Inequality and Redistribution

Inequality and Redistribution, The Need for New Perspectives, by Agnar Sandmo, Discussion Paper 04/2005.

Excerpt: … The sources of increased inequality.

The causation behind the recent increase in inequality in the Western world is unlikely to be a simple one; I believe that it must be understood in terms of the interaction of a number of forces whose relative importance may vary from one country to another as well as over time. The following list is brief and selective.

First of all, it is often maintained that the increase in inequality of factor income, particularly income from labour, is due to globalisation. A short version of this theory is that globalisation has liberalised trade and factor movements between the rich and the poor countries of the world. The poor countries have a relative abundance of unskilled labour, while the rich countries have a relatively large endowment of skilled labour. As countries utilize their comparative advantage, the demand for unskilled labour increases in the poor countries, whereas skilled workers in the rich part of the world experience increased demand for their services. Therefore, the skilled-unskilled wage differential increases in the rich countries, while it decreases in the poor countries. If trade unions in the rich countries try to resist the fall in the wages of the unskilled, the result will be increased unemployment – another source of increased inequality. For further discussion and references see e.g. Atkinson (1999) and Sandmo (2003).

Second, it is widely believed that the development of technology has a built- in inequality bias. To an increasing extent, both manufacturing and services require high-skill employees, workers who are able to handle advanced technological equipment. Since the required skills are scarce, those who possess them will be able to sell their services at an increased premium in the labour market. Consequently, the skilled-unskilled wage differential increases. An econometric study by Krusell et. al. (2000) interprets this general hypothesis as capital-skill complementarity, i.e. as the hypothesis that capital accumulation raises the marginal productivity of skilled labour but reduces the marginal productivity of the unskilled. They find considerable support for this hypothesis in United States data for 1963-1992, even though there was a substantial increase in the supply of skilled workers during the same period. Acemoglu (2002), whose analysis is based on a broad survey of the literature, confirms this conclusion but adopts a different view of the chain of causation than most of the previous literature. He argues that although technical change in the United States has been skill-biased during most of the 20th century, this should primarily be interpreted as the technological response to an increased supply of skilled workers.

Third, during the past couple of decades Western countries have gone through a period of deregulation and tax reform with increased emphasis on economic incentives. It is highly unlikely that individuals respond in a uniform way to improved incentives. Some will react to the substitution effects of lower marginal tax rates by working harder and saving more. Others will change their behaviour only to a very small degree; in other words, the income effects will wholly or partly dominate the substitution effects. The consequence of this could be that the former group of individuals will increase their incomes relative to the latter. In this perspective, some increase of inequality in factor incomes is an expected and unavoidable consequence of the creation of improved incentives for economic efficiency. Blomquist et. al. (2001) present evidence indicating that the Swedish tax reform of the 1980s did indeed contribute to increased inequality. For the United States it has been suggested that part of the increased inequality of labour incomes following the Tax Reform Act of 1986, has been due to income shifting from other tax bases as a response to lower marginal tax rates; see e.g. the discussion in Slemrod (1998). This source of increased inequality is of a different nature than the two previously mentioned, since they are the results of economic policy reforms, not of developments that are due to causes that are exogenous, at least to the national economy. To the extent that this kind of increased inequality can be interpreted as the outcome of some sort of social welfare maximization, it could even be argued that it is desirable, being the outcome of a rational trade-off between efficiency and equality.

These three causes of increased inequality can all be interpreted in terms of the standard competitive model; in particular, they assume that wage rates reflect the marginal productivities of different types of labour. But is the competitive theory of wages a realistic one? There is no simple answer to this question. There can be no doubt that for a number of problems, especially perhaps at a high level of aggregation, the competitive theory is a good guide to understanding how the labour market works. But in applications of a less aggregative kind, such as the development of the personal distribution of income, the answer to the question is much more in doubt, and there have always been economists who have been sceptical to the marginal productivity theory of wages … (Read the whole 16 pages on NHH Norwegian School of Economics and Business Administration).

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