The drivers of inequality: global market forces versus policies
Over the past few decades, income inequality has increased in both advanced and emerging economies (Figures 9 and 10). It has generated a sense of disillusionment in the capacity of the liberal international economic model to deliver shared prosperity.
Figure 9: Trend in labour shares
Source: European Commission, AMECO database.
Note: Labour shares are defined as compensation per employee as percentage of GDP at market prices per person employed in the total economy.
Figure 10: Income share of the top 10%
Source: World Inequality Lab, World Inequality database.
Notes: Share of pre-tax national income of the 90-100 percentile of adult individuals. Pre-tax national income is the sum of all pre-tax personal income flows accruing to the owners of the production factors.
The exceptional period of socioeconomic expansion experienced most directly by baby boomers in advanced countries after World War II has been hailed as a remarkable developmental achievement of economic liberalism. This in turn created the expectation that, going forward, economic growth would continue to deliver similar results and lift all boats in advanced and developing economies alike.
However, growth and shared prosperity started to decouple in most of the advanced economies by the 1970s, and they have further diverged since the early 2000s. In the United States, for instance, the percentage of children earning more than their parents fell from 92% in the 1940s to only 50% in the 1980s.40 Similarly, in developing and emerging economies, growth has been accompanied by a significant increase in inequality—despite pulling millions out of poverty and reducing the gap with advanced economies.
To find solutions to the inequality challenge it is important to understand its causes. The most-cited causes in academic studies and political debates are globalization and technology. Globalization has increased inequality within countries by transferring low-skilled jobs in high-productivity sectors from advanced economies to developing and emerging countries, mainly in Asia,41 and, consequently, penalizing workers in specific locations and jobs. Technology has impacted inequality by reducing demand for low-skilled jobs and rewarding high-skilled jobs disproportionately. However, recent studies point at further possible drivers including the consequence of business cycle effects,42 and depreciation effects (owing to a shift towards intangibles).43 Additionally, despite some progress, entrenched inequality of opportunities (i.e. socio-economic background, ethnicity, location) are still limiting social mobility and perpetuating inequalities.
With these factors viewed as being determined by global forces on which individuals have no control, they are perceived as largely unfair, in contrast to cases where inequality is the result of merit or effort, and consequently more acceptable.44 Such perceptions matter: empirical behavioural economic studies reveal that when people believe that income distribution is unfair, they change their attitude and do not contribute to society in the same way as they would otherwise.45 This in turn contributes to the erosion of trust among stakeholders, the polarization of society, the rise of extremism and the weakening of social fabric, and can potentially lead to social unrest and political instability. Furthermore, the idea that inequality stems from global forces fuels the belief that it is the inevitable by-product of capitalism, leading to the conviction that economic liberalism has failed to deliver on the promise of widespread prosperity.
The emergence of inequality instead should be considered as the result of policy choices: over the past 40 years, countries have deregulated labour markets46 and finance,47 changed tax codes48 and reduced public investments—all with insufficient attention to the consequences on income distribution and to some potentially negative social externalities. Insufficient policy attention was also granted to preparing workers and entrepreneurs to embrace the Fourth Industrial Revolution and to mitigate the effects of globalization for those parts of society that have not fully benefited from it.
The observed increase in inequality therefore is not the inevitable by-product of a knowledge-intensive and internationally open economic model. Instead, proactive national policies and international coordination can mitigate the potentially adverse effects of globalization and technology on income distribution and can create more equal opportunities for all.
Inequality and competitiveness: is there a link?
The relationship between economic growth and inequality is complex—owing to multiple factors—and a causal link between the two cannot be established empirically. Productivity, however, is one factor that drives both economic growth and higher labour shares. For instance, a recent study shows that productivity growth in manufacturing in the United States has reduced inequality at the municipal level, and wherever productivity has grown, earnings of local less-skilled workers grew as rapidly as those of local skilled workers.49 On average, American workers have benefited substantially from productivity growth, even after controlling for differences in workers’ education levels.
