Reasons to be concerned about income inequality

The statement that labour shares are constant over time is not only theoretically weak, as it has been said, but is also contrary to empirical evidence. Figures 2.1 and 2.2 are enough to show an overall declining share of labour during the last 30-40 years.

On the side of personal distribution, there is also wide empirical evidence of the general increase in the Gini coefficient in the last decades (Figure 2.3).

Then, there is the appalling difference among top-level salaries and ordinary wages. It is not an irrelevant fact that while in the 1970s and 1980s the salary of staff in the 350 largest companies in the US were 20-30 times the wage of an ordinary worker, around 2010 the difference jumped to 200-400 times, and in the UK above 300 times (Mishel and Sabadish, 2012). Moreover, in general,

In most OECD countries, the gap between rich and poor is at its highest level for 30 years. Today, the richest 10 per cent of the population in the OECD area earn 9.5 times the income of the poorest 10 per cent; in the 1980s this ratio stood at 7:1 and has been rising continuously ever since.

(Cingano, 2014)

The reasons to care about the undoubtable worsening of wage share and income inequality are grounded on the one side in fairness issues, and on the other side in the impact on economic performance itself.

Fairness is obviously connected with a system of value judgements, but in general terms excessive inequality (we always speak of excessive and growing inequality) is becoming more and more socially rejected, and fairness in income distribution, conceived as a low

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Figure 2.1 Labour share on GDP in G7 economies (weighted), 1960-2016 Source: Ameco database 2015

Figure 2.2 Adjusted wage shares, continental European countries 1960-2016 Source: Ameco database 2015

level of inequality, is more and more being considered as a positive requirement of modern and democratic societies. Apart from an “abstract” principle of justice, this is also due to some negative consequences that income inequality as such is bound to produce in society.

One of these is the reduction of social mobility. There is wide empirical evidence that high levels of income inequality as measured by Gini coefficients are associated with high levels of intergenerational elasticity (which is the coefficient obtained by regressing children’s income in adulthood on their parental income; a coefficient of 1 would mean that all the income difference between parents would be passed on to children). This is shown in the Figures 2.4 and 2.5.

Figure 2.3 Gini coefficients, 1980-2010 (1980 = 100) market income, disposable income = market income minus taxes and transfers Source: oECD data elaborated by Smeeding, Morelli, Thompson (2013)

Figure 2.4 Income and intergenerational earnings inequalities Source: Corak, 2013

Figure 2.5 Incomes inequality and intergenerational income mobility Source: Esping-Andersen, 2009

Figure 2.6 Correlation between trust and income inequality Source: American Journal of Public Health

Another unpleasant consequence is the lowering of social cohesion, and particularly of trust relationships, which is of vital importance for the good and smooth working of markets and of social interactions as a whole. The sense of unfairness which is connected with large inequality creates distrust and lack of cooperative attitude among people. Furthermore, since

Table 2.1 Relationship between (net) income inequality in reach countries and some social problems

Source: Wilkinsons and Pickett (2009)

unleashed inequality is perceived as a violation of the principles of appropriate rewards and reconnaissance of merits and skills, it appears to be a consequence of “predatory behaviour” (Fitoussi, 2011) and it may also discourage young people from engaging in skill acquisition and in accumulation of human capital (Figure 2.6)

Finally, income inequality has been proved to be positively correlated with all sort of bad social indicators, such as crime, violence, drug abuse and so on. Also health and life expectancy are correlated with income inequality (Wilkinson and Pickett, 2009) (Table 2.1).

Clearly, most of these problems could be more plausibly explained by the absolute level of individual income, rather than by inequality, although in general it is inequality that pushes individual incomes below a problematic threshold, so establishing a link between the two. Inequality “per se”, when not accompanied by a critical absolute income level, seems to act negatively on social indicators through the creation of “status anxiety”, “because it places people in a hierarchy that increases status competition and causes stress, which leads to poor health and other negative outcomes” (Rowlingson, 2011).

Having considered all this, it may still be objected that the fairness argument is not decisive in order to make a choice towards taking action to reduce inequality.

