The distribution of income can be divided into the distribution of labor earnings and the distribution of income from property (capital). The contribution of capital income to greater inequality has received a great deal of attention from many people, including Thomas Piketty, who hypothesized that developments in the last 30 years are part of a longer historical pattern of changes in the distribution of income. Karabarbounis and Neiman (2014) have shown that the increased share of capital income is a broad phenomenon that has occurred in most of the 58 countries in their sample. The increase in the share of capital income has also occurred in most of the 50 states of the U.S. The rise in capital’s share has contributed to greater inequality, but changes in the earnings of labor have also contributed to greater inequality. Incomes of high skilled labor have increased relative to earnings of middle and low-skilled workers. A satisfactory explanation of changes in income inequality must explain similar changes in many countries, and it must also be capable of explaining increased earnings of both capital and high-skilled labor. An explanation for rising inequality based solely on developments in the United States (taxes, government spending, minimum wage, unions) is not sufficient.
Technical change has had a major effect on national income, the rate of economic growth, and the distribution of income. Technical change has occurred across countries and industries, and the forces of globalization have contributed to its dissemination. Innovations have been a specific type biased toward using capital and high-skilled labor and against the use of middle and low-skilled labor. Technical change has contributed to greater prosperity by raising the productivity of capital and labor, but a side effect of recent technical change has been a redistribution of income in favor of owners of high-skilled labor and capital.
Equal opportunity is important for efficiency and economic growth. It is important for people to be able to acquire skills, enter occupations, and start businesses without restrictions. However, equal opportunity to use one’s labor and capital productively does not imply equality of results or equal incomes. Economic history is filled with spurts of innovation (shipping innovations in the 15th century, the steam engine, petroleum related innovations, and the microprocessor that Intel introduced in 1971) in which the innovators received large rewards that temporarily increased income inequality (Gordon, 2014). Greater concentration of wealth has provoked envy and resentment, but attempts to use government policy to increase equality may reduce the incomes of both the poor and the rich, even if they increase the share of the poor in a smaller total income. Failed experiments with planned economies in China and the Soviet Union, intended to promote greater equality, are extreme examples, but Casey Mulligan (2014) has documented recent US policies intended to reduce inequality, that have also reduced incentives for people to work.
Observed increases in inequality in a given year should not be confused with changes in intergenerational economic mobility. Some critics have claimed that America is no longer a “land of opportunity”? A recent study by Chetty et al (2014) challenged this claim and concluded that “young adults entering the labor market today have roughly the same likelihood of moving up the income distribution ladder relative to their parents as those who were born in the 1970s and entered the labor market two decades ago”. Increases in inequality in particular years have not prevented individuals from rising above or falling below the incomes of their parents.
SOURCES OF INCREASED INEQUALITY
Technical change has been the main source of increases in income inequality across many countries. It has been biased toward using higher-skilled labor and capital, and it has been widely disseminated by globalization. New patterns of international trade have contributed to the bias against middle and low skilled labor. Production of many products has become increasingly specialized (fragmented), such that components of the final product have been produced in many different countries. The fraction of foreign value added in a typical product has increased substantially in recent years. A well-known study of iPods shows that components were made in 13 different countries and assembled in China (Dedrick et al, 2010). When they are imported into the U.S., iPods are classified by Customs officials as “made in China”, even though only 3% of the total value added comes from China, and 33%-50% accrues to Apple. The supply chain is managed by Apple in the U.S. so as to use the best technology in a way that minimizes total cost. One result of this complex fragmentation of production is an increase in the share of skilled labor and capital in total value added and a reduction in the shares of middle and unskilled labor. This process that favors skilled labor and capital also applies to other Apple products, and it has been shown to apply to a wide variety of other manufactured products in a sample of countries that comprise 85% of world GDP. (Timmer et al, 2014).
