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 consequences of the recent shift in the wage structure in the United States. Welfare calculations based on changes in the empirical distributions of consumption and hours worked – analyzed through the lens of a social welfare function– yield welfare losses on the order of two percent of lifetime consumption. However, two key components of the shift in the wage structure – the growth in the skill premium and the rise in wage volatility – can potentially generate welfare gains as individuals adjust their education and labor supply decisions. Quantifying the importance of these channels of adjustment requires a structural model. In our model-based calculations, under a plausible calibration, we find welfare gains exceeding one percent of lifetime consumption. This paper was prepared for Gianluca Violante’s invited talk at the Tenth World Congress of the Econometric Society (Shanghai, China). We thank our discussant Steve Davis for many useful comments. We are grateful to Chris Tonetti for outstanding research assistance and to Mark Aguiar, Erich Battistin, and Fatih Guvenen for sharing their data. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.