It could well be that equity was detrimental to economic performance or more specifically to the rate of GDP growth, as one could deduct if less inequality were empirically associated with lower economic performance or lower growth. In that case it might as well be preferable to sacrifice some equity in order to achieve more growth. A trade off would appear and the choice would become dependent on the preference function of society. But, as is well known, it’s impossible to aggregate individual preferences into a social welfare function. Nevertheless, it may be that transferring some money from a rich person to a poor person results in an aggregate wellbeing gain because the benefit to the poor individual exceeds the loss to the rich person (Sacks et al., 2012). Since the goal of economic policy is to maximize happiness (or “utility”), societies may thus be able to increase the “aggregate” welfare or wellbeing through policy changes which increase equality. This view is consistent with the principle of decreasing marginal utility of income and in line with what Pigou wrote:

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The old “law of diminishing utility” thus leads securely to the proposition: any cause which increases the absolute share of real income in the hands of the poor, provided that it does not lead to a contraction in the size of the national dividend from any point of view, will, in general, increase economic welfare.

(Pigou, 1920)

As a matter of fact, the alleged trade-off between equity and growth does not seem to exist. It is not possible here to comment on all the existing literature on this issue, but it is possible to say that in general the empirical evidence shows that “there is a strong negative relation between the level of net inequality and growth of income per capita in the sequent period; the statistical evidence generally supports the view that inequality impedes growth, at least over the medium term, and have found that inequality is associated with slower and less durable growth. The few exceptions (Forbes, 2000; and Banerjee and Duflo, 2003) tend to pick up ambiguous short-run correlations” (Ostry et al., 2014). On the same line: “Drawing on harmonised data covering the oECD countries over the past 30 years, the econometric analysis suggests that income inequality has a negative and statistically significant impact on subsequent growth” (Cingano 2014). This is shown in the figures below.

As far as developing countries are concerned it seems that “longer growth spells are robustly associated with more equality in the income distribution” (Berg, 2011). As for the relation between redistribution policies and growth, some qualifications have to be introduced, which we shall discuss later.

Figure 2.7 shows the relationship between disposable Gini of 2008 and per capita real GDP in the next five years.

The factors to which such relation can be attributed are now to be pointed out.

A first factor is the shrinking of effective demand, with direct consequences on this fundamental driver of growth, Due to different (and decreasing) marginal propensity to consume, a growing concentration of income implies a declining consumer demand. This decline could lead to underconsumption crisis (of Marxian flavour), which if not treated with appropriate economic policies would not only undermine growth but possibly start a recession.

Figure 2.7 Inequality and real GDP per capita in OECD countries (2008-2014) Source: OECD statistics

A second factor of impairment to growth is due to the financial instability created by inadequate aggregate consumer demand: the need to sustain aggregate demand may lead to allow excessive increase of private indebtness. Actually this is what has happened between 2000 and 2008 particularly in the USA, UK, Ireland. Greece, Portugal and Spain.

A third factor is the accumulation of enormous wealth in the hands of a restricted number of people. This accumulation takes place through a combined dynamic of uneven distribution of income and expansion of the financial sector, implying in this way a significant change in factor share due to growth of financial rents. As a consequence, and with the help of lacking financial markets regulation, financial excess becomes possible and likely, and with it the fading of growth and the developing of financial instability (Stiglitz, 2012; Galbraith, 2012). Milanovic (2009). Lansley (2009) explicitly attributes a central role to widening inequality in the build-up of the financial crisis, credit crunch and subsequent recession.

Besides, the richest may come to get enough power as to gain full control of the policy makers. In this way they can prevent the adoption of policies capable of reducing inequality, and possibly they will be also able to effectively support policies capable of increasing income and wealth concentration.

A fourth factor can be detected in the fact that income inequality undermines progress in health and education. Bad health conditions, low living standards and poor education among the population lead to hold up growth (Galor and Moav, 2004).

Although the relation between human capital and growth, or per capita income, is far from univocal, mostly due to ambiguities in human capital measurement, it is generally recognized, though, that higher levels (and better quality) of education improve the progrowth attitudes of economic agents and increase the absorption capacity of innovations. Since excessive income inequality negatively affects human capital accumulation it also negatively affects growth.

Finally, “a contrario”, a low level of inequality is thought to enhance social cohesion, and this in turn is able to provide an institutional set up capable of solving conflicts and better reacting to external shocks (Rodrik, 1999). The lack of social consensus, which is favoured by inequality, is bound to seriously dampen social and political stability, the efficient working of the market and the process of growth.