From Wages to Welfare: Decomposing Gains and Losses from Rising Inequality

This paper offers a critical evaluation of the large literature that studies the welfare conse-quences of the recent shift in the wage structure in the United States. Welfare calculations based on changes in the the empirical distribution of consumption and hours worked –analyzed through the lenses of a social welfare function – yield welfare losses of the order of 2 percent of lifetime consumption. We argue that these welfare calculations ignore that the same sources behind the shift in the wage structure –the growth in the skill premium and the rise in wage volatility – can lead to a welfare improvement as individuals adjust their education and labor supply decisions. Quantifying the importance of these channels of adjustment requires a struc-tural model. In our model-based calculations, under a plausible calibration, welfare losses turn into gains over 1 percent of lifetime consumption. *We are grateful to Chris Tonetti for outstanding research assistance and to Mark Aguiar, Erich Battistin, and Fatih Guvenen for sharing their data. The opinions expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. 1