The issue of income inequality has dramatically shifted public attitudes toward economic and fiscal policy, and today dominates the national political debate. Fueled by the works of economists such as Thomas Piketty, many have accepted as fact that 1) income inequality has increased dramatically, and 2) further redistributive policies must be undertaken to correct the disparity. But this diagnosis and resulting prescription overlook a key contributor to earnings inequality: rapidly increasing health care costs.  

Most previous analyses of inequality focused exclusively on comparing the earnings of lower- and higher-paid workers. By failing to account for total compensation—including employer-provided health care benefits, which make up a far larger share of total compensation for lower earners than for higher earners—such analyses significantly inflated the perceived severity of workers’ earnings inequality. This pervasive misperception continues to drive ineffective redistributive policies.

A few other studies have looked at the effect of the role of the increasing cost of healthcare benefits in rising earnings inequality and found mixed results. But unlike earlier studies, in a new study for the Mercatus Center at George Mason University, I use unpublished data from the Bureau of Labor Statistics that required no imputation or data base matching. I was thus able to directly link and quantify the effect on inequality of rising employer health costs.   

First, it is true that earnings have grown faster for higher- than lower-income workers, but total compensation (including increasingly expensive health benefits) have not experienced the same degree of divergence. Most employers pay full-time workers a combination of both earnings and benefits, which include retirement plans and health insurance coverage. Both economic theory and empirical findings indicate a trade-off between earnings and benefits: if benefits become more expensive, earnings growth will suffer. Indeed, the fact that average employer costs for family health coverage exploded from around $4,200 in 1999 to nearly $11,800 in 2013 gives a reasonable explanation for why earnings have stagnated in recent years.

However, not every employee is affected in the same proportion by rising health costs. For an employer, because of non-discrimination rules in the tax code, the dollar cost of health coverage is the same for low-paid full-time worker as for a high-paid worker.  This means health care costs makes up a far larger share of total compensation for lower earners. Though rising health care costs eat away at earnings growth for everyone, the effects will be largest for the working middle classes because their health costs are so large relative to the rest of their compensation package.

As my study shows, the disparate effect of rising health care costs is not just theory. From 1996 to 2008, I find that total compensation inequality did not change despite a significant increase in earnings inequality. The difference between compensation and earnings inequality can almost wholly be attributed to surging health care costs.

Results from a broader time period show a similar effect, although more modestly. My study further analyzed data from 1992 to 2010 (both one year after a recession trough which accounts for business cycle effects), and found high-income workers saw earnings increase 20 percent faster than low-income workers, but total compensation for high-income workers grew only 12 percent faster than for low-income workers. This result again shows that a significant share of perceived “income” inequality is inequality only in earnings, not in total compensation. The result also answers the question of where the raises have gone for lower-income workers: they have been eaten up by increasing costs of providing health benefits.

The rapid growth in the cost of health care in the United States is widely noted (after a slight pause due to the recent recession, it has started again). This growth is correctly said to cause burgeoning government spending and deficits, slower overall growth in worker earnings, and later retirements. As we now know, it is also a primary driver of earnings inequality.

The current course of redistributive policies will not address the root cause of inequality, and may be counter-productive because of their negative implications for overall economic growth. For policymakers interested in addressing inequality of earnings, the best course is to focus on policies that reduce the rate of increase in health care costs. Such policies should include: reducing the highly favorable tax treatment given health care spending and insurance; strictly enforcing anti-trust laws in the health care sector; and encouraging employers to give insurance coverage with more scope for consumer sensitivity to costs.