Lecture 11: Income Inequality in Europe and the USA

Introduction 

In all societies income inequality can be unpacked into three interactive terms:

  • inequality in income from labour
  • inequality in income arising from the ownership of capital
  • and the interaction between these two terms

The causal mechanism, and normative justification, underpinning each of these is different.

What is Vautrin’s social lesson to Rastignac in Balzac’s Père Goriot? Why does Piketty use this story to explain the difference between work, merit and inheritance?

Vautrin explains to Rastignac that it is illusory to think that social success can be achieved through study, talent and effort.

He explains to Rastignac what income he can expect to earn, and what career paths he can expect to pursue in the various professions in France at the time, such as medicine or law, where learned competences/skills are more necessary than inherited wealth.

Vautrin claims that even if Rastingnac is talented and learns brilliant skills, he will never become wealthy. By contrast, the best strategy for social success is inheritance. On this basis he encourage Rastignac to marry Mademoiselle Victorine.

But to do this he must first murder her brother, to ensure that she gets the inheritance. Rastingnac is prepared to marry without love but not quite prepared to commit murder.

The key question being proposed by this moral dilemma is whether it pays to work if dishonesty, petty crime, inheritance and corruption matter much more for success. If such deep social inequalities exist, why should anyone bother to follow societal norms and market rules?

The structure of wealth and income hierarchies in 19th century Europe meant that the standard of living of the wealthiest greatly exceeded that of those who earned their income from labour.

Under such conditions why not be immoral and appropriate capital by whatever means?

The key question: work or inheritance? 

In these societies (which existed in all European countries until World War 1) the question of work/labour/skill did not arise. All that mattered was the size of one’s wealth and the size of one’s fortune, whether acquired through inheritance or marriage.

The shock of WW1 brought these patrimonial societies to an end. But Piketty suggests that rising wealth inequalities today mean they are making a comeback.

Democratic capitalism is founded on the normative belief that those inequalities that are based on merit, talent and hard work are more justified than other inequalities, such as inheritance.

For example, it is probably safe to assume that those who work the hardest in this class will most likely get the best grades. Everyone would rightly abhor a situation whereby grades were distributed on the basis of favour or social class.

Inequalities need normative justification. Liberal capitalism is justified on the basis that free markets encourage fair and open competition, and that rewards are distributed on the basis of hard work, not corporate influence and power.

The core question to ask yourself over the coming weeks is whether we live in a society where social class matters more than hard work and merit? Do we live in a meritocracy? Does this vary by country, region and city? For example, ask yourself which countries have the highest levels and lowest levels of social mobility.

Inequalities with respect to labor and capital

To answer these questions we need to distinguish between those inequalities that arise from selling labour and owning capital. Lets remind ourselves of some basic trends and concepts.

  • Income can be expressed as the sum total of all income from labor (usually wages and salaries) and capital (usually rent, interest, capital gains).
  • Total income inequality is the result of adding up these two components: inequality of income from labour and inequality of income from capital.

The more unequally distributed both of these are, the greater the total level of income inequality.

It is not always true that individuals with high income from labour/wages have a high income from capital, and vice versa. Jane Austen’s heroes owned so much capital (land) that they did not have to work. They had no labour income. They didn’t need a wage.

The difference 

There are two reasons why we need to understand these differences.

  • First, for normative reasons, the justification of inequality arising from labour effort is totally different from inequalities associated with inherited wealth and owning capital. There is probably only one Messi in the world. We tend to accept that it is justifiable that he earns a huge labour income from his very particular footballing skills (but not his tax avoidance).
  • Second, the causal mechanism that explains how rising wealth and wage inequalities, and how they change, are totally different.
    • In the case of wages/labour, what matters most is the supply and demand for different skills within a given labour market; the quality and type of the educational system in place; the rules and institutions of the labour market; the strength of trade unions and the structure of collective bargaining.
    • Note: in the study of economics these institutions are considered a rigidity that block the presence of competitive labor market forces. What policy implications emerge from this?
  • In the case of the inequality that arises from income from capital, what matters most are cross-national differences in the organisation of capital/finance markets; savings and investment behaviour;  laws on inheritance; and the operation of rental and housing/land markets.

Inequality has multiple dimensions and different mechanisms and cannot be adequately captured in unidimensional indicators.

Synthetic indices such as the Gini coefficient (ranging from 0-1) tend to lump all of these different things together. We are going to use distribution tables, which express inequalities in terms of social class. To quote Piketty directly:

distribution tables allow us to have a more concrete and visceral understanding of social inequality. They emphasize the shares of national wealth and income held by different groups, as well as an appreciation of the data to study these issues…the Gini coefficient gives a sterile and atemporal view of inequality.

Inequalities: some orders of magnitude 

There are two regularities/trends in the study of income inequality.

First, capital income is allays more unequally distributed than labour income. This is the case in all time periods and all countries, without exception. The ownership of capital is significantly more concentrated than labour. Therefore, by definition, it is more unequally distributed.

Second, the concentration of capital ownership is explained mainly by inherited wealth and its cumulative effects (it is easier to save if you inherit an apartment and don’t have to pay rent).

inequalities with respect to labour income (wages) always seem moderate whereas inequalities with respect to capital always seem more extreme.

In public discourse we tend to think and talk more about wage inequality, primarily because most of us don’t experience capital inequality in the same way. Just think of the media coverage given to the Dublin Bus drivers wage demand, and the coverage given to massive increases in asset/capital prices.

