The conflict over income inequality, the rich versus the poor, is a tale as old as time. The relevant and modern policy question is what, if anything, should be done about it. Is it exploitative that Bill Gates has extravagant homes and private planes while some are struggling to find their next meal? Are there systemic distortions built into market economies that allow the rich to perpetuate their wealth at the expense of the poor?

These are important questions. To do well by the world, we must first understand the world’s problems; only then can economic thinking help us craft a better way forward.

Is Income Inequality Bad?

Income inequality is measured with a statistical tool called the Gini index, which shows how income is held across a group of individuals. We could measure the Gini in a college classroom, a neighborhood, a town, or a country. Most often, economists use national data for income inequality and compare it across countries.

If we were to measure the income inequality in a classroom, we might see that incomes are close to being equal. This is because most college students have similar incomes (or perhaps none) because they have similar backgrounds and are at similar stages in life. Once we broaden our measure to include more people who are different in experience and skill, the Gini index will reflect greater levels of inequality.

The Gini index is measured on a scale from zero to one. A score of zero indicates perfect income equality, so everyone being measured makes exactly the same income. A score of one indicates perfect income inequality: one person has all the income and everyone else has none. At first glance, we might desire equal income outcomes. We might want to live in a society with a Gini index of zero, or at least close to zero; it seems fairer. On the other hand, it’s easy to see why living in a society with a Gini index of one is not desirable at all, unless you are the one making all the income. All others must fend for themselves; thuggery and cronyism will be the only means for everyone else to survive.

The question of whether income inequality is bad hinges on the institutions within that society and whether they support entrepreneurship and creativity or thuggery and exploitation. Income inequality is good when people earn their money by discovering new and better ways of doing things and, through the profit mechanism, are encouraged to bring those discoveries to ordinary people.

Bill Gates’ profound wealth is a sign that he has built products that serve ordinary people, and what matters most is that we have alternatives for his products. The more alternatives we have, at higher levels of quality and ever lower prices, the more every income group is served. What matters is the way trade occurs. When trade is voluntary then we can know that value is being created by consumers, when trade is rigged politically or blocked involuntarily, then the service of strangers starts to break down.

Rising incomes across all income groups (even if at different rates) is most often the sign of a vibrant economy where strangers are encouraged to serve each other and solve problems. Stagnant incomes suggest something else: either a rigged economy where only insiders can play, or an economy where the government controls a large portion of social resources, stalling incomes, wealth, and wellbeing.

Nobel Laureate Angus Deaton said it this way:

I both love inequality and am terrified of it. Inequality is partly a marker of success, so that if someone thinks of something, some new innovation that benefits us all, and the market works properly, they get richly rewarded for that. And that’s just terrific. And that creates inequality. So some of the greatest inequalities in the world have come from the greatest successes.

The terror part is — well, there are several different things. One that I worry about is that some of the enormous riches we’re seeing at the top in the United States today are coming from activities whose social value is in doubt. So some of the activities that are going on in Wall Street that are occupying some of the smartest of our young minds, it’s not entirely clear that their society really wants them to be doing that as opposed to innovating in the private sector, or curing cancer. The other thing that I worry about is the political power that comes with extreme wealth.

It’s not so much the difference in income that matters (inequality as measured by the Gini index) but how people gain their income. If institutions, such as those that have persisted on Wall Street, encourage cronyism, then the result will be exploitation — some will gain only because they rigged the system. But in a voluntary market, capitalists only gain when they serve a vast number of people.

Mobility Is Better than Equality.

What we know is that income inequality is nuanced, and the nuance we need to understand whether it is “good” or “bad” is not often picked up by the Gini index.

Consider the following thought experiment: knowing nothing other than the Gini index scores, would you rather live in a world with a Gini of .296 (closer to equality) or .537 (farther from equality)? Many people when asked this question choose the world of .296. These are the real Gini scores of Pakistan (.296) and Hong Kong (.537). If given the choice, I would live in Hong Kong without thinking twice. Hong Kong has a thriving economy and high incomes, and it is the world leader in economic freedom.

The difference between these two countries could not be more striking. In Pakistan, there might be more income equality, but everyone is poorer. It is difficult to emerge out of poverty in Pakistan. Hong Kong provides a much richer environment where people are encouraged to start businesses, and this is the best hope for rising incomes, or income mobility.

Income mobility exists when one’s income can increase over time as skills, education, and productivity increase. Income mobility signifies a dynamic and thriving society where one can enter the labor force with lower levels of productivity and increase his or her skills and experience over time which earns him or her income gains.

If we want to make the world better, particularly for the poor, we need to understand why they are poor. The bottom billion today are poor because they suffer under terrible economic and political institutions which are difficult if not impossible to escape. If we want their incomes to rise, they need the chance to be free to use their talents to engage in exchange, and this will bring with it the promise of income mobility — and income inequality. This cannot be accomplished solely through redistribution to promote greater income equality but rather requires systemic institutional change toward market-based entrepreneurship. The rapid decline of poverty over the past forty years shows that there has never been more hope for rising incomes among the poor. We can help them best by promoting mobility through economic freedom.