Reducing income inequality in Europe

In her speech to the 2013 Davos meeting, Christine Lagarde quoted Franklin Roosevelt as saying that “the test of our progress is not whether we add more to the abundance of those who have much; it is whether we provide enough for those who have too little”. She went on to say

“I was not surprised, therefore, to see that the World Economic Forum’s most recent survey puts “severe income disparity” at the very top of global risks over the next decade. Excessive inequality is corrosive to growth; it is corrosive to society. I believe that the economics profession and the policy community have downplayed inequality for too long. Now all of us—including the IMF—have a better understanding that a more equal distribution of income allows for more economic stability, more sustained economic growth, and healthier societies with stronger bonds of cohesion and trust. The research reaffirms this finding. What is less clear is how we achieve more inclusive growth in practice”.

The aim of this paper is to consider how Europe could reduce excessive income inequality. It suggests three approaches:

In discussing these issues my primary focus is on inequality within countries, but I return at the end to world inequality.

Income inequality in most, but not all, OECD countries is significantly higher than thirty years ago (Atkinson, 2013a). The EU as a whole has failed to make a significant reduction in the proportion of its citizens living at risk of poverty. Top income shares are racing away in many countries. However, it has not always been so. We tend to focus on recent decades, but we can learn from earlier periods when inequality fell. The downward section of the Kuznets curve did really exist. It is for this reason that, together with colleagues, I have invested much time in studying the long-run development of inequality (see, for example, the World Top Incomes Database, and Atkinson and Morelli, 2013).

The long-run picture shows that history is not dominated by secular trends, but rather by distinct episodes. In the case of the UK, this is illustrated in Figure 1, which shows the dispersion of individual earnings, measured by the top and bottom deciles, expressed as percentages of the median, over nearly sixty years. There are four distinct phases. In the first and the third phases, dispersion is unambiguously widening; in the most recent the top has been rising at the same rate as in phases 1 and 3, but the bottom decile has not fallen relative to the median. And there was phase 2: the period of the second half of the 1960s and 1970s when the bottom decile rose from around 45 per cent of the median to over 55 per cent, and the top decile fell from 175 per cent to 165 per cent.

If we turn to the distribution of household disposable income, we see that there have been salient falls in the Gini coefficient. As a guide to thinking about “salience”, I use a criterion of a 3 percentage points fall. To achieve such a fall via a linear tax would require 5 percentage point increase in the marginal tax rate (where government real spending is 20 per cent of total income and the pre-redistribution Gini is 48 per cent). A 5 percentage point increase in taxation would certainly be treated as a major political challenge by any minister of finance.

From Figure 2, we can see that salient – indeed large - falls were achieved in the Nordic countries in the later 1960s and 1970s – broadly the same period as the fall in earnings dispersion in the UK. The Gini coefficients fell by some 10 percentage points in Denmark and Finland, making them among the least unequal countries in the world. The fall in Sweden was some 5 percentage points. In the same way, Figure 3 shows more than salient falls in the countries of Continental Europe. In France and Italy, the decrease – from quite a high level - was again some 10 percentage points; in Germany and the Netherlands, it was more than 5 percentage points. (Figure 3 also shows the salient increase in the Gini coefficient in Germany that has taken place in the past decade.)

How were these reductions in inequality brought about? In part, they were the product of tax and transfer policy. At this time, all the countries concerned operated highly progressive personal income taxes. There were progressive taxes on wealth, or on the transfer of wealth via inheritance. It was the time of the expansion of the welfare state, which meant that the safety net became more effective and that those at the bottom of the income distribution were able to share in rising prosperity.

Since then, many countries have scaled back their redistributive ambitions. In the United Kingdom, National Insurance in the 1960s provided earnings-related unemployment benefits for six months and flat-rate benefit for a further six months. The earnings-related benefit scheme was abolished in the 1980s. Child benefit when introduced in the 1970s was some 18 per cent of mean gross income for a family with 2 children; today it is only 10 per cent. The UK is not alone. Other OECD countries have seen major cuts in their tax-transfer programmes, such as the Hartz IV measures in Germany. This general trend has been documented by the OECD in their reports Growing Unequal? (OECD, 2008) and Divided We Stand OECD, 2011). As summarised by the Secretary-General of OECD, “from the mid-1990s … the reduced redistributive capacity of tax-benefit systems was sometimes the main source of widening household-income gaps” (OECD, 2011).

