How does inequality affect wellbeing?

Rising income inequality in the United States over the past several decades is well-documented. But how this trend affects economic growth and well-being requires researchers to look beyond incomes to other factors in the lives of people from all walks of life.

That is why the Washington Center for Equitable Growth has awarded one of its inaugural grants to Timothy Smeeding, the Arts and Sciences Distinguished Professor of Public Affairs and Economics at the University of Wisconsin-Madison. He, along with his coauthors –  Jonathan Fisher of Stanford University, Jeff Thompson of the Federal Reserve Board, and David Johnson of the Bureau of Economic – will analyze income, wealth, and consumption records in order to understand how changes in the distribution of income and wealth affects consumption and savings decisions, and then show how these factors affect the U.S. economy.

His research may well be central to our understanding of whether and how economic inequality impacts growth given the sudden divergence in consumption inequality and income inequality following the Great Recession of 2007-2009. From 1984 to 2006, consumption and income inequality increased in parallel, as one would expect. As higher income households gained income, they also spent more.

Yet Smeeding noticed that something interesting began to happen in 2006—consumption inequality fell and continued to fall throughout the Great Recession. Smeeding and his two colleagues, Jonathan Fisher and David Johnson, find that it was, somewhat surprisingly, the top of the income distribution that had the biggest decrease in consumption during the recession while those at the bottom of the income ladder cut their spending by much smaller margins. High-income households usually have better savings and financial tools during economic downturns, which usually buffers them from having to drastically change their spending habits. But during the Great Recession these high-income households lost a great deal of these savings, and cut back on consumption as a means to rebuild their wealth.

The Great Recession also created a loss in confidence, which may have motivated the top income to increase their savings because they were pessimistic about the economy overall.  Economists understand that consumption and income inequality diverged during the Great Recession, and that wealth may have played a role, but they do not yet have a complete picture of how consumption, income, and wealth (three widely accepted components of economic growth and well-being) interact. Nor has anyone evaluated changes in the distribution of these measures over time.

Smeeding and his colleagues will use the Panel Study of Income Dynamics, or PSID, alongside the U.S. Bureau of Labor Statistics’ Consumer Expenditure Survey and the Federal Reserve Board’s Survey of Consumer Finance to compare and contrast all three measures of economic well-being for the same individuals at the same time.

In particular, Smeeding will use all this data to create a model examining the average propensity to consume (the percentage of income  and wealth spent on goods and services rather than savings) as well as the marginal propensity to consume (the increase in spending, as opposed to saving, resulting from an increase in income or wealth ) over  the 1989-2013 period . Smeeding anticipates that these models will show that as savings and wealth as a percentage of income goes up, consumption as a percentage of income goes down.

Smeeding’s work provides an alternative to a purely income-based definition of household living standards. Income and consumption alone do not accurately paint a picture of whether a household’s well-being is sustainable. If an individual making a decent living is suddenly hit with an emergency medical expense, for example, it may require withdrawals from savings, which compromises long-term economic security.  Understanding the distribution of income, consumption, and wealth should help researchers and policymakers see a much more accurate picture of economic growth and well-being.

This article is published in collaboration with The Washington Center for Equitable Growth. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Bridget Ansel is Equitable Growth’s Assistant Editor for Publications and Development.

Image: A man looks at an electronic board displaying share prices in Tokyo July 8, 2009. REUTERS/Yuriko Nakao.