The economic cause of income inequality, now and a century ago

September 13, 2016

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A bit less than two centuries ago, in a period known as the industrial revolution, the West was wrestling with the problem of income inequality. Combined with a relatively low standard of living, it caused great revolt from the working class. Through political reform, the income inequality from the peak of the industrial revolution was decreased successfully. Less than a century later, we find ourselves in a situation where income inequality has reached equal proportions as it did during the peak of the industrial revolution. This article will delve into the factors involved with income inequality back then and now. Ultimately, it will try to answer if the resolve from the past is applicable now.

The issue of income inequality has become a hot topic since the start of the Great Recession eight years ago. Anti-austerity protests, such as Occupy Wall Street, have been on the rise throughout the West and academic publications surrounding the topic such are gaining traction, both with the public and in politics in the West. The French economist Thomas Piketty went as far as stating that the level of income inequality present in the West right now is of equal proportion as during the industrial revolution.

The income gap during the industrial revolution

Before the industrial revolution, wealth gaps between countries were modest: income per person in the world’s ten richest countries was only six times higher than that in the ten poorest. But within each country the distribution of income was skewed. In most places a small elite lorded it over a mass of peasants. There was little social mobility, with marriage being the most common method of families in the middle class to rise in the social ranks and become part of the elite.
Enter the industrial revolution: new technologies such as railways, the sewing machine and steel mills changed the production process for firms active in associated sectors. The industrialists, a small number of middle class business owners, took the opportunity that these transformative technologies provided to create goods more cheaply and quickly than before. They managed to accumulate great fortunes that were boosted by monopolistic power and managed to move up in the social ranks, becoming part of the elite in the society.
With incomes accelerating during the industrial revolution in Europe and America, the income gap between the West and other countries in the world increased greatly. The same can be said about the internal income inequality, which widened in the countries where the industrial revolution took place. The Gini coefficient, a common measure of income inequality (see block), rose in England from 0.4 to 0.63 in the period of 1823 to 1871, implying a substantial widening of the income gap. The arguable peak of income inequality during the industrial revolution occurred from 1860 to 1900, a period often referred to as the Gilded Age. During this period, the wealthiest 2% of American households owned more than a third of the nation’s wealth, while the top 10% owned roughly three fourths of it. The bottom 40% had no wealth at all. In terms of property, the wealthiest 1% owned 51%, while the bottom 44% claimed 1.1%.
The industrial revolution changed the life of many poor people. For centuries they had worked on farms, now they worked in factories. This change did not imply improvement: wages were low, working conditions harsh. Being uneducated and limited to unskilled labor in factories, the poor were stuck to their socioeconomic position in society.


A measure for inequality: the Gini coefficient

The Italian statistician and sociologist Corrado Gini published a paper called “Variability and Mutability” in the year 1912. In this paper, he presented what has since been the most used measure of income inequality: the Gini coefficient. The Gini coefficient is a measure of statistical dispersion (like the standard deviation), to represent the income distribution of a nation’s residents. It measures the inequality among values of a frequency distribution of different income levels. It is a number between zero and one, zero meaning all the income is completely equally distributed, one meaning one person has all the income. While it is the most widely used measure for income inequality, its usage has one major that anyone with some undergraduate statistical knowledge can understand: there are many different types of income distributions that could lead to the same value for the Gini coefficient.


Closing the gap, unions and political policy

The size of the industrial workforce kept growing as the economy expanded and with it came increasing political pressure. Marxist ideology and socialist parties were on the rise. At the start of the 20th century the trend of widening income inequality seemed to be in reverse thanks to numerous economic policy reforms and the invention of labor unions.
The policy reforms can be divided into three categories: taxation policy, government spending and regulation. Regulation allowed for instantiating minimum wages and managed to break up monopolistic businesses; lowering the entry barrier and increasing competition. After came tax reforms. Until the late 19th century, the main source of tax revenue came from import tax and sales tax. This changed through the introduction of progressive income taxes. Britain’s tax take in 1860 was some 8% of GDP; by 1927 it had risen to almost 20%. America changed its constitution to introduce an income dependant tax in 1913. In 1944 the top rate reached a peak of 94%.
This increase in tax revenue allowed governments to redistribute the country’s wealth through spending. The way governments in the Europe and America chose to do this varied greatly. Following the ideology of the American dream, spending in the US was aimed at creating equal opportunity than of income, in the form of bringing mass education to the people. In Europe and the UK the emphasis was on building a welfare states, focusing on generous jobless benefits, child subsidies and income support.

