Growing inequality is one of the biggest social, Growing inequality is one of the biggest social, economic and political challenges of our time but it is not inevitable.
The concentration of wealth at the very top is part of a much broader rise in disparities all along with the income distribution. The best-known way of measuring inequality is the Gini coefficient, named after an Italian statistician called Corrado Gini. It aggregates the gaps between people’s incomes into a single measure. If everyone in a group has the same income, the Gini coefficient is 0; if all income goes to one person, it is 1. The level of inequality differs widely around the world. Emerging economies are more unequal than rich ones. Scandinavian countries have the smallest income disparities, with a Gini coefficient for the disposable income of around 0.25. At the other end of the spectrum the world’s most unequal, such as South Africa, register Ginis of around 0.6. (Because of the way the scale is constructed, a modest-sounding difference in the Gini ratio implies a big difference in inequality.)
Income gaps have also changed to varying degrees. America’s Gini for disposable income is up by almost 30% since 1980, to 0.39. Sweden’s is up by a quarter, to 0.24. China has risen by around 50% to 0.42 (and by some measures to 0.48). The biggest exception to the general upward trend is Latin America, long the world’s most unequal continent, where Gini coefficients have fallen sharply over the past ten years. But the majority of the people on the planet live in countries where income disparities are bigger than they were a generation ago.
That does not mean the world as a whole has become more unequal. Global inequality—the income gaps between all people on the planet—has begun to fall as poorer countries catch up with richer ones. Two French economists, François Bourguignon, and Christian Morrisson have calculated a “global Gini” that measures the scale of income disparities among everyone in the world. Their index shows that global inequality rose in the 19th and 20th centuries because richer economies, on average, grew faster than poorer ones. Recently that pattern has reversed and global inequality has started to fall even as inequality within many countries has risen. By that measure, the planet as a whole is becoming a fairer place. But in a world of nation-states, it is inequality within countries that has political salience, and this special report will focus on that.
From U to N
The widening of income gaps is a reversal of the pattern in much of the 20th century when inequality narrowed in many countries. That narrowing seemed so inevitable that Simon Kuznets, a Belarusian-born Harvard economist, in 1955 famously described the relationship between inequality and prosperity as an upside-down U. According to the “Kuznets curve”, inequality rises in the early stages of industrialization as people leave the land, become more productive and earn more in factories. Once industrialization is complete and better-educated citizens demand redistribution from their government, it declines again.
Until 1980 this prediction appeared to have been vindicated. But the past 30 years have put paid to the Kuznets curve, at least in advanced economies. These days the inverted U has turned into something closer to an italicized N, with the final stroke pointing menacingly upwards.
Although inequality has been on the rise for three decades, its political prominence is newer. During the go-go years before the financial crisis, growing disparities were hardly at the top of politicians’ to-do lists. One reason was that asset bubbles and cheap credit eased life for everyone. Financiers were growing fabulously wealthy in the early 2000s, but others could also borrow ever more against the value of their home.
That changed after the crash. The bank rescues shone a spotlight on the unfairness of a system in which affluent bankers were bailed out whereas ordinary folk lost their houses and jobs. And in today’s sluggish economies, more inequality often means that people at the bottom and even in the middle of the income distribution are falling behind not just in relative but also in absolute terms.
The Occupy Wall Street campaign proved incoherent and ephemeral, but inequality and fairness have moved right up the political agenda. America’s presidential election is largely being fought over questions such as whether taxes should rise at the top, and how big a role government should play in helping the rest. In Europe France’s new president, François Hollande wants a top income-tax rate of 75%. New surcharges on the richest are part of austerity programs in Portugal and Spain.
Even in more buoyant emerging economies, inequality is a growing worry. India’s government is under fire for the lack of “inclusive growth” and for cronyism that has enriched insiders, evident from dubious mobile-phone-spectrum auctions and dodgy mining deals. China’s leaders fear that growing disparities will cause social unrest. Wen Jiabao, the outgoing prime minister, has long pushed for a “harmonious society”.
