Explaining Inequality

Income inequality has been growing around the globe in recent decades, with the steepest spikes seen in the United States. Few issues are more gripping than the question of inequality in society, yet we don’t fully understand the mechanisms driving the increase.

A recent panel discussion on the University of Chicago campus brought together experts who have been studying the question for decades to explore the forces driving inequality and possible policy responses. To a packed hall at Max Palevsky Cinema, panelists explained different but interconnected causes and solutions.

“Inequality is a complicated story,” said Thomas Piketty, a professor at the Paris School of Economics. “There’s a whole set of institutions that matter: education, labor markets,  progressive taxation. It involves contradictory mechanisms—forces that lead to a reduction in inequality but also forces that increase inequality, for reasons that are difficult to justify.”

Piketty’s contribution has been to gather evidence on long-term trends on the concentration of income and wealth in 20 nations in his best-selling book Capital in the 21st Century. “Between 1950 and 1980, we have a distribution with about 30 to 35 percent of national income going to the top 10 percent of earners. After 1980, this share starts rising and we’re back to 50 percent,” about where the US stood in 1930, Piketty said.

Why is this happening? Many people point to globalization, particularly China’s entry into the world market. “But we need a little bit more than globalization to explain what we see,” he noted. Countries like Sweden, Japan, and Germany are impacted by the forces of globalization but don’t show the same rise in inequality.

“There’s no magic bullet, magic explanation,” he noted. “Clearly, different policies and institutions in broad range of domains from education to labor markets to progressive taxation,  have played a role.”

“Unequal access to education I think is clearly a very big  part in the explanation for why inequality has increased so much more in the US than in the rest of the rich world,” he said, noting that there’s a gap between very good American universities and secondary schools of widely varying quality.

“This is a main explanation, but it cannot be the whole explanation,” he said, noting that education alone doesn’t account for trends seen at the top and bottom of the income distribution. For instance, inequality shows up most clearly in the vast salaries paid to top managers. Those salaries are hard to explain in terms of education and greater productivity. Piketty speculated that they arise from a pay-setting process designed to provide incentives to get the best talent in the top positions.

The decline in labor unions and a stagnant minimum wage are other possible factors.

Piketty pointed to a final possible cause:  “There’s been a huge decline in tax progressivity at the top of the tax distribution in the US compared to other countries.”

With the data he and others have brought to the table, Piketty said, “We know a little bit more than we used to, but we don’t know enough. There are many different ways to interpret the same data. We have to be modest. Still, I think there re import lessons to be drawn about sources of inequality and ways to reduce inequality in some cases.”

Focusing on Flourishing

Steven Durlauf, Kenneth J. Arrow Professor of Economics at the University of Wisconsin-Madison, turned the discussion to a narrower segment of the inequality phenomenon, focusing on the disadvantaged at the low end of the income.

Durlauf illustrated the state of inequality by describing three well-known charts drawn from the work of leading researchers. First was the Heckman curve, which shows that the rate of returns to investments in children decline significantly from age 3 to age 17. “What’s really important is the mechanism underneath [this observation]. First, it recognizes that social and emotional skills are critical; they are part and parcel of what creates economic success and flourishing in life. Second, it moves us beyond income, to thinking about the consequences of rich early childhood investment and stable families.

“I think 21st century inequality demands that we move beyond measures of income to thinking about what it means to have a flourishing life. Recognizing that disadvantage damages people in ways that have to do with their psychological makeup that has to be part of the story of how to fix it,” he said.

In the second telling picture he described, Chetty, Hendren, Kline, and Saez have mapped intergenerational mobility across the US and found that it varies greatly if you zoom in to small geographical units. This work stresses that that neighborhoods and schools are social units influencing individuals, and shows that exposure to poverty and disadvantage has long term consequences.

Finally, he described the so-called Great Gatsby curve based on the work of Alan Krueger, Miles Corak, and others, which shows that in industrial economies, low levels of inequality also have high social mobility, and vice versa. “This translates into an attack on the traditional arguments for meritocracy,” he said.