The Kuznets curve: the industrialization inequality pattern

The Kuznets curve, formulated by Simon Kuznets in the mid-1950s, argues that in preindustrial societies, almost everybody is equally poor so inequality is low. Inequality then rises as people move from low-productivity agriculture to the more productive industrial sector, where average income is higher and wages are less uniform. But as a society matures and becomes richer, the urban-rural gap is reduced and old-age pensions, unemployment benefits, and other social transfers lower inequality. So the Kuznets curve resembles an upside-down “U.” The rise of income inequality in mature economies such as in the West today is therefore likely to have surprised Kuznets and other like minded economists.


Another reversal: the gap starts to widen yet again

Despite these different ways of government spending, the combined measures were successful in reducing income inequality across the West, without seeming to sacrifice economic growth. This trend of a decreasing income inequality started to reverse again in the seventies and eighties. Including capital gains, the share of national income going to the richest 1% of Americans has doubled since 1980, from 10% to 20%, roughly where it was a century ago. Even more striking, the share going to the top 0.01%—some 16,000 families with an average income of $24m—has quadrupled, from just over 1% to almost 5%. That is a bigger slice of the national pie than the top 0.01% received 100 years ago.
How did this happen? There is a multitude of factors contributing to the widening inequality of the past three decades. A decrease in upper income taxation that has taken place in some Western countries (most notably the US, see figure) certainly plays a role. Even in cases where it is not the rich necessarily getting the benefit from tax cuts, the poor are the ones profiting most from high government spending. Deregulation that has taken place on many fronts in the economy likely also plays its part.
It is tempting to look at policy and regulations alone to blame for the recent rise of income inequality, but just like during the industrial revolution, the economic cause should not be overlooked. The policies should be there as a reaction to shifts in the economic landscape, and our economic landscape has changed drastically over the past few decades.

This chart shows the federal tax rate per income group in the United States during the last century.


The economic landscape today

The information technology revolution, globalisation and the associated expansion of trade increased the size of markets and the rewards to the most successful. The information technology revolution has given rise to a new kind of company and have transformed the way business is done by existing ones.
One force that was present during the industrial revolution, but that seems to be still relevant today is that of capital being able to replace labor due to new technologies. A hundred years ago, it was just jobs involving physical labor that were being threatened. The computer powered machines of today seem to threaten evermore jobs, and not just in jobs involving physical labor.
But there is also a new way information technology seems to affect income inequality. Fifty years ago, a company like Facebook, having a global reach with its product (over 1.4 Billion active users), a market cap of over 200 Billion dollars, yet less than 7000 employees, would be unheard of.
Not only do advancements in information technology favour a small minority of brainy elite workers, they also allow companies to work with enormous economies of scale. The disrupting information technologies does not only apply in the field of software. The internet allows individuals and small companies to reach a global market in many industries, be it entertainment, fashion, education supplies and many others. These developments often mean the local suppliers of these goods lose revenue or cease to exist.
How globalization can cause an increase in income inequality can be explained using the Heckscher-Ohlin-Samuelson theorem from international trade. This theorem is based on the idea that as poor countries engage more in global trade, they tend to specialize in the production of goods in which they hold a comparative advantage, namely low-skill goods. Doing so increases demand in the country for low-skilled labor and raises the wages of low-skilled workers relative to that of skilled workers. As a consequence, inequality should decline. The opposite happens in rich countries: as they export more high-skilled goods, inequality would rise.
Globalization on grand scale has become possible thanks to a combination of deregulation and technological advancement. It has brought a new kind of competition to the lowest paid labor in rich countries. Where labor unions were able to protect the wage of workers in the past, they are powerless in the face of this new international competition, forcing the unskilled workers to strive for a political solution. Trying to stop globalization through regulation is widely seen as a highly unsustainable strategy from an economic standpoint, so it is doubtful that a long term solution will be obtained through this route.

On the left hand side of the figure, the Gini coefficient worldwide is plotted. On the right hand side, the income going to the richest one percent is shown for a few different countries in the West.


