Causes of income inequality

Since, beside being considered unfair, excessive income inequality is also detrimental to growth, there are enough reasons to believe that action should be taken to reduce it. There are essentially two ways to reduce inequality: one is to adopt redistribution measures once it has happened, the other is to adopt measures and strategies to prevent it from happening. In order to be able to act on this second line it is necessary to consider the causes which are at the root of the process of growing unequal distribution.

As we hinted at the beginning, there is a link between personal income distribution and functional income distribution. In fact “household market income” is made up of individual and household labour earnings, plus capital income. Therefore, all factors that impact on any of these components (including changes in functional distribution) also affect the “household market income”, on the unequal distribution of which the level of unemployment obviously plays a great role, given that unemployed people have no labour earnings. The unequal distribution of such “market income“, when considered excessive, can subsequently be the object of policy measures aimed at “correcting” it. The result of these measures is the “household disposable income”, which is household market income after taxes and transfers. Furthermore, when “in kind” transfers of the welfare system are taken into account, a sort of household “effective” disposable income will be arrived at.

Considering all that, it can be agreed that the deepest root of the general growth of income inequality that has taken place in the last decades is surely to be found in the change of political climate towards neo liberalism (Dumenil, 2001). Political and institutional evolution has been deeply influenced by this ideological orientation so that the entire working of the economic system has taken a shape coherent with the growth of inequality.

An expression of this attitude is given by labour market policy. Here the insistence on “flexibilization” together with “wage devaluation” in order to win competition has led to a strong segmentation of labour markets with high wage dispersion and a fall in their general level. The orthodox model assumed that the consequent fall in aggregate demand would be compensated by an increase in exports due to higher competitiveness; something that, of course, cannot stand if all countries are taken together as a whole. These policies have been completely unsuccessful with regard to overcoming the recent crisis, nevertheless, they have led to increasing dispersion of labour earnings and growing income inequality.

A second expression of the offensive of neoliberalism has been the adoption of recessive macroeconomic policy. The obsessive concentration on fiscal consolidation, the pro-cyclical automatic mechanism of balanced public budget adopted by the European Union, the set of recessive economic policies imposed by international financial institutions (particularly the IMF) in change for financial assistance to countries with difficulties has led to an increase in unemployment and, therefore, to growing income inequality.

As a consequence of growing unemployment, of the so called “flexibilization” of the labour market and of deliberate steps to reduce trade unions’ power and role, the neoliberalism attitude has led to a decline of unionization. But both union density and union coverage appear to be negatively correlated with income inequality, as can be seen in Figures

2.8 and 2.9.

In addition, the space of collective bargaining has diminished everywhere. An increasing trend towards decentralization of collective bargaining to firm level on the one hand, and to

Inequality and unionization in OECD countries (2004-2012) Source

Figure 2.8 Inequality and unionization in OECD countries (2004-2012) Source: Own elaboration on OECD database (download May 2015)

34 Sebastiano Fadda

Union coverage and inequality in OECD countries (2007-2011) Source

Figure 2.9 Union coverage and inequality in OECD countries (2007-2011) Source: Own elaboration on OECD. stat - ILOSTATdata

individual agreements on the other hand, has weakened the resistance against wage fall and has enhanced the inequality in labour earnings.

A fourth cause of the rise of income inequality is the progressive rise of financialization since the ‘80s. one relevant aspect of this rise is the size of the financial capital involved and the other is the absence of appropriate regulation of financial markets. The unleashed diffusion of derivatives, the large proportion of OTC transactions, the mixture of commercial and investment banks have enhanced the possibility of gains for those at the top to such an extent to allow wide and excessive speculative behaviour. In addition, the financial sector has been so empowered to gain control over the policymakers and the institutions that policy action to change the status quo is rendered highly unlikely, if not impossible. (Epstein, 2005; Glyn, 2006; Palley, 2008). Another unpleasant consequence concerns the real sector: the possibility that investment in financial assets (which offer higher returns) becomes substitute for investment in physical capital, dampening the growth of productive capacity and depressing the level of economic activity (Stockhammer, 2004). It is also possible that the increasing transfer of firms ownership to financial institutions exerts on them a stronger pressure for higher returns, which means a pressure for increasing profits at the expense of wages, consequently boosting the inequality of income distribution.

A further cause of inequality is abundantly mentioned in the literature: globalization. Globalization actually boils down to the fact that goods can be produced everywhere and sold everywhere, with no restrictions to their mobility and with diminishing transport costs. This situation is able to produce a series of consequences that affect income distribution. Contrary to the ambiguous advantages alleged by traditional mainstream trade theory fundamentally based on the Samuel theorem, the empirical evidence shows that globalization has definitely contributed to the decline of the wage share, as also the IMF has come to admit: “globalization is one of several factors that have acted to reduce the share of income accruing to labor in advanced economies” (IMF, 2007, 161). There is no evidence at all that the opposite might have happened in developing economies. There are presumably three main ways through which a pressure to reduce wages is exerted by globalization. The first is the attempt of firms to become more competitive through wage cost reduction, the second is the offshoring of production to where total unit costs (not only labour) are lower, which undermines the levels of employment in advanced countries and so acts against wage rise. The third is the simple threat of relocating production, which can be used as a sort of “discipline device” to cut down the bargaining power of trade unions and workers in general (Rodrik, 1997). Such a threat is also used to induce workers to accept not only lower wages but also worse working conditions, and governments to change labour market regulation towards lower labour standards and lower employment protection.

A sixth causal factor of inequality has to be pointed out, and that is technological change. Although deducting the evolution of “capital intensity” of production from a neoclassical production function is somehow less than correct, empirical evidence shows an association between the evolution of productive technology and the evolution of income inequality. The European Commission, in a report of the 2007, states that “the estimation results clearly indicate that technological progress made the largest contribution to the fall in the aggregate labour income share”. The possible explanations for its influence on unequal income distribution go from the one saying that skill biased technical progress increases the marginal productivity of high skilled workers relative to low skilled, so determining a widening of the different compensations to another one saying that, being technologically advanced capital goods substitutes for unskilled labour, the demand for this kind of labour tends to fall compared to demand for skilled workers and consequently the wage gap tends to increase. Summers’ suggestion may be included in this broad category. His modified production function Y = F(PK, L + I(1-p)K) assumes that one unit of capital designed to substitute for labour is equivalent to 1 units of labour; one share of the capital stock being used in a customary way and the other to substitute for labour. “When capital is reallocated to substituting for labour, the stock of effective labour rises and the stock of conventional capital falls, and so wage rates fall” (Summers, 2013, 4).

A last causal factor to be mentioned is the growth of bargaining power of firms. This power enables them on one side to compress the level of nominal wages and on the other side to increase the mark-up and raise the level of prices. The intensity of this process is determined by the degree of monopoly, as Kalecki pointed out. The consequent increase in profits is then enjoyed by the executives of the monopolistic firms, through decisions about their salaries and benefits taken at the level of the board of administrators. No restrictions whatsoever are met in taking these decisions, so the enormous and growing gap between top-level salaries and ordinary-level wages cannot be ascribed to increasing productivity or other imaginary forces of a perfect competitive market, but only to what has been called the “predatory behaviour” of the executives, made possible precisely by the enormous power obtained by the high degree of monopoly in the market.

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