Inequality of income distribution 

Tables 7.1, 7.2, and 7.3 chart the distribution of inequality from labour income, capital income, and total income.

They give an indicative picture of low, medium and highly unequal countries. Note: they are before taxes.

The top 10% of the labour income distribution usually receive 25-35% of total labour income, whereas the top 10% of capital owners usually receive 50% of all wealth (and in some societies as much as 90%).

Lets examine each of these distribution tables in turn (inequalities of labour income, capital income and the sum total).

Table 7.1 illustrates that in societies where labour income inequality is low (Scandinavia in the 1970’s), the top 10% received 20% of labour income, the middle 40% took 45% of labour income, and the bottom 50% took 35%.

In real terms: if average pay is €2,000 per month, the top 10% would take €4,000 (the top 1% would take €6,000) the bottom 50% would take €1,400 and the middle 40% would take €2,250.

Labour income is almost entirely earned wages and constitutes around three quarters of all national income. Most people live off their wages, not income earned from owning capital.

Piketty uses deciles (10 percent) and centiles (1 percent) to discuss distribution and inequality. These may lack the poetry of peasants, nobles, elites, workers and bourgeoise. But they enable us to make clear statistical comparisons across time and space.

Top decile/centile 

When discussing the top decile it is essential that we distinguish between the top 9 and 1 percent.

This was one of the major innovations of Piketty. He demonstrates that it is the top 1 percent, or more precisely the top one thousandth, where most of the change (inequality) has taken place, over the past 30 years.

Remember the top centile is the top 1 percent. This means that in the USA, with a population of 320 million, the top centile is 2.6 million individuals (adults). This is a numerically large group of people, capable of significant political influence.

The USA

The one country that stands out from table 7.1 is the USA,  where the inequality of labour income has broken historical records.

In real terms, what this means is that in the USA if average pay is $2,000 per month:

  • The top 10% would take $7,000 ($24,000 for the top 1 percent),
  • The middle 40% would take $2,000
  • The bottom 50% would take $1,000.
    • If these trends continue the top 1 percent could effectively employ the bottom 50 percent as domestic servants.

Think about these magnitudes. In Sweden the bottom half of the population earn $1,400 whereas in the USA it is $1,000.

This is a 40 percent difference, which is a significant amount. If we take into consideration the difference in the price of third level education, and the cost of public services, this income difference is likely to have a significant impact on equality of opportunity (and social mobility).

Women are significantly over-represented in the bottom 50 percent. What this suggests is that class-based inequalities are also gender-based income inequalities.

Looking at table 7.1 we can probably conclude that it is better to be a low wage earner in western Europe than to be a low wage earner in the the USA.

Why do different countries have different attitudes toward social inequalities?

Inequality of capital ownership

Table 7.2 shows that inequalities with respect to wealth and capital ownership are even more extreme.

In Europe the top decile typical own 60% of wealth, the middle class own 35%, whereas the bottom 50 percent own 5% of wealth.

In the US, the top decile typically owns 70% of wealth, the middle class own 25%, whereas the bottom 50 percent also own little more than 5% of wealth.

It is important to ask whether an optimal distribution of capital ownership can exist? Can normative political theories inform these debates (on preferences toward efficiency and equity). This about John Rawls.

In real terms, if average net wealth is $200k (divided into real estate and financial assets) this would imply that in the US:

  • The top decile would own capital worth $1.2 million
  • the top centile would own capital worth $5 million.
  • The poorest 50 percent would have net wealth of less than $20,000.

The importance of housing as a form of wealth decreases the further one goes up the income distribution. Housing is the asset of the middle class, whereas true wealth/fortune almost always consists of financial and business assets.

The growth of a propertied middle class was the principle structural transformation of the distribution of wealth (and politics) in the 20th century.

In the 19th century, and right up to WW1, there was no middle class. Almost 90 percent of national wealth was owned by the top 10 percent. The vast majority of a society’s assets were owned by an elite minority.

Nevertheless, despite the emergence of a middle class, table 7.2 shows that inequality in the ownership of capital remains extreme (the top decile own 60 percent of national wealth in Europe and 70 percent in the USA).

Inequality of total income

Table 7.3 shows inequality of total income (and the one that you will most often hear in public debate) with corresponding Gini coefficients.

Is it possible to imagine a society where the concentration of income is much greater than this? Could we imagine a democracy where the top decile appropriates 90 percent of all national income?

Democratic societies are clearly capable of accepting high levels of wealth inequality, probably because capital-income only constitutes one quarter to one third of national income.

But if the same level of inequality (top decile owning 90 percent of all output) applied to total income then surely a democratic revolution would occur? Or would it?

Table 7.3 shows that the USA may set a new record on income inequality in 2030. The top decile may take 60 percent whereas the bottom half of the population would barely get 15 percent.

Conclusion

Lets return to our opening question on merit versus inheritance. How are each of these inequalities justified? It is the justification of inequality that matters most in a democratic society.

One way to think about this is to compare high-inequality societies, such as the US today, with Europe in the 19th century.

19th century Europe was a hyper-patrimonial society where high incomes from capital (and inherited wealth) dominated.

The new high levels of inequality in the USA  emerge from high incomes from labour (super-managers).

If these co-evolve, as Piketty suggests they will, the 21st century will reach levels of inequality not seen since the 19th century. This is why the original title of the book was “the return of patrimonial capitalism”.

Growing inequalities in labour income are assumed to be justified on the basis of merit (better skills and new technologies). But is this true?

Next week we look at the composition of top incomes in Europe and the USA.

Lecture slides: Lecture 11

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