Income Inequality: Consumption Inequality as a Supposed Proxy (Again)

Mark Thoma is providing us with thorough coverage of the good, the bad, and the ugly on this debate on whether income inequality is increasing. I cannot do justice to all of what Mark links to, but I have a reason to focus on what Dirk Krueger and Fabrizio Perri said:

Measuring inequality in lifetime consumption and leisure is an impossible task as it would require data on consumption for many households, each followed for a very long period of time. Such data unfortunately do not exist. What is then a feasible and appropriate way of measuring inequality in lifetime consumption? If people would earn constant income throughout their lives, current income would be a very good approximation of lifetime consumption. In the data, though, current income fluctuates substantially over the life cycle and thus it is a potentially poor indicator of lifetime resources. Fortunately, we can use simple theories of consumption decisions of households over time (pioneered by Nobel prize winners Milton Friedman and Franco Modigliani), which show that if households can borrow and lend on financial markets, then there is a strong link between the lifetime resources of a household (sometimes also called its permanent income) and its current consumption. Current income shocks that are not fully permanent (such as seasonal shocks, job losses, bonus payments) strongly affect current income (and thus have a strong impact on the distribution of current income), but only have a moderate impact on permanent income and thus consumption.

Yes, I realize that measured consumption inequality has not increased as much as measured income inequality. And I’m sort of on record for suggesting lifetime income inequality has indeed increased. AB readers will note that I did discuss a research paper by Dirk Krueger and Fabrizio Perri as well as a related paper by Matteo Iacoviello. AB readers might also recall that that I often appeal to the logic of this Ando-Modigliani model. So how do I reconcile my respect for this Ando-Modigliani model and my view that income inequality has indeed increased. First of all, Dirk Krueger and Fabrizio Perri note several caveats about using their proxy for lifetime income inequality. Secondly, consider what I wrote way back then:

Iacoviello’s model predicts that consumption inequality grows less than proportionally as income inequality grows, while wealth inequality grows more than proportionally. Examining the distribution of current consumption misses the point that living standards should be gauged across individual’s lifetimes. While the very wealthy have ample resources for old age retirement, the evidence suggests that the working poor may not – unless we retain the Social Security Trust Fund as a vehicle to supplement their retirement benefits. Rightwingers like John Hood, however, are advocating that the government substantially reduce Social Security benefits. Go figure.

Simply put – the rise in wealth inequality over time is a statistic that is not consistent with this lifecycle model explanation of why income inequality has grown by much more than consumption inequality has grown.