The post-war reductions in inequality were not only achieved by redistribution. Significant measures were taken to change the pre-tax and transfer distribution. These included labour market interventions, not least those in response to the increased participation of women in the labour force. In the case of the UK, for example, the narrowing of the earnings distribution in the 1970s was in part the result of the laws governing equal pay for men and women. In many countries there were minimum wages, governed by legislation, or effected via collective bargaining.

There was intervention in the capital market. Capital markets were highly regulated. Such a situation may now be regarded as anachronistic; however it is worth remembering that it also contributed to ensuring financial stability. In our study of financial crises in 25 countries, Salvatore Morelli and I found that in the period 1945 to 1980, there were only 3 crises in these countries, whereas since 1980 there have been 24 crises, such as the Nordic financial crises of the early 1990s. It was also the case that many governments were engaged in re-building their balance sheets. In 1957, the net worth of the UK public sector was negative, minus 40 per cent of national income; by 1979 this had become positive and equal to 140 per cent of national income. The state had a stake in the productive wealth of the economy, including the direct ownership of shares, such as a 51 per cent stake in BP.

Finally, when talking of anachronistic policies, it should be recalled that the 1960s and 1970s were the period of incomes policies, some of which were explicitly redistributive. When I was a student at Cambridge, my teachers were actively engaged in the design of such policies, and incomes policies seemed a natural part of the policy armoury, but today they are largely forgotten. To obtain a modern perspective, I checked Wikipedia, according to which:

“During the French Revolution, “The Law of the Maximum” imposed price controls (by penalty of death) in an unsuccessful attempt to curb inflation, and such measures were also attempted after World War II. Peacetime income policies were resorted to in the USA in August 1971 [under President Nixon] as a response to inflation. The wage and price controls were effective initially but were made less restrictive in January 1973, and later removed when they seemed to be having no effect on curbing inflation. Incomes policies were successful in the United Kingdom during World War II but less successful in the post-war era. Experience was mixed but somewhat more favourable in countries such as Australia and the Netherlands”.

Parts of this history are alarming, but we should perhaps look again at the possible function of incomes policies, particularly in the context of fiscal consolidation measures, where there may be renewed interest in tax-based incomes policies.

We can learn not only from history but also from economic analysis. Christine Lagarde criticised the economics profession for having neglected the economics of inequality, but they have not totally ignored the subject. Indeed, the 1980s saw the launching of a large literature in the field of labour economics concerning the widening wage distribution. Hundreds of articles have been written on this subject, and there is now a standard story. Open virtually any introductory economics textbook and you will find an explanation of rising income inequality in terms of supply and demand. The explanation was originally due to the Dutch economist, Jan Tinbergen, who talked in the 1970s about the race between technology, raising the demand for skilled workers, and education, increasing the supply. If, he argued, demand rose faster, then the relative earnings of skilled workers would rise, and vice versa. Since he wrote, a further factor has been introduced: globalisation. The increased supply of goods on the world market from countries with lower wage costs has driven down the relative price of goods in which unskilled workers are more intensively engaged, and hence widened the wage differential.

The outcome of the race depends on the supply response, which is crucial. If the supply of skilled labour does not react, then wage dispersion will go on rising, but it seems highly improbable that there will be no supply response. In an open economy, there will be inward migration of skilled workers, and in all economies the increased skill premium provides an incentive for the acquisition of skills. If we take a simple human capital view, which is that people will seek training where the wage differential for educated work is sufficient to offset the cost of training, then an infinite speed of response would mean that the wage differential did not move from that required to repay the cost of education. In the more likely intermediate case, where supply responds gradually according to the excess of the skilled wage over the cost of becoming skilled, then a continued shift in demand leads to a rising wage premium, but one that eventually levels-off. (The dynamics are set out in Atkinson, 2008.)

Such a theoretical framework has immediate policy implications. The size of the permanent increase in the wage premium depends on the rate of demand shift, broadly common across OECD countries, but also on the speed of adjustment, which varies from country to country according to their institutions and the policies adopted. Hence the emphasis on education and training that recurs in European policy agendas. But there is also a less discussed aspect. The wage premium may also have increased because of rise in the effective cost of borrowing to fund education, which points to policies to reduce costs of training and education. This in turn implies an inter-connection between the labour market and the capital market, to which I now turn.

