Income Inequality and Saving
| Author | Mayssun El‐Attar Vilalta,Francisco Alvarez‐Cuadrado |
| Date | 01 December 2018 |
| DOI | http://doi.org/10.1111/obes.12236 |
| Published date | 01 December 2018 |
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©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 80, 6 (2018) 0305–9049
doi: 10.1111/obes.12236
Income Inequality and Saving*
Francisco Alvarez-Cuadrado†, ‡ and Mayssun El-Attar Vilalta†
†Department of Economics, McGill University, 855 Sherbrooke St. West Montreal, QC
Canada H3A 2T7, (e-mail: francisco.alvarez-cuadrado@mcgill.ca;
mayssun.el-attarvilalta@mcgill.ca)
‡CIREQ, Centre interuniversitaire de recherche en ´economie quantitative, Pavillon
Lionel-Groulx, Universit´e de Montr´eal, 3150, rue Jean-Brillant Montr´eal, QC, H3T 1N8
Abstract
Over the last three decades, the average income for the bottom half of the US distribution
increased by 8% while their average saving rate decreased by 8 percentage points. Over
the same period, the US experienced a substantial increase in inequality and a continuous
decrease in the aggregate saving rate. We propose an explanation based on interpersonal
comparisons consistent with these trends. When households care about their consumption
relative to others, individual saving rates decrease with reference income while aggregate
saving decreases with income inequality. We provide evidence from the PSID and a panel
of OECD countries consistent with these predictions.
I. Introduction
In his seminal work Income, Saving and theTheory of Consumer Behaviour (1949), James
Duesenberry introduces the relative income hypothesis in an attempt to rationalize the well-
established differences between cross-sectional and time-series properties of saving rates.
On the one hand, a wealth of studies based on 1935–36 and 1941–42 cross-sectional budget
surveys present a saving ratio that increases with income. On the other hand, the time-series
data on savings and income collected by Kuznets (1942) present a trend-less saving ratio.
Duesenberry (1949) proposes an individual consumption function that depends not only
on current individual income but also on the level of income of the reference group. As
a result ‘for any given relative income distribution, the percentage of income saved by a
family will tend to be a unique, invariant, and increasing function of its percentile position
in the income distribution. The percentage saved will be independent of the absolute level
of income. It follows that the aggregate saving ratio will be independent of the absolute
level of income’ (Duesenberry, 1949, p. 3).
Despite its empirical success, see for instance Mayer (1966, 1972), the relative in-
come hypothesis was quickly replaced by the well-known permanent income hypothesis
(Modigliani and Brumberg, 1954; Friedman, 1957) as the economists’ workhorse to un-
JEL Classification numbers: D91, E21, C23.
*We wouldlike to thank Mutlu Yuksel for pointing us to some relevant data.
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derstand saving behaviour.1According to this view the cross-sectional correlation between
saving rates and income is driven by transitory deviations from permanent income, while
in the aggregate, most transitory components cancel out, leading to the close relation be-
tween consumption and income observed in time series data. In an influential paper,Dynan,
Skinner and Zeldes (2004) address this old empirical question. Applying new methods to
a variety of saving measures derived from the Panel Study of Income Dynamics (PSID),
the Survey of Consumer Finances (SCF), and the Consumer Expenditure Survey (CEX)
they find a strong positive relationship between saving rates and lifetime income.
The goal of this paper is twofold. First, we identify interpersonal comparisons as one
of the channels behind the documented gradient between saving rates and lifetime income.
Second, we explore the impact of income inequality on this gradient. For this purpose, we
propose a simple overlapping generations model of interpersonal comparisons along the
lines of Alvarez-Cuadrado and Long (2011, 2012). Analyzing the saving choices of one
generation, we find severaltestable implications. First, individual saving rates increase with
lifetime income. Second, saving rates decrease with the level of income of the reference
group and they do so more for poor households. Third, an increase in income inequality
leads to an increase in inequality of saving rates.And four th, once weassume that inter per-
sonal comparisons are only upward-looking, a mean preserving spread in the distribution
of labour income leads to a decrease in the aggregate saving rate.
Using several measures of saving derived from the PSID, we test the first three predic-
tions. We find, in line with Dynan et al. (2004), a strong positive gradient between saving
rates and income conditional on life-cycle and demographic characteristics. On average,
an increase in income of 10% is associated with an increase in the saving rate that ranges
between 0.4 and 0.5 percentage points depending on the measure of saving used.Approxi-
mating income of the reference group by average income in the state of residence, we find
that, after controlling for household income and other individual characteristics, saving
rates decrease in comparison income and do so more for poor households. For instance,
our results suggest that a 10% increase in income of the reference group leads to a decrease
in the total saving rate for a household in the 10th income percentile of one fifth of a per-
centage point. This is a large decrease, particularly if one considers that the average saving
rate in the bottom decile is close to zero. When we include a measure of income inequality
in our regressions, we find that those regions or periods with higher income inequality
are characterized by a more unequal distribution of saving rates controlling for income.
