RDP 2015-15: Household Economic Inequality in Australia 1. Introduction

Since the early 1990s, real per capita consumption and disposable income in Australia have both risen by an average of close to 2 per cent annually. However, aggregate trends can mask important changes over time in the distribution of income and spending across households.

We explore how the distribution of living standards has evolved over recent decades by examining trends in household income and consumption inequality (which we will refer to as ‘household economic inequality’). We also explore some short-run trends in wealth inequality.

Most of the empirical research to date, particularly for Australia, has focused on inequality in current income. But current income is not necessarily a good guide to welfare. Since most individuals experience a period of growing income during their early working years, and a period of lower income as they transition to retirement, and since individuals can borrow and save to smooth out temporary fluctuations in income, overall living standards depend more on lifetime income than on current income. To gauge inequality in living standards, it is better to focus on that part of household income which is due to factors that are likely to persist through time, since this persistent component of income (reflecting things like promotions and long-term unemployment) is likely to be more strongly correlated with lifetime income than the transitory component of income (reflecting things like bonuses, short-term illness and temporary lay-offs).

These underlying factors are not easily observed in available datasets. We thus take two indirect approaches to estimate the degree of inequality in the persistent (and hence welfare-relevant) component of income for Australia. First, we follow other studies that suggest that consumption is a more appropriate measure of household wellbeing than current income or wealth (see, for example, Slesnick (1998)).^[1] Under this approach, we use repeated cross-sections of the Australian Bureau of Statistics (ABS) Household Expenditure Survey (HES) to examine how consumption inequality has evolved, relative to inequality in current income and wealth, over recent decades. We also explore some of the drivers of these changes over time.

Our second approach to estimating persistent income inequality is to exploit the panel dimension of the Melbourne Institute's Household, Income and Labour Dynamics in Australia (HILDA) Survey. By tracking the same households across time we are able to estimate a statistical model of household income dynamics that allows the distribution of temporary and persistent income to evolve separately over time. Through the lens of the estimated model, we can then measure the evolution of each type of inequality.

Our paper is motivated by the recent shift in focus in macroeconomics from the time series dynamics of household consumption and income to an exploration of the cross-sectional distributions of these variables across households and how the distributions change over time. Research into the distributions of household income and spending is an important input into identifying emerging risks to financial stability. It can also broaden our understanding of how monetary and fiscal policies affect the economy. The sensitivity (or resilience) of the household sector to shocks can be affected by which households are saving and which are borrowing at a given time. For example, aggregate spending will be particularly sensitive to changes in interest rates if there is a relatively large share of households that are constrained from borrowing.

Australian research on inequality has increased of late. For instance, Fletcher and Guttmann (2013), Greenville, Pobke and Rogers (2013) and Wilkins (2015) document trends in current income inequality in Australia using household survey data. They find that there has been a slight increase in income inequality over recent years which has largely been driven by an increase in capital income at the top of the distribution. Some Australian studies have also examined trends in expenditure inequality (e.g. Harding and Greenwell 2002; Bray 2014) and non-durable consumption inequality (Barrett, Crossley and Worswick 1999). Bray (2014) finds that expenditure inequality has been lower and more stable than income inequality over the past three decades, although it appears to have been increasing since the late 1990s.

We construct estimates of household economic inequality using several sources of data. Our consumption inequality estimates primarily come from the HES. Nevertheless, we explore measures of inequality using other data sources, including the HILDA Survey, the ABS Survey of Income and Housing (SIH) and data based on individual income tax records provided by the Australian Taxation Office (ATO).

We will consider a wide range of inequality measures, including indicators that are specifically designed to measure inequality, such as the Gini coefficient, along with simpler measures that are advocated in Piketty (2014), such as the share of total household income held by the highest-earning households and the variance of the logarithm of income. Our paper makes the following contributions:

1. To the best of our knowledge, we are the first to quantify the extent to which the trends in income inequality in Australia are due to changes in observable characteristics and to changes in the distribution of unobserved persistent and temporary income shocks.^[2]
2. We construct estimates of consumption inequality that are broader than previous Australian studies.
3. We examine in detail how housing prices can affect estimates of household economic inequality. In particular, we show how it can have different effects on estimates of wealth inequality as compared with income and consumption inequality.

Our key findings are that:

1. Consumption inequality is lower on average than income inequality and has risen by less since at least the early 1990s.
2. The rise in consumption inequality has reflected a relatively large increase in spending by the highest-spending households (within the top 1 per cent of the distribution).
3. The increase in income inequality over the past decade has not been due to observable factors, such as an ageing population or rising educational attainment. Instead, it has reflected an increase in the variance of unobserved shocks, particularly since the middle of the 2000s. At least some of the increase in income inequality has been persistent, implying higher inequality in household welfare.

Footnotes

As consumption is a choice variable, it is more closely connected with the lifetime wealth constraint faced by households than is current income. If some households smooth temporary fluctuations in income by borrowing and saving, then income will tend to be more variable than consumption at a point in time and hence income will overstate the level of inequality in household welfare. [1]

We focus on trends in inequality for household income in this paper in order to allow for direct comparisons with the consumption trends, which are only available at a household level. We have also examined the trends in individual income inequality, but the key results are basically the same. [2]