Our most recent published study looking at GPI in Ohio has received some coverage recently. As a result, I wanted to revisit it one more time to cover one of the most significant differences between GPI and GDP: the income inequality adjustment.
In Ohio, we estimate that income inequality costs the state over $100 billion annually, by far the largest cost measured by GPI.
Taking a step back, we should think about why we want to measure the cost of income inequality. People have very different opinions about how much inequality is acceptable. Most people tolerate some of the inequality that comes with more efficient growth (e.g. employees might get small raises when their company’s profits double), but find extreme inequality undesirable.
From a theoretical perspective, this ties into the idea of the marginal utility of money, in other words how much our money is worth to our well-being. If your first thought is that every dollar is the same, consider this example.
Imagine two people. Person A spends $300 a month on food, never goes hungry, and budgets carefully. Person B spends $3,000 a month on food and goes to expensive restaurants regularly. Is person B really getting 10 times the value from their money as person A?
We should expect person B to have some added value from their extra $2,700 a month in food spending: you don’t have to prepare your own food at a fancy restaurant and it is a form of recreation that is valuable. Still, it is unlikely that person B is getting 10 times as much value from that spending as person A.
Another way to think about it, imagine instead of person B living lavishly, they adopted the same budget as person A, and used the leftover money to feed 9 additional people on the same budget who would otherwise have to skip meals or stretch their budget to eat. Surely those people would receive more value for that money than person B otherwise would.
So how do we factor this intuitive insight into an economic model?
When calculating GPI, we follow the approach used by John Talberth and Michael Weisdorf. They propose a logarithmic adjustment for the diminishing marginal utility of income. Essentially, $100 is worth less to a rich person than a poor person, and is worth almost nothing to the people with the highest incomes.
There are a few key factors in this adjustment. First, we only adjust incomes above the median. This assumes that people earning less than or equal to median income in a given area are receiving the full economic benefit of their income.
Additionally, because of the logarithmic reduction in utility, very high earners contribute very little additional benefit to the economy with their consumption. The natural extension of this idea is that these individuals would contribute more to the society if they didn’t consume all of their resources, but rather distributed them throughout the income distribution.
A final consideration with the income inequality adjustment is that more than any other indicator, it measures the efficiency of our economy rather than the effectiveness of it. Other costs like pollution and underemployment are designed to shine a light on tangible economic activity that GDP ignores, but this adjustment is an inherently distinct concept.
Its inclusion is certainly relevant, there is research showing that including measures for inequality is important to public policy. Despite the fact that it is the most unique of all the measures in GPI, accounting for income inequality helps us better understand how our economy truly is faring.