Many economists, too, now worry that widening income disparities may have damaging side effects. In theory, inequality has an ambiguous relationship with prosperity. It can boost growth, because richer folk save and invest more and because people work harder in response to incentives. But big income gaps can also be inefficient because they can bar talented poor people from access to education or feed resentment that results in growth-destroying populist policies.
The mainstream consensus has long been that a growing economy raises all boats, to much better effect than incentive-dulling redistribution. Robert Lucas, a Nobel prize-winner, epitomized the orthodoxy when he wrote in 2003 that “of the tendencies that are harmful to sound economics, the most seductive and…poisonous is to focus on questions of distribution.”
But now the economic establishment has become concerned about who gets what. Research by economists at the IMF suggests that income inequality slows growth, causes financial crises and weakens demand. In a recent report the Asian Development Bank argued that if emerging Asia’s income distribution had not worsened over the past 20 years, the region’s rapid growth would have lifted an extra 240m people out of extreme poverty. More controversial studies purport to link widening income gaps with all manner of ills, from obesity to suicide.
The widening gaps within many countries are beginning to worry even the plutocrats. A survey for the World Economic Forum meeting at Davos pointed to inequality as the most pressing problem of the coming decade (alongside fiscal imbalances). In all sections of society, there is growing agreement that the world is becoming more unequal, and that today’s disparities and their likely trajectory are dangerous.
Not so fast
That is too simplistic. Inequality, as measured by Gini coefficients, is simply a snapshot of outcomes. It does not tell you why those gaps have opened up or what the trend is over time. And like any snapshot, the picture can be misleading. Income gaps can arise for good reasons (such as when people are rewarded for productive work) or for bad ones (if poorer children do not get the same opportunities as richer ones). Equally, inequality of outcomes might be acceptable if the gaps are between young people and older folk, so may shrink over time. But in societies without this sort of mobility, a high Gini is troubling.
Some societies are more concerned about equality of opportunity, others more about equality of outcome. Europeans tend to be more egalitarian, believing that in a fair society there should be no big income gaps. Americans and Chinese put more emphasis on equality of opportunity. Provided people can move up the social ladder, they believe a society with wide income gaps can still be fair. Whatever people’s preferences, static measures of income gaps tell only half the story.
Despite the lack of nuance, today’s debate over inequality will have important consequences. The unstable history of Latin America, long the continent with the biggest income gaps, suggests that countries run by entrenched wealthy elites do not do very well. Yet the 20th century’s focus on redistribution brought its own problems. Too often high-tax welfare states turned out to be inefficient and unsustainable. Government cures for inequality have sometimes been worse than the disease itself.
This special report will explore how 21st-century capitalism should respond to the present challenge; it will examine the recent history of both inequality and social mobility; and it will offer four contemporary case studies: the United States, emerging Asia, Latin America, and Sweden. Based on this evidence it will make three arguments. First, although the modern global economy is leading to wider gaps between the more and the less educated, a big driver of today’s income distributions is government policy. Second, a lot of today’s inequality is inefficient, particularly in the most unequal countries. It reflects the market and government failures that also reduce growth. And where this is happening, bigger income gaps themselves are likely to reduce both social mobility and future prosperity.
Third, there is a reform agenda to reduce income disparities that makes sense whatever your attitude towards fairness. It is not about higher taxes and more handouts. Both in rich and emerging economies, it is about attacking cronyism and investing in the young. You could call it a “True Progressivism”.
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Before the industrial revolution, wealth gaps between countries were modest: income per person in the world’s ten richest countries was only six times higher than that in the ten poorest. But within each country, the distribution of income was skewed. In most places, a small elite lorded it over a mass of peasants. There was little social mobility except, as Elizabeth found, through marriage. Colonial America was an exception to this feudal sclerosis. Research by Peter Lindert and Jeffrey Williamson shows that on the eve of the American revolution incomes in the 13 colonies that formed the United States were more equal than in virtually “any other place on the planet”.
