Income Inequality and What You Can Do About It.

Income inequality is very much in the news recently and I wanted to explore some reasons for it. In looking at the reasons we will find possible cures.

I. Savings Rates

It’s been observed in the academic literature that those with higher incomes generally have higher savings rates for a variety of reasons. The chart below illustrates this.

Inequality itself reinforces this. Having more people in the lower income percentages decreases the overall savings rate.

http://www.nakedcapitalism.com/2010/03/high-income-disparity-leads-to-low-savings-rates.html

 

II. Taxes

When you add local, state, and federal taxes together, total taxes seem to be progressive until you get to around the 60-80% of high income earners. Then it flattens out and someone in the top 1% on average pays about as much as a percentage of their income in taxes (if not less) as those in the upper 40%.

Source: Institute on Taxation and Economic Policy Tax Model, April 2012

 

III. Risk Aversion

In my professional career I’ve noticed that people who don’t have much if any experience with investing are much less likely to do it at all. They are certainly less willing to take risk whether it’s in regards to investments, human capital, or professionally. More educated individuals are also more likely to be risk takers.[i] Riley and Chow (1992) found risk aversion to be a function of age, education, wealth and income.[ii]

 

What to Do About It.

So you add up savings rates, tax non-progressivity, and risk aversion and we can only expect a high level of inequality. All of these factors are interrelated: income, education, savings rates, taxes, risk aversion. Those with higher education will generally have higher incomes, higher savings rates, and be less risk averse etc.

So what you can do to combat inequality (aside from any political stuff) is pretty simple: (1) increase your savings rate somehow, (2) Try to keep your taxes low by saving in 401(k)s, IRAs, and qualified dividends and capital gains rates, etc, and (3) take some (calculated) risks whether it be in human capital, investments, or professionally.

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[i] Shaw, Kathryn L. An Empirical Analysis of Risk Aversion and Income Growth. Journal of Labor Economics, 1996, vol 14, no. 4

[ii] Chow, K. Victor and Willaim B. Riley Jr. Asset Allocation and Individual Risk Aversion. Financial Analysts Journal. November-December 1992.