Guest Post by Arpit Gupta: Causes of Inequality

by Arpit Gupta

Income Inequality is higher these days, but the reasons behind the rise matter. To the extent that greater inequality is the result of genuine shifts in productivity, rising wage dispersion may not be such a bad thing; and policies that attempt to counteract inequality may wind up hurting overall growth. Here are a couple of papers consistent with that idea.

1) Financial Liberalization and Growth

Economist Mauricio Larrain argues that capital goes together well with skilled labor. Firms that have more capital tend to also prefer more skilled labor to assist in production. As a result, financial liberalization — which improves capital allocation and allows firms to use more capital — also results in an increase in the demand for skilled labor. Inequality rises, but this reflects the greater returns to productivity of higher-skilled workers who live in a world of greater capital.

Larrain finds that episodes of financial liberalization in both America and Europe were associated with higher wages for both skilled and unskilled workers; but higher wages for skilled workers, resulting in greater inequality. This happened in non-financial sector industries highly dependent on capital for production, suggesting that the story isn’t just about richer bankers. He suggests that financial liberalization can account for 15% of the rise in inequality in the US from 1980-2000.

The particular US reforms he looks at were removal of interstate branch banking restrictions, which increasingly seem like a fairly harmful set of regulations to begin with, having arguably set the stage for America’s chronic financial instability in the 19th century. Though removing these laws raised measured inequality, raising American incomes in general seems like a good thing, even if some workers gained more than others. 

2) Taxes and Inequality

The University of Minnesota’s Fatih Guvenen has a paper with colleagues investigating the role of tax rates in influencing inequality. The authors focus on comparing inequality trends between America and European countries, which have lower inequality. They confirm that progressive taxes are higher in Europe, particularly in Scandinavia. 

Importantly, higher labor tax rates in Europe result in much lower rates of return from investing in education and human capital, since the higher earnings those investments yield are worth less after taxes. Their model suggests that the worse incentives generated by higher tax rates do end up resulting in lower education and pre-tax wages in Europe. Inequality is lower as a result, but only because worse incentives have diminished productive investments, work, and earnings. The authors suggest that they can account for 40% of the inequality gap between the US and Europe by looking at the impact of higher tax rates. 

These papers aren’t the whole story; there are clearly may other factors going on when thinking about why inequality is higher in the US now than it has been in the past, or compared with Europe today. Stagnating wages at the bottom end of the income distribution remains a concern, regardless of how well top earners are doing. Still, if inequality is rising due to increased premia for certain skills, that calls for a very different approach to inequality.