This page is optimized for a taller screen. Please rotate your device or increase the size of your browser window.

Expenses - the Neglected Half of the Household Budget Equation

December 12, 2016

Two papers released this month shed important light on the economic challenges facing low- and moderate-income Americans. One paper, by Thomas Piketty, Emmanuel Saez, and Gabriel Zucman, tells us that real incomes haven’t grown much for the bottom half of the population in the past 40 years, even after considering taxes and transfers. The other, by Raj Chetty, David Grusky, Maximilian Hell, Nathaniel Hendren, Robert Manduca, and Jimmy Narang, tells us that the chances of earning more than your parents have steadily decreased over the past 45 years.

While these themes are familiar, the new papers make important methodological advances and have thus garnered significant attention from a press interested in the related issues of income inequality and social mobility. While I would urge a measure of caution until the papers have been peer reviewed, I agree they merit attention. The papers provide useful yardsticks to measure Americans’ overall financial condition and to examine the extent to which that condition varies across income levels and over the generations.

The Piketty team’s research documents a few areas of improvement over time – notably, important gains in the pre-tax median incomes of women and increases in post-tax incomes for middle-income households due to government transfers. But on the whole, the new research paints a depressing picture: Income inequality is widening. Social mobility is declining. Transfers haven’t done nearly as much as one might hope to boost real net incomes for the bottom half of the income distribution.

So go ahead and read the papers. But as you do so, keep one thing in mind: income is only half of the household budget equation that determines whether a household can afford a decent standard of living. 

To Understand the Whole Picture, Look at Income and Expenses

The household budget has two main components: income and expenses. To understand whether individual households are stressed financially, we need to look at both their incomes and their expenses. Similarly, to understand whether Americans are growing more or less financially stressed, we need to look at trends in both income and expenses – ideally at the same time, so we can measure whether and to what extent households’ incomes are growing fast enough to keep pace with expenses. (We also need to look at financial assets, but that’s a different column . . .)

Of course, following standard practice, the new papers adjust for inflation, which provides a way of controlling for expenses over time. But allowing the national Consumer Price Index (a composite measure of inflation) to act as a proxy for detailed data on changes in Americans’ expenses is like allowing a single measure of growth in national median incomes to act as a proxy for more detailed data on changes in Americans’ incomes.  If Piketty’s research stands for anything, it is that trends in median incomes mask hugely important variation. Household expenses similarly vary considerably. Most notably, housing costs vary substantially by income level and geography.

To gain a more complete understanding of how Americans’ financial condition has changed, we need to look comprehensively at changes over time in both incomes and expenses. This analysis should examine trends over time by income level, ideally capturing the effects of taxes and transfers. It should also look at how results vary by geography and from one generation to the next.

Why is it Important to Examine Income and Expenses Together?

This dual focus is important for two reasons. First, a more holistic look at income and expenses together would help us better understand the financial challenges of Americans of different income levels, in different parts of the U.S. and facing different types of circumstances (such as life stage or health). For example, there is reason to think that rent and utility inflation may be greater for Americans with lower incomes than for Americans with moderate and higher incomes.  If confirmed, this would lend greater urgency to the financial challenges facing low-income Americans as they would not just be treading water (from an income perspective) but actually less able than previously to afford a basic standard of living. The same might be true for Americans without adequate health insurance or with large amounts of student debt. 

On the other hand, there may be some categories of Americans whose expenses have increased more slowly than overall inflation or their incomes.  The financial burdens facing these Americans may be less urgent than those of others.  Being able to distinguish between Americans that are less able or better able to meet their basic expenses can help us identify those most in need of assistance.

Second, this approach will help us better identify which levers may be most impactful for improving households’ ability to meet their basic expenses.  Rents are consuming an ever greater share of our incomes.  Expenses for education and health are also rising sharply.  Increasing incomes through overall growth or reduced inequality is one way of dealing with these problems, but it’s only one of several possible approaches for improving Americans’ financial prospects.  Other, complementary, approaches would involve reducing housing, health and education expenses.  A more complete picture of the changing household budget could help us identify which approaches to focus on and for whom.

It won’t be easy to reduce housing, health and education expenses.  But it may well be easier than boosting incomes.  And given the possibility that increases in earnings may simply get consumed in the form of higher rent in high-demand communities due to limitations in the overall supply of housing, it’s clear we can’t ignore the expense side of the equation.

Work With Us
Ready to change people's lives? We want to hear from you.
We do more than solve the challenges our clients have today. We collaborate to solve the challenges of tomorrow.