Individual heterogeneity and perceptions matter: an analysis of income inequality and subjective well-being

Abstract

Abstract This paper discusses the ambiguous relationship between income inequality and subjective well-being. It starts from the hypothesis that measures of perceived income inequality and ‘fair’ inequality better explain subjective well-being than objective measures. Not only do people systematically fail to locate their income position within an objectively observable income distribution but income inequality is not always negatively perceived. Individuals seem more tolerant of income inequality if the process leading to it is perceived as fair. Hence, an emerging consensus is that perceived rather than objective income inequality measures are more relevant. Moreover, heterogeneity at the individual level may affect the link between inequality and subjective well-being. Interaction terms between income inequality measures and individual characteristics reveal the heterogeneity of people. We use regression models to analyse a household survey from northern Thailand covering variables that are relevant to this issue. We find only weak evidence that perceived income inequality better explains subjective well-being than objective measures. However, the higher the discrepancy is between perceived inequality and the preferred level of ‘fair’ inequality, the lower the reported subjective well-being becomes. We further show that subjective and objective income inequality measures cannot necessarily replace one another but are complementary. In the model without interaction terms, we find little evidence for the often-quoted tunnel effect (people may feel optimistic about their future income based on other people’s higher incomes), but the tunnel effect appears when interaction terms with other variables are added. This indicates that the tunnel effect is present but hidden by individual heterogeneity.