Growing Wage Dispersion Increases Income Inequality

In the past five years, concerns about increasing income inequality have been at the center of economic policy debates. There is one area though that has remained relatively unexplored. This is the area that deals with the relationship between the labor share of income and personal income inequality. Income inequality refers to the personal distribution of income, and the labor share refers to the remuneration of employees in total factor income (value added) in a given year. When one looks at these two series, the visual impact is striking. For example, between 1970 and 2012 the labor share in G7 countries declined on average by 12 percent while income inequality increased by 25 percent.

The analysis of factor shares (labor and capital) of national income was considered the principal problem of political economy by classic economists like David Ricardo. Up until the 1960s, this topic was given great preeminence in economic textbooks and academic research. When Kaldor famously summarized the long term properties of economic growth in the 1960s, he stated that the shares of national income received by labor and capital were roughly constant over long periods of time. The analysis of factor income shares was the subject of ninety percent of the papers presented at the conference of the International Economic Association in 1965. The dominant theme was that factor shares were important for the macroeconomic performance of economies, as they were linked to the potential problem of profits squeeze or real wages growing above productivity.

Since the 1970s, however, the analysis of factor shares has no longer been at the center of economic debates, given their lack of volatility and reflecting the fact that the division of income could be easily explained by a Cobb-Douglas production function. Those concerned with personal income distribution started to emphasize that there was no direct (or mechanical) link between factors shares and inequality, and that differences in personal income were related to differences in educational attainment. In addition, a broader share of the population was starting to enjoy some kind of capital income. As home ownership, financial assets holdings and capital-funded pensions expanded in advanced economies between 1970 and 1990, the division into (pure) workers receiving only wages and (pure) capitalists/landlords receiving only profits/rents became blurred, thus contributing to the decline in attention paid to this theme.

The interest in the analysis of factor shares returned, however, in the early 2000s. Atkinson cited in 2009 three reasons to explain this renovated attention: first, the analysis of factor shares was useful to understand the link between incomes at the macroeconomic level (national accounts) and incomes at the individual/household level; second, factor shares could potentially help explain inequality in the personal income (at least partly, if certain types of income were mainly received by some type of economic agents); and last but not least, they addressed the concern of social justice with the fairness of different sources of income.

Initially, researchers returning to work in this area focused on explaining the shifts in the labor share, its gradual but constant decline and the relationship between wages and productivity. The perception that citizens were not fully enjoying the fruits of the long period of economic expansion of the late 1990s and early 2000s attracted the attention also of national policy-makers and international organizations. In 2006 Ben Bernanke, the Fed’s Chairman expressed the hope that “corporations would use some of those profit margins to meet demands from workers for higher wages” and in 2007, Germany’s finance minister asked European companies to “give a fairer share of their soaring profits.”  The IMF, the European Commission, the Bank of International Settlements and the OECD all published reports in the mid 2000s that documented the decline in the labor share of income and provided several explanations of this trend, mainly linked to the impact of globalization and technological change on labor skills, international capital mobility, and wage bargaining. The interest in this field returned after the financial crisis, because the decline in the labor share of income and the sharp increase in personal income inequality ran in parallel and this led many analysts to think that they were strongly correlated.

But the truth is that while apparently correlated, the decline in the labor share of income and the increase in personal income inequality are not directly linked in a causal relationship.  In a recent study entitled “Functional Income Distribution and its

Role in Explaining Inequality” that I have co-authored with Maura Franzese and will be published by the IMF, we test if the declining labor share of income has been a key driving factor for growing inequality. We conclude that it has not been a key factor. Instead, the most important determinant of rising income inequality has been the growing dispersion of wages, especially at the top of the wage distribution. Using a unique database that combines household surveys and macroeconomic data from 81 countries over 4 decades, we show that the most important determinant of increasing income inequality has not the declining share of income that accrues to labor, but the growing dispersion of wages within labor income. This result reflects the fact that the lion’s share of household income is labor earnings. It also occurs because top salaries have grown enormously and wage dispersion has become a driving force behind income inequality. We also found that the increase in wage dispersion has been associated with growing financial globalization, a decrease in industry unionization and a decline in the size of the state.

From a policy perspective our results suggest that to avoid unfavorable (or undesired) distributional consequences, policymakers will have to pay attention to labor market outcomes and to the dispersion of wages, including distortions induced in the labor market by different policy interventions or by changes in labor market institutions. In addition, tax and transfer policies should be properly assessed in terms of their costs and the relative effectiveness in correcting market income inequalities while minimizing distortions. Finally, public policies that support inclusive growth (by for example promoting participation in the labor market and strengthening the human capital of low income groups) should be reinforced to prevent the rise in economic disparities.

2 Responses to "Growing Wage Dispersion Increases Income Inequality"

  1. PZ_   June 27, 2015 at 4:46 pm

    In my view, growing inequality reflects changing preferences of people with power. Corporate management just deals more money to themselves and their closest allies.

    This behavior abuses trust placed on them and is morally wrong. Leadership, as an institution, is based on instincts we inherit from our ancestors. In the old days, largest social group was a tribe, and every knew each other. Leaders were kept in check by their direct contact with their subordinates. In a modern economy leaders have lost contact with their subordinates, and that gives them freedom to behave in morally corrupt ways. Problem is inherit in the capitalism that have no countervailing power to corporate managers. There is need for collective action to keep these people in check.

  2. rLipkowitz   December 8, 2015 at 1:47 am

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