Editor’s Note: Dr. Mike Walden is a William Neal Reynolds Distinguished and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.
State versus Carolina, Pepsi versus Coke, Yankees versus the Red Sox, Democrats versus Republicans – life is full of rivalries – some serious and some for fun.
It’s no different in economics. Although economists agree on many things, they also disagree – sometimes even with themselves. So much so that President Truman was reported to have asked for a one-armed economic advisor. The story goes that the plain talking President was tired of hearing his economic experts respond by saying, “on the one hand, this; but on the other hand, that!”
One area where economists disagree is in comparing income changes over time. You’d think this would be easy – just add the number of dollars that someone’s income has gone up or gone down over the years. People who have more dollars are doing better, and people who have less dollars have fallen behind.
There’s one big flaw in this simple addition, and it’s inflation – or the rise in the cost of living. Inflation makes every dollar we earn worth less. So, for example, if your income has risen 3%, but the inflation rate – or increase in the cost of living – is 5%, then not only have you not moved ahead, but your standard of living has actually dropped by 2%.
Actually, there’s no disagreement among economists that income changes always need to be adjusted for inflation. Economists are all on the same page – or same hand – on this score. Where the approaches diverge is in making inflation-adjusted income comparisons between people.
One approach I’ll call “look at your own paycheck” (the technical term is the “absolute income” approach). Here people just watch what happens to their own inflation-adjusted income. If it rises, they’re better-off; if it falls, they’re worse-off.
The alternative way could be termed “keeping up with the Joneses” (the formal name is the “relative income” approach). The assumption is that people will always compare changes in their own inflation-adjusted income to changes in inflation-adjusted incomes of others. And, very importantly, if your inflation-adjusted income has risen, but it has risen less than the incomes for others, you may very well feel worse-off. That is, you’re better-off absolutely, but worse-off relatively.
These two ways of looking at income changes are more than ivory tower concepts. They have a great deal of relevance to what’s been happening to incomes in our country for the past three decades.
In terms of the “look at your own paycheck” approach, statistics from the U.S. Census show inflation-adjusted average incomes of households of all income levels – high, middle, and low – are higher today than they were thirty years ago. But the income gains have by no means been equal. Households at the top 20% of the income ladder had inflation-adjusted income gains of 83%; while households in the bottom 20% of the income ladder realized inflation-adjusted increases of just 38%.
So in terms of “keeping up with the Joneses”, lower-income households have fallen further behind their higher-income colleagues. A big reason is educational differences. Many studies have shown that differences in educational attainment – especially between those with college degrees and those without – are the key factor explaining “who’s getting ahead” in today’s economy. Those with more education earn more, and they’re also receiving the largest pay raises.
Yet perspective is important. If you’re a “look at your own paycheck” person, as long as your income (after inflation) rises, you’re happy. But life is more complicated for a “keeping up with the Joneses” person – here your gains must be compared to the gains of others. But which approach you decide to use will determine not only how you view your own situation, but also how you view the progress of the entire economy.