Twenty years of studying these relationships has led Durlauf to think in terms of a memberships theory of inequality. “If you want to understand inequality, one of the many perspectives…is to realize that individuals are influenced throughout their life course by the groups that they are members of and interact with.” Family is the first and strongest influence on  a child’s chances of flourishing in life, but her neighborhood, school system, connections and experiences in college, and relationships on the job also play a role.

Durlauf said this presents “a vision where the key mechanism in understanding persistent inequality is segregation: in other words, assortative mating of highly educated parent, economic segregation, racial segregation of school districts, or segregation by the quality  level by high school achievement across colleges.” These factors become mechanisms that translate initial inequalities into persistent inequality within an individual’s lifecourse and across generations.

A Supply and Demand Story

Kevin Murphy, George J. Stigler Distinguished Service Professor of Economics, explained inequality in terms of supply of and demand for human capital in labor markets.

“Within the US, I think far and away the most important changes we’ve seen over time is changes in in relative returns to low-skill and high-skill labor,” he said. That is mirrored in the tremendous growth since the 1980s on returns to education, with an enormous gap in earnings between those who finished college and those with a high school education or less. “Comparing today to 1980, returns have doubled or tripled, depending on how you measure,” Murphy said.

Technological advances lead to investment in better physical capital, and both raise the demand for skilled labor, while replacing some unskilled labor with automation, Murphy explained. Those investments increase inequality. Growth in human capital counteracts those forces.

The result “is sort of a tug of war, with an increase on technology and physical capital on the demand side and increases in human capital on the supply side,” Murphy said. “When demand [for skills] grows faster than supply, prices [or wages] go up and returns to human capital go up. When supply grows faster than demand, prices fall and returns to human capital falls.”

Since the 1980s, we’ve seen the supply side of skilled labor fall, and with demand outstripping supply, wages for skilled workers rose. People respond to that incentive, investing more in their human capital, and were rewarded with even higher wages.

On the low end of the earnings scale, the opposite happens; people lose jobs lose jobs, struggle with low wages, and invest less in their own human capital. The pattern creates a widening of inequality.  “This theory does an amazing job of explaining much of what we’ve seen in the the returns to education,” Murphy said.

Like Durlauf, Murphy stressed that wages and income are only part of the story because developing more human capital enhances all aspects of life. “You take [human capital]  home with you when you go home at night. It affects your skill at raising children, at maintaining your own health, at running your financial life; and  how good you are at interacting with friends and family and the like.”

Global Differences

Piketty pointed out that significant political and institutional differences across nations feed into inequality. For instance,  education is an area where policies, institutions, and ideologies differ in important ways. European nations are doing better at educating the young than the US, he said. “Why is it that part of US society don’t want to pay for the education for the youngest groups?” he asked. Institutional features also have a strong impact on firm formation and wage-setting; German firms, for instance, are doing well under German practices.

Durlauf agreed, but also pointed out the underestimated role of ideology—an area economists are uncomfortable with—that shapes not just tax policy but attitudes and beliefs about equality and opportunity.

Discussions of inequality often elicit the meritocratic argument that it arises from rewarding differing levels of skill, talent, and hard work. Americans like to think of themselves and their society that way, Durlauf said.

Piketty noted “the tendency of the elite to justify inequality with claims of meritocracy” in all countries, not just the US. “The gap between official discourse on meritocracy and opportunity and what’s really going on is incredibly large,” Piketty said. “Sometimes claims of meritocracy are true;  sometimes they are off the mark. It’s important to put these claims in context, to have access to data.” Such data is hard to access and publish, he added, calling for more transparency for a more informed and democratic discussion of inequality.

Murphy took issue with claims for meritocracy. “I don’t see how more meritocracy gets you more [economic] mobility. I think it’s just not correct,” he said. “If we had a meritocracy where everybody got paid what they were worth based on what they produced, we wouldn’t have more equality; those born with wealth and advantages will get more advantages.”

“We live in a world in which your real environment matters: parents matter, schools matter, neighborhoods matter,” he continued. Most theories of investment cannot explain how the disadvantaged in those areas can outcompete and outproduce individuals more richly endowed. “As an economist, I don’t see where you get more equality,” he stated.

