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Making Adjustments

by Chris Sarlo

According to a Statistics Canada income survey, in 1995, Canadian household incomes ranged from a high of $2.8 million to a low of -$75,000. This is clearly an enormous difference. However, any useful discussion of the distribution of incomes requires some explanation.

First, focusing on the highs and lows of individual incomes does not reveal anything about the financial positions of most households. On the low side are some 10,000 households reporting negative incomes. In almost every case, these households have large business losses to declare against other income, which results in a negative net income. This absurdly low value does not reflect the actual living standards of these households. Indeed, I have pointed out in an earlier article that those with incomes below zero are better educated and are more likely to be home owners than those with positive incomes. On the high side, a small number of superstars in fields like business, sports, and entertainment account for the million-dollar incomes. However, fully 75 percent of households in the top decile have incomes in the $90,000 to $150,000 range.

The 1995 decile distribution of income for Canadian households provides some very useful detail that is missed by a simple range. It tells us, for example, that 80 percent of Canadian households have incomes between $11,700 and $87,000, and that half have incomes between $30,000 and $87,000.

Still, most observers will find the gaps in incomes quite large. Economists are frequently asked to comment on the inequality of incomes and to provide some sense of how significant the gaps really are. What we know is that merely lining up, from top to bottom, all households on the basis of total, unadjusted income will give us a very distorted picture of the economic circumstances of Canadian households. Some reasonable adjustments are needed to give us a more accurate accounting.

It is well known, for example, that there is a universal ‘age' pattern of incomes. That is, income from earnings typically rises as the earner gets older and acquires more skill, takes on more responsibility, or is promoted. This effect tends to peak around age 50 and decline from there as the effects of illness, structural change, and retirement begin to set in.

This age pattern of incomes is displayed in the graph above. For convenience, I have used an index of incomes (with the average income of the youngest age group set to 100), rather than actual incomes. The solid line labelled “total income” represents the index value of the average total incomes of households whose head is in the given age grouping. So, for example, the average income of households in the 50 to 54 age range is almost five times that of the average income for households whose head is less than 20 years old.

Next, we must make some adjustment for family size. We understand intuitively that a household of four persons living on $60,000 is not three times better off than a household of one living on $20,000. It may not, in fact, be better off at all. Taking into account the economies of scale in living (especially with housing), the more people in the household, the greater the income must be to achieve a given standard of living.

The Organization for Economic Cooperation and Development (OECD) has established an “equivalence scale” for use in academic research. The equivalence scores are: 1.0 for a single person or first household member; 0.7 for the second household member; and 0.5 for each additional member. Consider a household of two parents and two children with a total annual income of $55,000. It would have an equivalence score of 2.7, and an equivalent income of $20,370 (the household's total income divided by its aggregate equivalence score).

Finally, economists often use after-tax income rather than total income to better reflect the potential living standard that the household could enjoy. It can be argued that taxes pay for government services that, all things considered, benefit everyone equally. So, it is after-tax income that really differentiates households.

The dashed line in figure 1, labelled “adjusted income,” results from adjusting for household size and after tax income. Once these adjustments are made, there is much less variation between average households in the different age groups. Indeed, apart from the most youthful households (where the head is age 24 or under), there is a very modest 30 percent variation in adjusted income.

Chris Sarlo teaches economics at Nipissing University in North Bay, ON. He is the author of Poverty in Canada, published by The Fraser Institute.

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