The industrial revolution widened the gaps both between countries and within them. As incomes accelerated in western Europe and then America, the distance between these countries and others grew. So, too, did internal income disparities. One study suggests that England’s Gini coefficient shot up from 0.4 in 1823 to 0.63 in 1871. Mill workers were more productive and earned more than rural laborers. The great industrialists reaped the rewards of building railways, steel mills, and other transformative technologies. Their fortunes were also boosted by monopolistic power and crony capitalism.
The growth of the industrial workforce brought increasing political pressure for redistribution. Communism was the most dramatic result. But capitalist economies changed profoundly too. In response first to the formation of workers’ unions and the rise of socialist parties and then to the Depression, politicians on both sides of the Atlantic introduced progressive taxes, government regulation, and social protection. In Germany, Bismarck pioneered pensions and unemployment insurance in the 1880s. In USA Theodore Roosevelt’s Square Deal broke up monopolies (“trusts”) in the first decade of the 20th century. In the 1930s the New Deal introduced Social Security (pensions), disability, and unemployment insurance. In Britain Lloyd George’s People’s Budget of 1909 raised income taxes and inheritance taxes at the top to fund basic pensions as well as unemployment and health insurance for workers. This spartan social safety net was transformed by the Labour government after 1945 with a National Health Service and a system of cradle-to-grave benefits.
Of the three levers used to narrow inequality—taxation, government spending, and regulation—the tax system changed the fastest. Until the late 19th century tariffs and excise taxes were the main sources of revenue. By the 1930s governments relied heavily on progressive income taxes to fund their (much larger) spending. Britain’s tax take in 1860 was some 8% of GDP; by 1927 it had risen to almost 20%. America changed its constitution to introduce an income tax in 1913. In 1944 the top rate reached a peak of 94%.
Punitive rates of taxation did not, by themselves, transform the income distribution. Many fortunes in the early 20th century were destroyed by wars, hyperinflation, and the Depression; France, for instance, lost a third of its capital stock in the first world war and two-thirds in the second. But high tax rates made it much harder for fortunes to be built up again. In most countries, the share of the top 1% fell persistently from the 1920s until the late 1970s.
Taxes rose across the advanced world, but the ways that governments spent them varied greatly. In America, whose government was more interested in inequality of opportunity than of income, the most transformative shift was to bring in mass education. Starting around 1910, America made huge investments in public high schools in pursuit of universal secondary education. After the second world war, the GI bill offered all returning soldiers the chance of higher education.
Claudia Goldin and Larry Katz, two economists at Harvard, see this dramatic boost to education as the main cause of the narrowing of inequality in America in the mid-20th century. It also boosted social mobility. Daniel Aaronson and Bhashkar Mazumder of the Federal Reserve Bank of Chicago found that as college enrolment surged in the 1940s, the relationship between parents and their children’s relative earnings notably weakened.
In Europe, the emphasis was on ensuring egalitarian outcomes with big government transfers, particularly after the second world war. Governments in Europe were slower than in America to invest in mass education, but many continental countries built even bigger welfare states than Britain, with generous jobless benefits, child subsidies, and income support. In virtually all rich countries other than America such benefits (rather than progressive tax systems) became the most important instruments for reducing inequality.
The third leg of the state’s response to inequality was regulation. Roosevelt’s trustbusting weakened America’s robber barons, and other legal changes protected workers’ rights to organize and, especially in Europe, to conclude binding national pay agreements. Union power soared and minimum wages enshrined in law narrowed the gap between workers and managers. Banking, a big source of wealth in the early 20th century, was heavily regulated after the Depression.