However, the relationship between earnings and productivity is not as clear as previously observed. While the typical worker’s compensation and productivity moved in tandem for two decades after World War II, they started to diverge in the 1970s,50 precisely when inequality started rising. This apparent contradiction can be reconciled: although productivity growth has continued to benefit workers’ pay, some factors (discussed in the previous section) have had only marginal effects (either positive or negative) on productivity but pushed wages down;51 and a second set of factors have at the same time contributed to increasing inequality and diminishing productivity.52 Among the latter group of factors, three stand out.
First, market concentration has been growing in advanced and emerging economies alike (Figure 11). Less competition has reduced business dynamism, increased capital shares and broadened differences in wages across companies. Increased concentration—while caused partially by the parallel emergence of technologies that empower network externalities—has been to a large extent the result of policies that have failed to remove barriers to entry and often lax anti-trust monitoring and enforcement.
Figure 11: Executives’ perception of business competition
Source: World Economic Forum, Executive Opinion Survey.
Second, both public and private productivity-enhancing investments have declined over the past decades. For instance, public spending on basic research and infrastructure has reduced significantly since the 1970s (Figure 12). China is a notable exception: public investments have doubled there since 1970, but are still far from the levels achieved by advanced economies during the “golden age”. In parallel, corporate investments as a share of GDP have diminished, a process that originated before the Great Recession (Figure 13). Furthermore, investments have to some extent been misallocated. Increasing trends in share buybacks signals a possible diversion of resources (hindering productivity growth) in favour of financial assets, whose returns benefit mostly those that already own significant capital.
Figure 12: Government investment, selected countries
Source: OECD, Investment by sector (indicator), 2011.
Notes: Investment by sector includes household, corporate and general government. For government this typically means investment in R&D, military weapons systems, transport infrastructure and public buildings such as schools and hospitals. Under the 1993 System of National Accounts (SNA), military expenditures on fixed assets were treated as gross fixed capital formation (GFCF) only if they could be used for civilian purposes of production (e.g. airfields, docks, roads etc.). The 2008 SNA treats all military expenditures on fixed assets as GFCF regardless of the purpose.
Figure 13: Trend in net share buybacks and net capital formation, non-financial corporations
Source: Deloitte Insights analysis based on Bureau of Economic Analysis and Board of Governors of the Federal Reserve System data.
Note: Dotted lines show linear trend.
Third, inequality of opportunities has prevented talent from being allocated to its best use. Although participation in higher education has increased on average, the distribution of educational attainment has remained uneven. The presence of barriers (e.g. credit constraints, geographical inequalities, political connections, corruption, discrimination) has led to a lack of high-quality education and training and gainful employment.53 This underinvestment in human capital (at times due a population’s own low expectation of returns54) has occurred in parallel with the development of skills that do not match the economy’s needs, even for those who have been able to acquire education and experience, further exacerbated by the impact of technological change on business models. In the Fourth Industrial Revolution, human capital is the driving force of economic growth, and frictions that prevent the best allocation of talent and impede the accumulation of human capital also limit growth. Inequalities of opportunity underpin such frictions, which not only perpetuate income inequality, but also hinder the drivers of productivity (Figure 14).
Figure 14: Absolute inequality of opportunity and productivity drivers in OECD countries
Sources: World Economic Forum and Equal chances—The World Database on Equality of Opportunity and Social Mobility
Note: The (absolute) inequality of opportunity index is computed by extracting from total inequality (Gini coefficient) the variability systematically correlated with three fundamental sources of unfair inequality: parental education, parental occupation and origin (i.e. race, ethnic origin, area of birth).
As discussed above, multiple forces that impact both productivity and inequality are at play. Policy interventions should focus on addressing these factors that can lead to improve productivity while reducing inequalities at the same time. Four of them are presented here.