Furthermore, all these results remain robust when we instrument for permanent income
using average labour earnings, different measures of consumption, and education. Most
importantly,we conduct several exercises to rule out the possibility of reverse causality and
provide additional evidence that the impact of inequality on saving rates that we identify
is indeed due to interpersonal comparisons and not to other factors.
Finally, wetest the fourth proposition constr ucting a panel that includes personal saving
rates for six developedcountries compiled from OECD statistics and measures of inequality
from Alvaredo et al. (2013). Our sample, although limited in terms of country coverage,
1One should point out that Friedman’s view is more nuanced than the profession seems to believe‘…and finally,
the evidence that we have cited seems to fit it (the permanent income hypothesis) somewhat better
…however, this
evidence is by no means sufficient to justify a firm rejection of the relative income hypothesis’(Friedman, 1957,
p. 169).
©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
Income inequality and saving 1031
spans over 50 years and accounts for roughly 40% of world GDP. Our results consistently
suggest a negative correlation between savingrates and inequality. This correlation persists
when we include country fixed effects and other determinants of aggregate saving such as
age dependency ratios (Modigliani, 1970), GDP growth (Carroll and Weil, 1994), or real
interest rates (Boskin, 1978).
Our empirical method is closely related to Dynan et al. (2004). While they focus
on documenting and exploring the robustness of the gradient between saving rates and
permanent income,2our paper investigates one of the channels through which changes
in permanent income lead to changes in saving rates, namely interpersonal comparisons,
and studies the impact of income inequality on this gradient. Our theoretical model is
closely related to the extensiveliterature on relative consumption. Abel (1990), Gali (1994),
Corneo and Jeanne (1998), Carroll, Overland and Weil (2000), Liu andTurnovsky (2005)
and Wendner (2014) are just a few examples. In a recent paper, De Giorgi, Frederiksen
and Pistaferri (2016) use a very comprehensive Danish dataset that includes information
that allows constructing networks of co-workers. They exploit this network structure to
explore the impact of relative consumption. Their results suggest an elasticity of own
consumption to peer’s consumption of about one third. Furthermore, their data allows to
explore whether these effects are driven by conspicuous (visible) consumption – status –,
average consumption – ‘keeping up with the Joneses –, or risk-sharing agreements among
peers. In line with the modelling strategy we will follow, their evidence suggests that peer
effects are driven by average consumption. Additional evidence on the empirical relevance
of relative consumption is provided by Levine, Frank and Dijk (2014) and Bertrand and
Morse (2016).3
Finally, Dynan et al. (2004) find both a strong positive relationship between saving
rates and lifetime income and evidence suggesting that the marginal propensity to save out
of lifetime income is higher for rich households than for poor ones. Figure 1a illustrates
these results. The rich not onlysave more as a fraction of their lifetime income but they also
save a higher fraction of each additional dollar of income. Other things equal, an increasing
marginal propensity to savehas at least two direct implications. First, as households become
richer their saving rates should increase. So at the individual level, we should find an
2Specifically these authors find that this gradient is not caused by life-cycle differences or variation in Social
Security replacement rates (Huggett andVentura, 2000), or by a precautionary motive togetherwith uncertain medical
expenses (De Nardi, French and Jones 2010; Kopecky and Koreshkova, 2010), or by the presence of dynastic
smoothing (Becker and Tomes, 1986) or by the inclusion of high-income entrepreneurs in their sample (Quadrini,
1999; Hurst and Lusardi, 2004).
3Coibion, Gorodnichenko, Kudlyak and Mondragon (2014) perform a ‘difference-in-difference’exercise across
income groups and regional inequality levels finding that low-income households in high-inequality regions accu-
mulated less debt relative to income than their counterparts in lower-inequality regions.At first sight, one may think
that their results contradict ours. In our view, the results of Coibion et al. (2014) only suggest that the relaxation of
borrowing limits is not homogeneous across regionsleading to larger increases in borrowing in more equal regions. In
fact, they document that credit card limits, aside from balances, increase more in low inequality areas suggesting this
geographically asymmetric change in credit supply.This asymmetric change in credit supply would only attenuate
the negative effect of inequality on saving rates that we document. Finally, our work also connects with the recent
literature on self-reported well-being (see, for instance, Oswald, 1997; Luttmer, 2005; Clark, Frijters and Shields,
2008; Easterlin, 1995, 2010) formalizing some of their insights and exploring its implications for savings. Finally,
our results are also informative for the literatures on income and consumption inequality (see, for instance, Katz and
Autor, 1999;Autor, Katz and Kearney, 2008; Attanasio, Hurst and Pistaferri, 2012) and saving and wealthinequality
(De Nardi and Fella, 2017).
©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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