Martin Duys, a member of our Emerging Fellows program inspects the drivers of in-country inequality in his third blog post. The views expressed are those of the author and not necessarily those of the APF or its other members.
When income inequality is discussed in casual conversation, people are generally referring to in-country inequality - the measure of how income is distributed amongst the population of a single country. The factors that drive in-country income inequality are multiple, interrelated, complex, and sometimes contradictory. Some factors tend to be more prevalent in advanced economies and others are more influential in emerging markets and developing countries (EMDCs). Geography, political history, and even culture also play a role.
The International Monetary Fund (IMF) has attempted to identify, measure, and rank the most important factors driving in-country income inequality. They conclude that over the past thirty years the three dominant factors have been: labour market flexibility, financial deepening and technological progress - in that order.
Flexible labour markets allow firms to reallocate resources and create conditions that encourage a certain amount of economic dynamism, but they also put tend to put the salaries of workers, and especially low skilled workers, under pressure. The primary beneficiaries of increased labour market flexibility tend to be those in the top ten percent of the income distribution. In EMDCs labour markets that are too rigid can create conditions that encourage informality resulting in increased levels of inequality. There is a strong body of evidence to suggest that labour market regulation (a legislated minimum wage, unionisation, and compulsory social security contributions) tends to improve income distribution. Labour market flexibility ranks as the most important factor in EMDCs and the second most important in advanced economies.
Financial deepening - increasing the provision and sophistication of financial services - is associated with increased inequality in EMDCs (ranked third), largely because the beneficiaries of this deepening tend to be those at the higher end of the income distribution. In advanced economies, where levels of financial inclusion are historically higher, the impact of financial deepening is not as significant, and it is only ranked fourth.
Advances in technology generate economic growth by increasing productivity. They also shed jobs through increased automation and require higher skill levels to run them. This ‘skill premium’ increases levels of income inequality as jobs shift from low-skilled workers at the bottom end of the income distribution to more skilled, better paid workers. Technology is the second most important factor in EMDCs. Although it is ranked only fourth in advanced economies, the skill premium factor which is as a direct result of technological advances, is the single most important driver of income inequality in advanced economies.
Globalisation, seen as more a reinforcer than a driver, is a fourth contributing factor. It creates circumstances that sometimes increase and sometimes decrease inequality. Trade liberalisation increases economic activity, generates economic growth, and decreases income inequality. Offshoring increases income inequality in the country outsourcing the manufacturing as it sheds jobs at the lower end of the salary spectrum, but the new jobs created in the offshore economy tend to decrease income inequality there. Although not fully understood, financial globalisation is thought to cause increased income inequality in both advanced and EMDC economies.
Many would expect education to appear on the list of the most influential factors, but the impact improving levels of education equality has on income inequality is dependent on a number of other variables that can dilute its impact. These variables include the size of the investment made in education, whether it is made by individuals or governments, and the level of return on the investment.
Although there are common themes in the sources of income inequality, there are no generalised lessons to be learned that can be taken from one successful attempt at addressing the issue and applying the same strategies uncritically elsewhere. Each country has its own unique mix of interrelated and intermingled factors and needs to be analysed and understood on its own merits.
Martin Duys, a member of our Emerging Fellows program inspects the drivers of inequality among countries in his second blog post. The views expressed are those of the author and not necessarily those of the APF or its other members.
The factor that plays the most critical role in determining a person’s income is the country in which they live. It has more influence than the persons parents’ economic circumstances (the second most important factor) and far more than any effort they may make to improve their situation through education. Geography is more important than class, or level of education, in determining income.
Between-country inequality has never been as extreme as now. Just before the start of the industrial revolution, the average income in the wealthiest countries (at the time Holland and the United Kingdom) was roughly three times higher than the poorest. Described as analogous to the ‘Big Bang’ rates of economic growth and average incomes exploded in countries that industrialised. Now the difference in average income between the rich industrial nations and those that have failed to industrialise is a multiple of one hundred.
From the second half of the twentieth century other factors have also contributed to driving between-country income inequality. The political and institutional instability experienced in some countries after decolonisation caused economic stagnation and in some cases, decline. In the Soviet Block and other socialist countries, socialism failed to lift income levels significantly.
There are factors driving a decrease in between-country inequality. Sustained economic growth since the 1980s in China and India has had an enormous impact. In China alone, the number of people whose incomes have doubled is ten times that in the United States over the same period.
In gross terms, the gap between rich and poor countries continues to grow. China's economy would need to grow by eighteen per cent to generate the same value created by a one percentage point increase in the GDP of the United States. This is an almost impossible task for any economy no matter how ‘on fire’ it is.
An assumption of neoclassical economics has been that globalisation would improve levels of between-country inequality. Poor countries with cheaper labour forces would attract more foreign direct investment (FDI), because corporations looking to increase returns by lowering production costs would invest. The result would be increased local income levels and decreased inequality. Emerging countries would also ‘slip-stream’ on the technological advances of richer countries by copying their innovations and avoiding the need for expensive research and development. They would also be able to avoid adopting dead-end technologies that proved unsuccessful or were quickly superseded by superior technologies. Unfortunately, these assumptions have not been borne out by reality.
In what is termed the “Lucas paradox” FDI has not flowed as expected from high-income to low-income countries. Instead, it has to tended to flow from high-income countries to other high-income countries, and even from low-income to high-income countries. Technology adoption by developing countries has not been an equaliser as expected. Royalty payments for new technologies tend to flow from the poorer adopting countries to the more affluent countries that own the intellectual property.
The failure of the focus is shifting to include institutional and cultural considerations. The goal is to create an environment fertile for innovation, technology, and economic growth. Whether this new approach improves levels of between-country inequality remains to be seen.