The Effects of Income Inequality on Financial Satisfaction, Trust, and Economic Optimism: Evidence from U.S. States, 1973-2012

Despite claims that rising income inequality—such as that experienced in the United States over the past forty years—should result in a broad range of adverse consequences, the academic community has not established meaningful consensus on the consequences of varying levels of income inequality for a number of important outcomes. Scholars have identified part of the problem as the lack of attention to the specific mechanisms through which the level of income inequality may matter.

In this paper I examine three proposed psychosocial effects of income inequality that existing studies have assumed are part of the key to explaining how income inequality matters, but have rarely examined directly. First, higher income inequality may increase feelings of relative deprivation and thus decrease financial satisfaction. Second, higher income inequality may reduce social trust, either because widening status differentials results in interacting less often and less effectively with people in other status groups or as a byproduct of increased feelings of relative deprivation. I consider both explanations. Third, higher income inequality may affect people's optimism about future upward economic mobility. The "tunnel effect theory" suggests that people will be more optimistic when they see the success of others in times of rising inequality, imagining they too will soon be upwardly mobile. However, they may become disillusioned and discouraged if these expectations remain unfulfilled.

I conduct individual-level regression analyses using the 1973–2012 General Social Surveys linked to state-level data from IRS tax reports, the Census, and the American Community Survey. These analyses include state fixed effects that control for all time-invariant differences between states and also include a wide range of individual and state level covariates that could otherwise confound the relationship between income inequality and each outcome.

I find that income inequality increases feelings of relative deprivation and decreases financial satisfaction. Those at the top and bottom of the income distribution appear to be the least negatively affected, while those in the second and third income quintiles appear to be the most negatively affected. This may be because the reference group for those near the middle includes those at the top who have gained the most during rising inequality. Also, those near the middle may experience the greatest gap between their "middle-class" aspirations and economic reality. But I find no positive effect of inequality for those in the top income quintile. I also find that inequality reduces trust. This negative effect is robust to accounting for financial satisfaction, supporting the explanation of reduced social mixing. Finally, I find that income inequality reduces optimism for economic mobility across the income distribution. I assess the sensitivity of these results to a number of robustness tests by varying the control variables, measures of inequality, and model types.