years has been a relatively inefficient source of extra utility.  The average American wedding now costs almost $30,000, nearly twice as much as in 1990. Does anyone believe that the extra spending has made couples and their families any happier?

Higher outlays of this sort crowd out other forms of spending that would produce real improvements in the quality of life.  If houses grew less rapidly, for example, we could invest in mass transit systems that would yield shorter, less stressful, commutes that would free up more time to spend with friends and family.  Or we could support medical research and safety investments that would reduce premature death.  The list goes on.

Inequality apologists like to remind us that the poor now enjoy many conveniences that even the very rich didn’t enjoy earlier.  But saying that rising income inequality has imposed enormous costs on middle-income families is not the same as saying that such families were better off a century ago.  Absolute income also matters, and everyone is indeed better off in many ways because it is so much higher now than in the past.

Saying that inequality has been costly is also not the same as saying that the optimal amount of inequality is zero. Few people would work if everyone were guaranteed an equal share of the national income irrespective of effort, in which case we would all be poor in absolute terms.

Yet precisely because relative spending power is so important for instrumental reasons, even very small absolute income differentials are sufficient to stimulate high levels of effort. There is no credible evidence that national income would fall if income disparities were to shrink substantially from today’s levels, and there is actually considerable reason for believing that it would be higher.

Many of the substantial costs associated with high income disparities are thus completely gratuitous. When the wealthy all build bigger mansions and stage more elaborate parties, they succeed only in raising the bar that defines adequate.  The associated waste is all the more troubling because it would be easy to eliminate so much of it with some simple changes in tax policy.