Ghetto to Goldman Sachs? Does Income Inequality Matter?

In his latest column on Yahoo finance, Charles Wheelan ("The Naked Economist") discusses a really interesting idea about income equality.

He is asking the important question about whether income inequality matters. To be clear, he is not referring to the need of helping people out of poverty, but instead whether the SIZE of the income gap matters once most people have basic necessities (i.e. a TV in every pot). The main question is: "If we succeed in raising the incomes of the poor, does it matter if incomes at the top are rising even faster, making us a more unequal society overall?".

Many economist argue that income inequality can be seen as an economic incentive for people on the lower end to "reach" up. Some argue that this inequality motivates risk, hard work, and innovation.

But does it? If not, is there a better way to distribute income?

The really interesting idea from the article centers around two points.

First, if the socioeconomic ladder is broken, there may not be a way for inner city kids to advance up the socioeconomic curve. Can they go from the ghetto to Goldman Sachs? Of course we have some instances of people from lower economic classes reaching wall street (or some other highly paid position), but how often does this happen? How much of a collective impact do these few instances have on people's motivation? It is possible that these citizens may look at our growing income inequality as a permanent structure and are unconvinced they can follow. It is also quite possible that they may decide to be more revolutionary and attempt their own economic structure.

Economic research may indicate this. Robert Putnam, professor of political science at Harvard, established links between social capital and economic inequality. Two of his studies (Putnam, Leonardi, and Nanetti 1993, Putnam 2000) established these links in both the United States and Italy.

"Community and equality are mutually reinforcing… Social capital and economic inequality moved in tandem through most of the twentieth century. In terms of the distribution of wealth and income, America in the 1950s and 1960s was more egalitarian than it had been in more than a century… [T]hose same decades were also the high point of social connectedness and civic engagement. Record highs in equality and social capital coincided. Conversely, the last third of the twentieth century was a time of growing inequality and eroding social capital… The timing of the two trends is striking: somewhere around 1965-70 America reversed course and started becoming both less just economically and less well connected socially and politically"

Secondly, Wheelan points out that relative wealth may be more important to our sense of well being than absolute wealth. Cornell economist Robert Frank found that a majority of Americans would prefer to earn $100,000 while everyone else earns $85,000, rather than earning $110,000 while everyone else earns $200,000.

So......what does this mean? This may question whether income inequality is acceptable as long as the pie gets larger and everyone moves up the scale.

To be fair, this is a very debatable point. However, it could be possible that a country (e.g. the U.S.) could be collectively better off if (depending on one's definition of well being) we had a smaller, more evenly divided pie.

http://finance.yahoo.com/expert/article/economist/19750