Published daily by the Lowy Institute

What can be done about income inequality?

What can be done about income inequality?
Published 3 Feb 2014 

The income-inequality debate is an old one, but it’s getting renewed interest, most recently from President Obama in his State of the Union address, where he advocated raising the minimum hourly wage from $7.25 to just over $10. He also spoke of the closely related issue of social mobility (a 'ladder of opportunity').

This is just one element of a wider inequality debate. At the other end of the income spectrum is the debate about the 'one percent', the rich apex of the income pyramid. This is starkest in the US. In the past three decades, the top 1% have increased their real after-tax income by close to 300%, doubling their share of total income to 16%. The very top (0.1%) have done even better: this tiny cohort gets 7% of total income. The rest of the top quintile (the richest 20%) have done OK, but the bottom 80% have lost income share, with median real wage unchanged for three decades.

There is no single, simple explanation. Economies have become more complex, with more capital and high returns to technological innovation and intellectual property. Technology has certainly not favoured unskilled labour.

Globalisation is also blamed. International trade has risen from 19% of global GDP in the early 1990s to 33% now (what one commentator calls 'hyperglobalisation').

The vexed issue is how, in this increasingly integrated world, traded goods can be profitably produced in advanced countries where even the meagre US minimum wage is ten times China's minimum and one hundred times Bangladesh's minimum. Of course the American worker is much more productive, but that gap is closing. When, in the not-too-distant future, China's automobile production lines are essentially the same as America's, will the wage of Chinese auto-workers rise to keep America competitive? [fold]

The experience of countries which have already made a rapid economic transition suggests that wages do tend to equilibrate. We no longer worry about low-wage competition from Japan, Singapore or South Korea. But the outlook is bleak for producers of standard manufactured goods in high-wage economies. There have already been big shifts in where traded goods are produced, and more are in store.

High-wage countries need to restructure in two directions. First, towards traded goods where they have a clear comparative advantage (Australia in minerals and agriculture; New Zealand in milk) or a sustainable niche market providing unique products. Second, towards services for the domestic market (ranging from hamburger flippers to heart surgeons), which fortunately are in higher demand as economies get wealthier. These restructurings are painful, and a market-determined unskilled wage in this environment is likely to be below socially acceptable norms.

One compensation for those at the bottom of the ladder comes from the prospect of mobility, always a central part of the American dream, and strong social glue everywhere. The widespread perception is that mobility has become worse, although recent research argues otherwise. Even if mobility hasn't changed much, it's still best to pick your parents carefully: 30% of low-income children who do well at school go on to finish university, while 74% of high-income high-score children do.

Globalisation isn't the whole story. Technology fosters more 'winner takes all' outcomes (eg. in sport and entertainment a mass audience can watch the very best, with little demand for the second best). Network externalities often produce a dominant product or technology, with the same sorts of supreme winners: Bill Gates, Steve Jobs and Mark Zuckerberg come to mind.

Tyler Cowen sees more of this coming. The winners in Cowen’s world will be individuals who can harness the power of technology to complement their natural talents. His model is chess: the player-plus-computer easily beats either the player or the computer alone. Angus Deaton has a similar message, particularly for the developing world: 'inequality is the handmaiden of progress'.   

But are the extreme income disparities seen in the US intrinsic and necessary? They don't seem to be essential as incentives to motivate the talented elite. After all, sports stars and entertainers rose to the top long before huge rewards were on offer. For business, salaries and bonuses are central to self-esteem and status, but are more about relativities than absolute need. Gates, Jobs and Zuckerberg would have done what they did for less.

This change in income distribution is not just technology-driven. It is a product of the institutional environment. The return on technology and intellectual property is supported by the quasi-monopolies created by patents. The complexity of modern society has created many rent-seeking opportunities, with income earned from holding a license (eg. taxi plates) or protected by regulation (eg. the professions).

Like all countries exposed to international competition, Australia will have to trim its sails to this international wind. Australia's minimum wage (nearly US$17) is over twice that of America. We have a better society because of that. The challenge now is to demonstrate that this can remain viable. This means we can't afford to sustain uncompetitive industries, tie up production with unnecessary red tape or reward rent-seekers whose returns exceed their contribution to society.

You may also be interested in