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Is inequality rising between the people in the top income group and the rest of society?

It will strike most readers as silly to ask this question. After all, it has become an article of faith in our society that the distribution of incomes has become more unequal, although it is often accurately noted that it is more pronounced in the U.S. than in Canada.

However, what is not fully recognized is that most studies of inequality exclude all forms of wealth and focus only on income. Income measures the money flowing to an individual over the course of a year. However, the total amount of resources available for an individual to consume includes not just this year's income flow, but also the stock of wealth they accumulated over their lifetime. This wealth includes assets such as money in savings accounts, investments in stocks and bonds, privately-held businesses, and real estate, the largest and only non-taxable asset for most people. This stock of assets reflects the accumulated savings made from past income flows, set aside either in financial institutions or through the purchase of assets like a home.

Indeed, a recent article on "Levels and Trends in US Income and Its Distribution" by Richard Burkhauser, Jeff Larrimore and Philip Armour, calls into question the exclusion of wealth. The authors demonstrate that an exclusive focus on income flows is misleading, and when the stock of wealth individuals possesses is included in the analysis, the trend to rising inequality in the U.S. disappears.

Most importantly, Burkhauser includes changes in the annual value of these assets as income. Usually, these assets are not reflected in income until the asset is sold. If your asset value rises over a given year, and you do not sell that asset at the higher price, you have decided implicitly to save the asset's increase in value. Adding together the flow of income and the change in the stock of wealth shows the change in the resources available to an individual in a particular year, which is the true change in income.

Adjusting income for changes in wealth on an annual basis also prevents the income data from being distorted by asset holders suddenly showing a large jump in incomes in a particular year just because they sold an important asset that year. For example, how much of the recent increase in high income earners in the U.S. is due to aging boomers leaving the labour force and selling assets to finance their retirement?

Some will argue that it is unfair to assume that a middle-income homeowner can access their home equity on a regular basis. Yet, individuals routinely re-mortgage their homes to finance everything from starting a new business to putting children through school. Such financing does not appear in the usual statistics on income, but clearly affect consumption patterns. While no one questions transfers to low income people lacking assets, is it good policy to increase taxes on upper incomes, as Ontario and Quebec recently did, to support transfers to people who have lower incomes but are sitting on valuable assets?

By studying the distribution of both income and wealth, Burkhauser concluded that not only has inequality not risen in recent decades, but the lower and the middle class in the U.S. actually posted higher income growth than the upper income groups. The recent surge in house values in Canada suggests that adjusting income for wealth would significantly alter the perception of how our income distribution has changed, especially when it is realized that 69 per cent of Canadians own their home while 42 per cent of these homeowners are mortgage free

Of course, the Burkhauser paper is not the last word on research on inequality. It remains to be seen whether this finding holds up once the full impact of the real estate debacle in the U.S. is factored in. And any paper that uses survey data for incomes risks errors in measuring the very poor and the very rich.

Analyzing inequality is extremely complex. It matters greatly whether you study individuals or the family unit; use incomes before or after taxes and transfers; measure consumption rather than income; adjust incomes for wealth; and how upper and lower incomes are defined. There is no simple answer to the question of whether inequality is rising, much as some reduce such complex matters to simple sound-bites.

The important message is that, just as the adequacy of retirement savings must adjust pensions for wealth, properly assessing trends in income distribution requires adjusting incomes for changes in wealth.

Philip Cross is research co-ordinator at the Macdonald-Laurier Institute and the former chief economic analyst at Statistics Canada. Ian Lee is assistant professor, Sprott School of Business, Carleton University