Income inequality. What causes it and how to curb it

Sebastiano Fadda

Introduction: basic definitions

As anybody can see, the answer to the first question in the title is functional to the second. Knowledge of the causes of inequality is required in order to choose appropriate measures to reduce it. But the question of whether it is proper or not to take measures against income inequality is to a certain extent influenced by what is thought to be at the root of inequality. The aim of this chapter is actually to suggest measures to curb income inequality, and this implies the idea that inequality is for some reason “bad” and not the natural consequence of a good working of a competitive economic system. But precisely this view has to be put under question in the first place. Nevertheless, even if inequality was thought as simply mirroring the correct working of a competitive system, it would still be possible to encourage measures to restrain it on the grounds of ethical or social reasons.

In order to consider all the above aspects it is first necessary to define clearly what is meant by “income inequality”. This concept has to do with the distribution of income, and, therefore, has to be considered under two aspects: functional distribution and personal distribution. The first is related to the shares of GDP which go to different factors of production and can be represented respectively by the ratio of labour income (wages, salaries and other work-related compensations) to total income and by the ratio of capital income (interests, dividends and other returns on capital) to total income. The second aspect is the dispersion of annual income across households and it is mostly indicated by the Gini coefficient.

Accordingly, considering capital income as the residual of labour income, the capital share, can be defined as

GDP - (employee compensation)


This definition still embodies some ambiguities. For instance, it does not consider the income of the self-employed, underestimating in this way the labour share. To adjust for this, Gollin (2002) suggests to include “the operating surplus of private unincorporated enterprises (OSPUE)” in the computation of labour share. Some doubts also exist about where to locate the fiscal wedge. Surely it is neither profit, nor rent: it should be labour income although workers do not perceive it as such. On the contrary, workers perceive as income the interest paid on public debt. Rent from owner-occupied houses, social transfers and government benefits, pension funds, the aggregation of profits and rents (Atkinson, 2003), and also the aggregation of physical capital and natural capital (Gollin, 2008) all pose similar problems.

Income inequality 23

Leaving apart these complications (which are beyond the scope of this chapter) the share of labour in a simplified model can be defined as:

Total labout cost GDP ,

which may also be expressed as:

Nd ?w

Y ? p

or, if Gollin’s suggestion is followed,

Nd ? w + ospue Y ? p


Nd is the number of employees, w the nominal wage,

ospue is the proxy of the number of self-employed multiplied by their unit income,

Y is the physical output, p the price level.

Alternatively, whatever the measures used for the aggregates, supposing that the average compensation for selfemployed and similar is the same as for employees, the share of labour can be viewed as:

W ? N / L Y


W is total wage compensation,

N is total employment,

L is total employees and

Y is total value added.


W N_

Y ' L And so

W / L

Y / N

is the share of labour

The ratio of capital income to labour income, on the other hand, can generally be described as:

П / W = K / L ? n / w

Therefore, changes in labour and capital share depend on the relative behaviour of the two ratios: capital/labour ratio and rate of profit/rate of wage ratio, and on all the factors that impact on them, technical progress included.

Income inequality is the extent to which the distribution of income among individuals or households within an economy deviates from a perfectly equal distribution. Obviously there are connections between factor shares and income inequality. A first connection is a structural one: since labour income is generally more evenly distributed than capital income, a change in factor shares entails per se a change in personal income distribution, in the sense that a decline in labour share is associated, given the previous assumption, automatically to a more uneven distribution of personal income. This effect is, obviously, stronger the higher the difference between the dispersion of income distribution, say the Gini coefficients, within each of the two categories. In addition, empirical evidence can be found that functional distribution of income is an essential and statistically significant determinant of the personal distribution (Daudey and Garcia-Penalosa, 2007).

As is well known, different measures of income inequality show different properties and may give different estimates of the change in inequality over time. The Gini coefficient does not allow to detect where exactly the changes in income distribution may occur, while the percentile ratios restrict the information to the percentiles selected. We don’t enter here the discussion about the statistical aspects of these and other measures of inequality.

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