This chart brings positive news concerning global inequality. Not only do we seem to become more wealthy, this wealth also seems more equally distributed


Inequality worldwide

While inequality has been firmly on the rise in most Western countries, global inequality, the income gaps between all people on the planet have begun to fall. Two French economists, François Bourguignon and Christian Morrisson, have calculated a “global Gini” that measures the scale of income disparities among everyone in the world. Their index shows that global inequality rose in the 19th and 20th centuries because richer economies, on average, grew faster than poorer ones. This trend has recently be one the reverse as poorer countries seem to be catching up with the richer ones. By this measure, the world as a whole is becoming a fairer place. This will not be a message that is likely to be focused on in the debate on income inequality though, as in a political landscape the focus will always be on inequality within a nation state.


Capital vs labor: the Gilded Age vs Silicon Valley

When it comes to inequality, the return on capital versus the return on labor has been central to the economic debate during the gilded age. Since capital logically tends to be concentrated in the hands of the richest percentiles, the larger return on capital is in comparison with the return on labor, the more income inequality will grow.
Karl Marx even went as far as labeling this phenomenon as the fundamental flaw of capitalism that would lead to its self destruction: there needs to exist a lower class which provides labor, that then pays with their income for products constructed by their lower class peers, yielding profits to the original owners of capital. This vicious cycle is seen as a form of slavery, inherent to a capitalist society. The rich keep getting richer, while the poor remain poor.
Whether this vicious cycle happens depends on the share of output of the economy that goes to labor versus capital and at what rate the output of an economy grows. In the Gilded Age, with capital being relatively scarce compared to the required unskilled labor, return on capital laid claim on the majority of the output.
Interestingly, the opposite seems to be going on in sectors such as the tech industry. The ratio of stock prices compared to earnings for tech companies is at an all time high, indicating that capital is not scarce at all in this sector. Salaries in this sector are amongst the highest worldwide, indicating the degree to which this form of high skilled labor is valued and thus its apparent scarcity.
The fact that this high skilled labor takes the bigger chunk of the output in the tech industry does not necessarily decrease the income gap directly, but it provides social mobility which was lacking greatly during the industrial revolution. Combined with education being more broadly available to the public than in the past, we live in a time of more equal opportunity than ever. So while labor inequality is getting higher with these new technological developments, it improves social mobility thus creates more equal opportunity.

Inequality, good or bad for economic growth?

The view that inequality harms economic growth or that improved equality can help sustain economic growth has become more widely accepted in recent years. Historically, the mainstream economic thought concerning the effect of inequality on the economy was that inequality was beneficial for economic growth. The main reason for this shift comes from the fact that human capital has become more important than physical capital.
When physical capital is more important, savings and investments are key. This means it can be greatly beneficial for the economy to have a group of high earners that can save the majority of their income and invest it. Over the course of the last decade, the scarcity of machines has decreased and the demand for human capital has been on the rise. In this new economic landscape, widespread education is thought to be the key to growth. The line of reasoning is as follows: a widespread education can only be achieved if it can be afforded by the majority. Since a widespread education in return also reduces the income gap between skilled and unskilled labor, it initiates a virtuous cycle, creating economic growth and a smaller and smaller income inequality.


Different times, same solution?

While income inequality may be on the same level as it was during the industrial revolution, its economic causes have fundamentally changed. Even though politicians talk the talk of being able to stop the effects of globalization, it is not something that can be controlled through regulations without it bearing negative economic consequences. Similarly, the ever increasing pace of technology seems inevitable. While these advancements threaten more and more existing jobs, it also increases the number of jobs with a high return on labor. This improves social mobility, creating a society of more equal opportunity than in the return on capital intensive days of the Gilded Age.
Income taxation is a measure that will still prove to be effective in decreasing income inequality. The lowering of the amount of tax paid in the uppermost tax brackets in the past decades is something that should be reversed. The taxation and accompanied government spending is vital when it comes to creating equal opportunity for everyone. High skilled labor requires top notch education. If high level education cannot be afforded by the masses, it is detrimental to the equal opportunity offered by the tech revolution. A high cost of education favors the rich, increasing income inequality further. Also, great talent is wasted when high level education can only be afforded by the elite.
From this, we can conclude that providing cheap, top level education should be a priority in government spending. Besides education, a safety net for the poorest is also important. Mainly pension schemes and unemployment insurance are vital in this day and age, with people getting older than ever and job availability to the masses being under pressure.
Even though income inequality is of similar height as during the industrial revolution, living standard is not. This might make the issue less pressing today as it was during the Gilded Age. Taking measurements against further increasing the income gap might be very urgent nonetheless. Both globalization and the development of information technology have definitely not reached their peak. If action is not taken soon, income inequality could easily surpass that of the industrial age.

This article was written by Lasse Vuursteen


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