Economic Freedom Matters for Intergenerational Income Mobility

Inequality is a hot political topic. So is income mobility. For the past few years, many economists have talked about the negative relationship between income inequality and income mobility. In the media, their work has become known as the “Great Gatsby Curve,” in reference to F. Scott Fitzgerald’s 1925 novel.

The Great Gatsby curve conveys a simple-yet-potent idea. If you chart income inequality on one axis, and intergenerational income mobility (i.e. how likely it is that you rise above the income class of your parents) on the other, you will observe an inverse relationship. Where inequality is greater, intergenerational income mobility is weaker. All else being equal, if you are born in the bottom centile of the income ladder in an unequal society, you are less likely to climb up to the top centile than your peer born in the bottom centile of a less-unequal society.

This does not mean that your income fails to increase relative to that of your parents. This would refer to “absolute mobility.” The Great Gatsby curve speaks to “relative mobility.” An immobile society would be one where the children born in the bottom income centile of the population will remain in the bottom centile even if they end up better off than their parents.

Why would there be a link between income inequality and intergenerational income mobility? The answer is simple: the ability to seize opportunities. If you are born into a rich family, it is easier for you to use your family’s wealth to seize opportunities that you would not have been able to seize otherwise. People in lower income brackets, on the other hand, are constrained by a lack of resources. Think about this illustration: if education is a way to out-earn your parents, and the cost of education is greater for the poor (many more years not working and little savings to draw on), the rich will be more likely to invest in their educations.

This explanation is elegantly simple. There is also a great deal of empirical evidence suggesting that it is a relevant economic fact. That said, it does not mean that it is a form of fatality. In fact, the literature that has created the Great Gatsby Curve tends to emphasise the mechanical role of inequality, where inequality has a negative impact that is everywhere the same. The role of institutions is generally omitted, except when discussing remedies to low mobility (i.e., greater redistribution, more investment by the state in education, etc.).

The absence of institutions from the conversation is problematic. Indeed, institutions can mitigate the effect of income inequality, if people from all income classes are legally able and incentivized to make investments in themselves. Imagine, for example, that a government placed numerous barriers to entry in low-skill occupations such as hairdressing, landscaping, interior designing or bricklaying. These barriers to entry legally limit the ability of people to climb the income ladder.

In our article in the Southern Economic Journal, Justin Callais and I argue that economic freedom (our proxy for institutions) is a powerful force to enhance income mobility. We argue that, in fact, in addition to reducing legal hurdles, economic freedom’s well-documented effect on economic growth matters more for those at the bottom. If equal income gains for everyone are secured, the gains of an extra one percent income are marginally more opportunity-expanding for the poor than the rich. By allowing for more “absolute mobility,” economic freedom increases “relative mobility” as well.

In the article, we rely on intergenerational relative income mobility data published by the World Bank for more than 120 countries. Their estimates, which are based on people born in the late 1970s and early 1980s, are best available for a wide array of countries.

We then run horse-races between estimates of income inequality and economic freedom across a variety of different tests.

When the aggregate index of economic freedom is used, we find that it rivals the effects of income inequality. This, however, probably underestimates the importance of economic freedom, as some components of the indexes that measure economic freedom have ambiguous effects. The size of government, for example, can both increase and decrease intergenerational mobility. It depresses mobility through the impact of higher taxes that discourage investments (notably investments in human capital). It can increase mobility if taxes are used to finance educational programs that disproportionately benefit those at the bottom of the income ladder. As such, there is value in separating the different components of the economic freedom index.

When we do so, we find that regulations and the security of property rights areimmensely powerful. These two sub-components of the economic freedom index are more powerful than income inequality is.

We also estimate the effect of economic freedom and income inequality against each other before adulthood. Our motivation to consider the pre-adulthood levels of economic freedom and income inequality is that the level of both variables in that period matters most, because trial and error processes are cheaper when one is younger. Greater economic freedom and less income inequality allows for more trials (and hopefully fewer errors) before one reaches adulthood. As such, we used the “lifetime” level of both variables to capture this mechanism. Again, we find that economic freedom is generally a more-powerful determinant of income mobility than is inequality.

The underappreciated role of economic freedom and institutions in the determination of intergenerational income mobility is probably one of the most problematic omissions of the literature on income mobility. In guiding policymakers, economists frequently emphasize remedies that rely on more redistribution, or at the very least, more targeted redistribution. In contrast, the general principle our results suggest is that less is better than more. Or in this case, more economic freedom is better than less.

This article is courtesy of Vincent Geloso and American Institute for Economic Research, under a Creative Commons Attribution 4.0 International License. The original can be found here.