Solutions

If inequality is driven by a skill shortage, as Murphy argued, environmental differences help explain that human capital shortfall. “We have a lot of people who don’t have very good opportunities to develop it. If you fall behind early in life, it’s not impossible to catch up but extremely difficult.”

His solution: “It’s critical to enable more people to get the human capital they need. And this is not just education; they need to get what we call soft skills, but they are hard in the sense that they are not so easy to get and critical for production.”

“We need to do what we can to increase skilled labor and create more opportunity for the people at the bottom,” Murphy said. There’s evidence that people do respond to the college wage premium and seek education, but many drop out because they are poorly prepared. That calls for better early education and secondary schools — a long-term fix, Murphy acknowledged.

Durlauf said it was important to address unequal experiences and environments.  “I put particular emphasis on policies that achieve partial integration”  Policies on affirmative action, public housing, voucher systems, and school district zoning “all speak to altering the potential of who interacts with who. That is where the currency of  for egalitarian justice lies,” he said.

Piketty said that Murphy’s supply-side story about a shortage of skills and human capital applies across other countries as well. He also stressed the importance of education and mentioned efforts to try to influence universities to move to more egalitarian admissions systems.

But as he famously concluded in his book, he called for higher taxes on higher earners. He pointed out that progressive taxation was a US invention; from 1923 to the 1980s, “no society in Europe was as progressive in taxation as America. This did not destroy American capitalism. I think it’s time to look at this again.”

Durlauf responded that historically, progressive taxation in the US was more a matter of structure and sources of income taxed than an ideology that favored taxing the rich.

“To me what’s important is the possibility to adapt the tax system for progressive taxation of  income and property,” Piketty continued. He called for flexibility in tax policy “to adapt to what we see, if we’re influencing supply and demand of capital. If don’t need to correct trends, then I would be very happy.”  But without more transparency and data about different income groups, it would be hard to respond and adapt, he added.

“The idea that that I’m going to index the tax structure to changes in prices [and wages] is the worst idea in world,” Murphy responded. “It stifles the supply and demand response.” Even without the indexing, “if you tax capital, you stop growth and you will lock in place the returns to labor,” he said. But if you allow capital to respond to the opportunity of profits, investment creates more opportunity and wage growth for workers. “That’s been the case for a long, long time,” Murphy added. “The return to capital hasn’t changed much over 100 years, but the returns to labor have increased.

“If you’re worried about inequality, don’t want to get to a world where you are taxing one group, giving money to other group that doesn’t. That gets you more inequality,” Murphy said. “And inequality goes beyond income; it involves the environmental things and interactions Steve talks about. We have to find a way to keep the other segments of society engaged.”

Piketty stressed that education reform and progressive taxation were not substitutes; complementary approaches that work together. But, he added, the idea that we need to resist taxation to keep incentives and productivity growth “just doesn’t square with the facts.”

Since effective solutions depend on the true drivers of inequality, moderator James J. Heckman pressed panelists to quantify how much of inequality could be attributed to the causes under discussion. Estimates were hard to come by.

Durlauf said measurement is tough because it’s increasingly clear that psychological and sociological as well as economic factors are involved, and there are methodological challenges in parsing out causal factors. The good news is that the research he cited is moving us toward emerging fields of psychological economics and sociological economics, but they still in their infancy.

Durlauf worried that in discussions of inequality, “income is being reified as the only thing to change.” He called for more focus on flourishing—a vague but important notion.

“The difference between France and US is not just income but what’s happening to kids in their early years. The policy we need may not be income adjustment but palliative measures on other dimensions,” Durlauf said. “My argument is not for progressive taxes but for progressivism, policies that address these imbalances.”

All agreed that inequality was a complicated problem to solve, but Murphy saw hope in small changes. “You might say, ‘We can’t rescue everybody;not everybody is going to be able to get more human capital.’ The saving grace of economics is you don’t have to.

“If we were to increase the human capital of some segment of population that is not keeping up, they would benefit, but the remaining low-skilled workers would also benefit because there would be less competing supply of unskilled workers. That would mean higher wages, and that could incentivize them to be more attached to the labor force.”

— Toni Shears