The textbook account of rising wage dispersion focuses on the roles of skilled and unskilled workers. Aggregate output is a function of L_S and L_U. Yet when I go back to a book that I read in 1964 when I was a student – Efficiency, Equality and the Ownership of Property - by James Meade (1964), I find a fascinating treatment of technological change – referred to as “automation” – in terms of the impact on capital and labour. For Meade, output was a function of K and L. It seems to me that these two strands should be combined. Output should be seen as a function of L_S, L_Uand K. This is important, since the share of capital in national income appears to be rising in many OECD countries. Before the crisis, the IMF noted that “over the past two decades, there has been a continued decline in the share of income that accrues to labor, especially in Europe and Japan” (International Monetary Fund IMF 2007, page 168). The European Commission equally reported that

“The part of added value allocated to labour reached a historically low level in 2006. This trend is in particular the result of technological progress and globalisation. It may have a negative impact on social equity, economic efficiency and macro-economic stability” (Summary of chapter in Employment in Europe 2007, European Commission 2007).

According to the 2012 Employment Outlook of the OECD 2012, “in recent decades, the labour share, or the share of labour compensation (wage, salaries and benefits) in the total national income, has been declining in almost all OECD countries. The median labour share dropped to 61.7% in the late 2000s, from 66.1% in the early 1990s and in some countries this decline began over 30 years ago”.

Perceived in terms of three, rather than two, factors of production, the issues of technical change and globalisation take on a different form, as has been highlighted in the recent US discussion of firms moving production back to the United States as a result of the spread of robotisation (Krugman, 2012). This may change the employment dynamic. In the past, it has been argued that it is semi-skilled production jobs that have been shipped abroad to lower wage countries, but that unskilled service sector jobs could not be so outsourced. This has led to job polarisation, with employment growth at both ends of the scale. Personal services have to be performed domestically. We have to ask, however, whether this will continue. With increased robotisation, unskilled service jobs may over time offer less employment. If my neighbour has a robot to mow his lawn (as he does), then he no longer needs a gardener. Technical change may well be benefiting capital at the expenses of workers as a whole.

What are the distributional implications of a rising profit share? Is it not the case that the capitalists of the past have been replaced by institutional shareholders, with the ultimate beneficiaries from an increased profit share being households (for example in the form of private pensions)? The indirect ownership of shares has certainly increased, but it has been accompanied by the development of financial intermediaries with funds under their management. Recourse to private pensions and increased savings for old age are one of the major drivers of the growth of the financial services industry. A significant proportion of increased profits goes therefore not to the ultimate holders but in management fees and other payments for financial services. In the UK, household spending on financial services rose in volume terms by 20 per cent between 2003 and 2011, compared with 6 per cent increase in total household consumer spending (Office for National Statistics, 2012, Table 6.5).

In choosing this title for the section, I am not suggesting that the standard policy prescriptions are without value. It is right that Europe, faced with the twin challenges posed by globalization and technological change, should emphasise education and the up-skilling of the labour force. “Smart growth” makes sense. In the same way, I support calls for a return to a more redistributive tax and transfer policy. Rises in top income tax rates, or the introduction of a luxury rate of VAT, can contribute to fiscal consolidation and help ensure that the burden of fiscal adjustment can be more fairly shared. But I also believe that we need to look beyond the options currently prominent in public debate, and be willing to “think outside the box”. The proposals sketched in this section may immediately be dismissed as politically infeasible; however, I would like to urge that they be given serious consideration.

The policies are grouped at the national level, the EU level, and the global level, with two under each head.

Ever -increasing income inequality is not inevitable. The recent rise is due not only to technology and globalisation but reflects the institutions and policies adopted in the labour and capital markets. National governments are not powerless to take measures to reduce excessive inequality; there are concrete steps that can be taken by European Union.

¹The text can be downloaded from the Official Website of the U.S. Social Security Administration. The website carries the caution: “this is an archival or historical document and may not reflect current policies or procedures”.

²This idea was put forward by Danny Pieters. In the field of pensions, Mario Monti in his 2010 report on the Single Market proposed “a 28th regime for supplementary pension rights. This would be a regime entirely set by EU rules but existing in parallel to national rules, and thus optional for companies and workers. A worker opting for this regime would be subject to the same rules for its non statutory benefits wherever it goes in Europe” (Monti, 2010, page 58).