Thus, new technology has produced valuable new products at costs that millions of consumers can afford, but an unintended side effect is increased inequality of income. The process is an example of Schumpeter’s “creative destruction”. The “destruction” can be avoided only by foregoing the valuable new products. The increased inequality need not be permanent. In the case of labor, lower skilled labor was matched to the old technology. If more workers acquire the higher skills that are in greater demand, relative labor earnings and the distribution of income will again become more equal. The dynamic process of adjustment to the innovation has been described as a “race between technology and skills” (Acemoglu and Autor, 2012). Gordon has described major innovations in US economic history that increased economic growth, enriched innovators, and temporarily increased income inequality.
WHAT SHOULD BE DONE ABOUT INCREASED INEQUALIITY?
The efficient response to increased inequality depends on what caused the increase. If technical change is the source, greater inequality of earnings performs a useful economic function of encouraging workers to acquire skills that are in greater demand. Policies that offset technologically- induced innovation decrease total income. For example, extending unemployment benefits to a longer period encourages workers to remain unemployed longer (or leave the work force), rather than acquire skills that are in greater demand under the new technology. Policies that motivate the unemployed to seek new employment and at the same time ease the acquisition of skills would increase total income and reduce inequality of earnings. In the “race between technology and skills”, faster response of skill supply to skill demand enhances economic efficiency. For example, the Hartz IV reforms implemented in Germany in 2005 that resulted in a significant cut in the unemployment benefits for the long-term unemployed along with Germany’s established dual vocational training system have been acknowledged to have significantly contributed to its low unemployment rate, including low youth unemployment.
Conversely, policies intended to reduce inequality (higher marginal tax rates, extended unemployment benefits, higher minimum wages) would have the unintended consequences of reducing total income and economic growth. Casey Mulligan (2014) has documented how policies that raised effective marginal tax rates (for example, extended unemployment benefits) have decreased employment and slowed the recovery from the Great Recession in the U.S.
If the source of greater inequality is greater privileges to the rich (rent-seeking) that enables them to protect themselves from competition, the solution is a more open and competitive economy. The rise of rich and powerful oligarchs in Russia and billionaires in China are examples of crony capitalism, in which politically powerful elites use the power of government to protect their economic interests. In the US, if influential individuals (Romney, Buffett) or corporations (General Electric) enhance their wealth by paying low or zero taxes, there is an economically efficient remedy. Closing the many loopholes in the tax code that favor special interests would broaden the tax base, and it would allow the government to receive the same tax revenue at lower tax rates. Eliminating sources of rent-seeking can reduce income inequality while also increasing economic efficiency.
CONCLUSION
The personal distribution of income has become less equal in the United States and many other countries in the last 30 years. This has been widely viewed as a negative development, and many proposals have been offered to achieve a more equal distribution. However, a prudent response depends on the source of the change in income inequality. Technical change that has spread to many countries and is biased toward using more skilled labor and capital is a major source of greater income inequality, but it is also a major source of economic growth. Since economic growth has been a major source of poverty reduction since the Industrial Revolution, it would be prudent to recognize that redistribution policies come at a cost.
REFERENCES
Acemoglu, D and David Autor. 2012. “What Does Human Capital Do? A Review of Goldin and Katz’s The Race Between Education and Technology”. Journal of Economic Literature, June.
Dedrick, Jason, Kenneth Kraemer, and Greg Linden. 2010. “Who Profits from Innovation in Global Value Chains?” A Study of the iPod and Notebook PCs”. Industrial and Corporate Change” 19(1)81-116.
Gordon, John Steele. 2014. “The Little Miracle Spurring Inequality”. Wall Street Journal June 3.
Karabarbounis, Loukas, and Brent Neiman. 2014. “The Global Decline of the Labor Share?”. Quarterly Journal of Economics. 129 (1): 61-103.
Mankiw, Gregory. 2013. “Defending the 1%”. Journal of Economic Perspectives. Summer .
Mulligan, Casey. 2014. “A Recovery Stymied by Redistribution”. Wall Street Journal, June 30.
Piketty, Thomas. “Capital in the 21st Century”.
Timmer, Marcel, Abdul Azzi Erumban, Bart Los, Robert Stehrer, and Gaaitzen de Vries. 2014. “Slicing Up Global Value Chains”. Journal of Economic Perspectives, Spring.