In recent years, economic inequality has become one of the most dominant topics in the public debate in various countries and is seen by many as one of the driving factors behind increasing political polarisation. It has also spurred academic discussion, at the latest since the publication of Thomas Piketty’s groundbreaking book “Capital in the 21st Century” in 2014. Economic inequality is often intertwined with social, racial or gender inequality and can be further broken down into income and wealth inequality, with both categories again being closely connected. And while there is a lot of work being done on investigating wealth distribution and inequality, e.g. by Saez and Zucman (2014) on the US, currently, our understanding of income distribution is more evolved. A lot of data has been gathered in recent years by Alvaredo et al. (2016) that makes it possible to take a look at the development of income inequality in various countries and helps to understand its possible drivers and consequences.
There are different approaches to measure income inequality. The historically most commonly used one is the Gini coefficient which is a mathematical definition that measures the deviation from an equal distribution where zero depicts perfect equality and one absolute inequality (one individual receives all of a nation’s income). While this approach is without a doubt useful, in recent years, it has become increasingly popular to gauge income inequality with top income shares. This can be more descriptive and additionally has the advantage of excellent comparability (whereas different income distributions can lead to similar Gini coefficients). The chart above depicts the share of the top one percent individuals with the highest incomes of the total national income, measured before taxes and excluding capital gains. One can note that, since the beginning of the 80s, income inequality in all observed countries has increased. This is true for the US, where the top one percent income share surged from 8.0 percent in 1981 to 18.4 percent in 2015, as well as for Sweden, a country that has become known for its equal society, where the top income share increased from 4.0 in 1981 to 7.2 in 2013 (developments in the same direction can be found when looking at the Gini coefficients, as reported by the OECD). Some countries have already reached the same level of income inequality they have last seen in the 30s and 40s, after all countries had experienced decreasing inequality in the decades that followed the Second World War.
A couple of possible explanations for growing income inequality have been brought forward. The market-driven story posits that globalisation and technological changes have favoured high-skilled individuals relative to low-skilled workers. This development is commonly dubbed as “The Economics of Superstars”, a term popularised by Rosen (1981). It is intuitive that automisation, digitalisation and an increasing global interconnectivity can lead to a concentration of income in the most-skilled groups of society and a devaluation of low-skilled work. In combination with the fact that the same developments increase demand for capital and therefore capital income, which is more concentrated than labour income, this becomes a powerful narrative and most likely at least partly explains growing income inequality. However, this does not explain why top income shares have grown fundamentally faster in some countries than in others (simplistically, there has been a bigger jump in inequality in English-speaking countries than in other developed countries). The second explanation that tries to incorporate this is institution-driven, considering changes in taxation, regulation and social norms.
Piketty et al. (2014) show that there is a strong correlation between decreasing top marginal income tax rates and increasing top income shares across countries, a connection which is prominently observable in the US where the top one percent income share more than doubled since the 60s while the top marginal tax rate gradually fell from an almost confiscating 91 percent to 35 percent in 2003 (the rate has since been raised to 39.6 percent again). Piketty et al. (2014) consider three channels through which top income shares respond to top marginal income tax rates: the supply-side response which describes top earners increasing their productivity when taxes are lowered, the tax-avoidance response which does not lead to a higher income but only to a bigger portion of the income being reported to the authorities when taxes fall and the compensation-bargaining response that posits that top earners bargain for higher wages due to lower tax rates. They find evidence for the hypothesis that the most important channel is compensation bargaining, implying that a considerable part of increasing income inequality is due to top earners bargaining more aggressively for higher pay. (If you are interested in their article and at the same time want to learn a thing or two about statistical programming, feel free to check out an interactive tutorial that I have developed last year.) Note that there are other possible institutional-driven explanations for growing income inequality (e.g. education; for an overview, see Dabla-Norris et al., 2015), and that most likely there are many drivers working together (for example, lower taxes could cause top earners to more aggressively exploit a higher bargaining power that is due to technological changes, linking market-driven with institution-driven effects).
Undoubtably, income inequality has been on the rise in most developed countries. But is income inequality inherently bad? Or, more precisely, at what level is income inequality bad? These questions have eventually to be answered on an ideological level as there is no clear definition of “fair pay” and marginal productivity as a determinant of income is mostly a theoretical construct. However, there is evidence that increasing inequality is harmful. Among others, Choe (2008) and Kelly (2000) find an effect of income inequality on crime. If income inequality is caused by increased compensation bargaining, as the evidence suggests, it could have a negative effect on economic productivity as low-skilled workers are discouraged and hence less productive. This theory is supported by the finding of Berg and Ostry (2011) that high inequality shortens spurts of growth. Furthermore, if high income inequality is combined with a low economic mobility, this leads to an almost perpetual increase in wealth inequality (which is always substantially higher than income inequality), which in turn can lead to further social tensions and an unequal distribution of political power.
The insufficient knowledge of the causes of income inequality and the lack of reliable data on wealth distribution makes it hard for governments to assess the situation and the possible need for redistributive measures. This is even more challenging as capital and high-skill work becomes increasingly internationally mobile (and a global capital tax, as suggested by Piketty (2014) seems completely out of reach). Hopefully, in the future there will be more comprehensive data on inequality that enables better economic inferences and more profound policy recommendations. However, the data on the evolution of income inequality does show a strong trend back towards more unequal societies and it would be a mistake to ignore this development. Especially considering the fact that it might be caused by economically harmful compensation bargaining and can lead to higher social tensions and crime rates.
Alvaredo, Facundo, Anthony B. Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. (2016). The World Wealth and Income Database. http://www.wid.world, 21/07/2016
Berg, A., & Ostry, J. (2011). Equality and efficiency. Finance & Development, 48(3), 12-15.
Choe, J. (2008). Income inequality and crime in the United States. Economics Letters, 101(1), 31-33.
Dabla-Norris, M. E., Kochhar, M. K., Suphaphiphat, M. N., Ricka, M. F., & Tsounta, E. (2015). Causes and consequences of income inequality: a global perspective. International Monetary Fund.
Kelly, M. (2000). Inequality and crime. Review of economics and Statistics,82(4), 530-539.
Piketty, T., Saez, E., & Stantcheva, S. (2014). Optimal taxation of top labor incomes: A tale of three elasticities. American economic journal: economic policy, 6(1), 230-271.
Piketty, T. (2014). Capital in the 21st Century. Cambridge: Harvard Uni.
Rosen, S. (1981). The economics of superstars. The American economic review, 71(5), 845-858.
Saez, E., & Zucman, G. (2014). Wealth inequality in the United States since 1913: Evidence from capitalized income tax data (No. w20625). National bureau of economic research.
Written by Jonas