The Great Compression
All this meant that for decades incomes at the bottom and in the middle of the distribution grew faster than those at the top. The exact timing and scale differed. In USA, disparities declined fastest in the 1930s and 1940s, in Europe after the second world war. America’s Gini coefficient reached a low of around 0.3 in the mid-1970s, and Sweden’s hit 0.2 at about the same time. In most advanced economies the gap between rich and poor in the 1970s was a lot narrower than it had been in the 1920s. This was the era now widely known as the “Great Compression”.
Income gaps between countries, however, continued to widen as the advanced industrial economies pulled ever farther ahead of less developed ones (with a few notable exceptions such as post-war Japan and then Taiwan and South Korea). By the 1970s average income per person in the ten richest countries was around 40 times higher than that in the ten poorest. This divergence among countries outweighed the compression within them. As a result, the “global Gini”, as measured by Messrs Bourguignon and Morrisson, rose.
But around 1980 both these trends went into reverse. Globally, poorer countries began to catch up with richer ones, and within countries, richer people began to pull ahead. The surge in emerging markets began with Deng Xiaoping’s 1978 reforms in China. By the 2000s the large majority of emerging economies were growing consistently faster than rich countries, so much so that global inequality, at last, started to fall even as the gaps within many countries increased.
The coincidence of timing suggests that the reversals are related. The huge changes that have swept the world economy since 1980—globalization, deregulation, the information-technology revolution, and the associated expansion of trade, capital flows, and global supply chains—narrowed income gaps between countries and widened them within them at the same time. The modern economy’s global reach hugely increased the size of markets and the rewards to the most successful. New technologies pushed up demand for the brainy and well-educated, boosting the incomes of elite workers. The integration of some 1.5 billion emerging-country workers into the global market economy boosted returns to capital, ensuring that the “haves” would have more. It also hit the rich world’s less-educated folk with the unaccustomed competition.
Politicians in search of a scapegoat find it easier to blame globalization than technology for the widening wage gaps in rich countries, and some studies of America’s wage dispersion conclude that around 10-15% of the widening wage gap can be explained by trade. One analysis, by David Autor at MIT and colleagues, suggests that in manufacturing the impact of trade with China could be much bigger. But most economists reckon that technological change plays a far bigger role. The OECD, in a big cross-country analysis, concludes that “skill-biased technological change” is one of the main determinants of the rich world’s wage inequality. On average, it finds, globalization—as measured by a country’s trade exposure and financial openness—has no significant impact.
Whatever the exact breakdown, these two factors are increasingly hard to separate. The IT revolution has allowed more goods and services to be traded across borders, and it has fuelled the integration of the global capital market. At the same time, emerging economies are now often the source of innovation. Technology accelerates globalization, and globalization accelerates technological progress.
At the same time technology is undermining some of the 20th century’s equalizing institutions. Assembly-line manufacturing, for instance, was conducive to union organization. That is much less true of many of the cognitive jobs of the digital era. Many social transformations are also making inequality worse, particularly the rise of single parenthood and “assortative mating” (the tendency of educated people to marry each other).
Does all this mean that ever-widening inequality is inevitable? The history of inequality suggests it need not be and offers two lessons. The first is that market and social forces do not operate in a vacuum. For good or ill, the mix of tax reforms, welfare programs, and regulatory interventions pursued in the 20th century combined to reduce inequality. Those policy choices matter just as much today. If they did not, changes in income distribution would have been much more uniform across countries. Instead, much like a century ago, sweeping global forces have been muted, or exacerbated, by government policies and social institutions.
The second lesson is that governments can narrow inequality without large-scale redistribution or an ever-growing state. The 20th century’s most dramatic reductions in income gaps took place when governments, by and large, were smaller than they are today. Large, rigid welfare states proved unsustainable. But there was also a successful progressive prescription for reducing income gaps and boosting mobility by attacking crony capitalism, investing in the young (especially by broadening access to education), and creating a safety net for the poorest (particularly through unemployment insurance and pension schemes). Worryingly, governments in some of the countries where inequality has risen most seem to have forgotten that.
