Income inequality is at the heart of the debate over the tax deal, currently pending in Congress. Democrats are outraged over the compromise of extending the Bush-tax-cuts for the “wealthy” in return for extended unemployment benefits.  The “rich” should make sacrifices and pay higher taxes, they say.

Many other people are also concerned about rising income inequality in the U.S. Robert Creamer wrote:

…inequality is a cancer that is attacking both the economy, and the social and political fabric of our society.

Others aren’t so sure why it’s supposedly bad. “Rising inequality” just sounds bad, in general.

George Mason University (my alma mater!) economist Tyler Cowen writes in the American Interest today that many worries over income inequality are overblown for three main reasons:

Demographic shifts:

…there is usually greater inequality of income among both older people and the more highly educated, if only because there is more time and more room for fortunes to vary. Since America is becoming both older and more highly educated, our measured income inequality will increase pretty much by demographic fiat. Economist Thomas Lemieux at the University of British Columbia estimates that these demographic effects explain three-quarters of the observed rise in income inequality for men, and even more for women.

Measurement problems:

…real incomes are measured using a common price index, yet poorer people are more likely to shop at discount outlets like Wal-Mart, which have seen big price drops over the past twenty years. Once we take this behavior into account, it is unclear whether the real income gaps between the poor and middle class have been widening much at all. Robert J. Gordon, an economist from Northwestern University who is hardly known as a right-wing apologist, wrote in a recent paper that “there was no increase of inequality after 1993 in the bottom 99 percent of the population”, and that whatever overall change there was “can be entirely explained by the behavior of income in the top 1 percent.”

Top earners work more hours:

It’s worth noting that over this same period of time, inequality of work hours increased too. The top earners worked a lot more and most other Americans worked somewhat less. That’s another reason why high earners don’t occasion more resentment: Many people understand how hard they have to work to get there. It also seems that most of the income gains of the top earners were related to performance pay-bonuses, in other words-and not wildly out-of-whack yearly salaries.

Cowen does assert, however, that there is one form of inequality we should be concerned about, because it leads to adverse incentives. He highlights the following paragraph from his article on Marginal Revolution:

If we are looking for objectionable problems in the top 1 percent of income earners, much of it boils down to finance and activities related to financial markets…The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed.

A heavily regulated financial sector where losses are socialized while gains are privatized naturally encourages irresponsible, risky investments. The economy still suffers from the consequences of the near-collapse of the financial sector in 2008.

That’s why it’s so important to extend current tax rates. Extending them permanently would be the best case, because it would allow businesses to make long-term investments, and create new jobs. However a temporary two-year extension of tax rates is better than no extension. The current uncertainty is the worst situation, because as businesses wait-and-see what will happen to tax rates, our unemployment rate remains unnecessarily high.

Extending the tax cuts has little effect on changing overall income inequality. The type of inequality we should be worried about is the one where less-politically connected entrepreneurs who make poor investment decisions suffer the consequences, while the well-connected get bailed out.