Tackling trends in inequality

By Professor Anton Muscatelli

The economic crisis of the last decade has cast the spotlight on economic inequality. But whilst inequality has been thrown into sharper relief by the recent recession, it has much deeper roots. Increasing inequality pre-dates the financial crisis in most industrialised countries. Understanding its causes is vital if we are to come up with any credible solution.

Inequality is not confined to a few industrialised countries. Inequality is usually measured by the Gini index, which varies from 0 (where there is complete income equality across the population) to 1 (complete inequality). OECD data shows that inequality rose between 1985 and 2008 not only in countries like the USA and the UK, but almost everywhere in the developed world. Although inequality is less marked in some countries, notably Scandinavia where Gini indexes were around 0.25-0.26 in 2008, compared to 0.38 in the UK, more progressive taxation systems in Sweden, Norway, Denmark and Finland have only modified, and not reversed the trend.

This phenomenon has led to a number of radical proposals. Thomas Piketty in his Capital in the 21st Century, demonstrates growing income and wealth inequality using historical data from over a century in countries like the US, UK, Sweden and France. Notwithstanding some recent critiques of Piketty’s data, the evidence of increasing inequality matches other research, and is pretty decisive. Piketty’s conclusion is that the only solution is world-wide progressive wealth taxation.

Whilst such collective action on a global scale is difficult, individual countries can address the fundamental drivers of social justice.

There are three major forces which can depress wages at the lower end of the income distribution and which offer some guidance. First, the role of globalisation and trade in depressing the wages of less skilled workers. Second, the reduction in labour protection legislation which shifts the distribution of income from labour to profit/capital. Third, the impact of rapid technological change which creates a premium for more skilled workers and distributes income away from lower-skilled workers. Addressing the first two causes is not easy as protectionism in trade or excessive labour market regulation may reduce inequality at the expense of overall employment and living standards. But the third force, skills-biased technological change, offers interesting insights, as it suggests that a promising way forward is to spread the benefits of education as widely as possible.

In a seminal contribution in 2008 Claudia Goldin and Lawrence Katz showed that one of the major drivers of greater inequality in the USA in recent years was the slowing down of the mass upskilling of the US population which universal free secondary education had delivered in the 20th century, and which allowed human capital growth to match technology-driven growth up to 1980. Similar effects are found across the industrialised world.

In addition to skills-biased technological change there are other factors at play. Not least an increase in inequality due to a rising share of income going to the highest 1% of earners, and the birth of ‘superstar effects’ in some sectors. This trend is particularly insidious because it undermines the social consensus in support of economic growth and erodes political cohesion. Joseph Stiglitz and others have shown that unequal income distribution can hamper economic growth through this and other channels. Furthermore, these inequality effects are reinforced by inherited wealth. The countries with the greatest inequality (eg. the USA and the UK) also have the highest positive correlations in incomes across generations: a relationship which has been labelled the ‘Great Gatsby curve’.

What needs to be understood is that there is no silver bullet to address growing inequality. It’s a problem with multiple causes which needs multiple cures. Progressive taxation can certainly help as part of any solution. The Nordic economies have been successful in moderating market effects on net incomes but even their progressive taxation systems have not been able to stem these trends entirely.

More can – and should – be done by targeting spending on public goods which benefit the less economically fortunate and which also help by building social capital. One such measure is widening access to education and particularly higher-level skills. There are many others: targeting investment in early years education; increasing childcare support to those who cannot afford to pay for it; tackling health inequalities in early years; fully integrating the benefit, social security payments and taxation systems so as to avoid punitive benefit reductions or higher marginal tax rates on the lower paid; incentivising wealth redistribution through greater inheritance tax breaks for donations to charity. Many of these interventions do not fall foul of the usual criticisms against higher taxes, namely that they disincentivise entrepreneurship and risk-taking, and hence overall economic growth.

Some of these changes to how we prioritise investments in certain public goods and how we design our taxation and benefit systems are radical. They focus on developing our economic institutions and our fiscal structures to level the playing field for our future generations, and not just for our current generations. But if we are serious about tackling inequality we may need to do more than tinker with existing structures. We need to design our economic and political system to place fairness and equality at its heart.

Anton Muscatelli is Professor of Economics and Principal of the University of Glasgow. He will deliver his President’s Lecture to the David Hume Institute on the macroeconomics of inequality in November.