Distribution of Income

The Cost of Income Inequality

Daniel Kahneman is an Israeli psychologist who has been awarded a Nobel Prize in Economics. His work involved a fascinating experiment.

Imagine a situation in which an amount of money is placed between two people. For example, we will imagine that the amount is $1,000. The first person can choose how that money will be split between the two people; the second person has only two choices – they can accept the split as offered (in which case each person receives the money identified in the split), or they can reject the offer. If the offer is rejected, neither person is allowed to have any money.

On one level you would imagine that the second person can’t lose. Even if the first person chooses to take $999, in accepting the offer the second person will still have one dollar that they didn’t have before. On this basis their standard of living would increase, and so they should accept the offer. There is only one problem – repeated experiments have shown that they don’t accept the offer. In fact, if the second person does not believe that they are being given a share that is fair, they will reject the offer.

We can apply this experiment to Australian workplaces. If employees are given a pay offer that they don’t believe is fair, they may find that they need to accept the offer in order to meet their bills. However, they might also choose to show their disapproval by reducing their productivity. In other words, whether or not the decision is a conscious one, people may respond to an offer that they believe is unfair by reducing their output, effectively mirroring the response that was seen in the Kahneman experiment. This proves that inequality can also result in a decline in productivity.

There are other problems associated with high levels of inequality. For example, research in over 120 countries has shown that when income inequality is high, the society will suffer from more health problems. This could be because people who receive a lower income try to minimise their expenditure on food by purchasing more pre-packaged food (or fast food). It has also been shown that those who receive low incomes will often try to cope with minor ailments rather than spend the money on a medical professional. Some of these problems inevitably grow into bigger issues. It is worth noting that nothing in the research that has been completed suggests that the health problems are isolated to those on lower incomes. While people in the lowest quintile may be the first to get sick, illnesses frequently spread throughout the society. At a simple level this could involve a cold or the ‘flu. On the other hand, rampant inequality in many countries in Africa has contributed to the spread of AIDS.

Inequality can also lead to an increase in crime. Once again, this is not something that is isolated to people in the lowest quintile. Research by Jong-Sung You from Harvard University has shown that those receiving a very high income may resort to corruption to try and protect their money and wealth. On the other hand, those at the other end of the spectrum may resort to crime in order to meet their basic needs.

Finally, it is worth noting that inequality breeds inequality. In other words, unless there is some form of government intervention, inequality is a problem that is self-perpetuating. Edward Glaeser, a professor of Economics from Harvard University, has noted that people gain more political influence as they gain more wealth. These people are almost certain to support political changes that help them to maintain or increase their wealth. As examples, Professor Glaeser highlights the fact that while George Bush was the President of the United States, both the top income tax and the capital gains tax rates were lowered, effectively reducing the income tax burden for the wealthiest people in the country. Similar policies were enacted during the Howard administration here in Australia; the GST (a regressive tax) was introduced, and changes to income tax rates tended to benefit those earning the highest incomes.

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