Enhance access to opportunities
Inequality of opportunity, inequality of income and economic growth form a circular nexus. If an economy does not develop, it will offer fewer quality jobs and fewer entrepreneurship opportunities. Lack of opportunities leads to under-investment in human capital and inefficient allocation of talent, which would at the same time reduce growth potential and further exclude under-privileged households from the benefits of economic growth. A solution to break this link could be enhancing the “conversion factors” that bridge the differences in circumstances and incentives between disadvantaged households and privileged ones. Among these factors, family policies (parental leave and access to quality childcare), equitable access to quality education systems, equal access to quality healthcare, meritocratic processes to access fair and dignified employment, and social safety nets to shelter households from temporary hardship together form the basis for a fairer and potentially more prosperous society.55 Notably, policies should aim to reduce network barriers and asymmetric information and modify risk profiles rather than relying on passive welfare that fosters a culture of dependency. The concept of inequality of opportunity is deeply linked to the idea of unfair inequality, according to which public intervention should remove barriers that prevent individuals from reaping the benefits of their talent and effort—and create an even playing field to contribute to socioeconomic progress.
Foster fair competition
Fair competition and level playing fields allow for better outcomes in terms of innovation, prices and product quality. If many firms compete in the markets, prices are lower—benefitting consumers—and stronger competitive pressure translates into greater innovation, investments, jobs and products improvement. Market power has increased across advanced economies.56 Indeed, the GCI results suggests that the effectiveness of anti-trust authorities as perceived by businesses has declined or remained weak since 2008 (Figure 15).
Figure 15: Executives’ perception of antitrust effectiveness
Source: World Economic Forum, Executive Opinion Survey.
Data shows that most sectors in advanced economies have gained some degree of market power, 57 yet the emerging and most dynamic sectors (i.e. data platforms, information technology, etc) are those where concentration has increased more significantly.58 These new segments are structurally different: they achieve higher efficiency through network effects that also create powerful barriers to entry.
Consequently, although traditional measures to foster competition (i.e. stronger enforcement of antitrust policies and a reduction of barriers to entry) remain important, they may also risk slowing down innovation in these new segments of the economy where the benefits of large scale play a critical role. As such, approaches that address the effect of concentration without stifling innovation should be adopted instead. These could include (1) using technology to reduce barriers to entry (i.e. increase accountability, transparency, access to data assets, update data ownership and rights), and (2) shifting the focus of anti-trust action from price levelling to addressing broader socioeconomic effects of winner-take-all business models.59 As business strategies in new segments apply low prices in the short run to gain substantial market share in the longer run,60 antitrust authorities should take a more holistic approach to assess whether a company is assuming a dominant position in the market.
Update tax systems and their composition as well as the architectures of social protection
Data shows that statutory tax rates on firms and top incomes have decreased over the past few decades. In the United Kingdom and the United States, for instance, the top statutory tax rates of income tax (applying to the highest incomes) were above 70% until 1980; today they are around 40%.61 At the same time, the corporate effective marginal rate has also declined while the fiscal burden on median incomes has increased since the 1980s.62
These facts suggest different options for interventions. When it comes to personal income, restoring greater tax progressivity with higher top tax rates should allow for more equitable income distribution without significant losses to economic activity or productivity.63 The economic rationale behind this approach is that, beyond a certain level of income, further earnings accruing to richer individuals increases inequality but does not benefit productivity.64
When it comes to corporate taxation, solutions need to consider the complexity of international tax architecture, the increasing importance of intangible assets and the digital economy that allow for greater profit shifting-opportunities by multinationals. In this context, it has proven harder to enforce high tax rates on corporate income as demonstrated by decreasingly effective tax rates and a higher share of corporate profits generated in tax havens.65 Against this backdrop, greater international coordination is essential, while countries—at the same time—are experimenting with revenue-based taxes and online advertainment taxes.66
Foster competitiveness-enhancing investments and incentives
Insufficient investments in productive factors represent an important reason behind subdued productivity growth. As an example, lacking investments in transport infrastructure has led to a deterioration of road quality (at least in relative terms; see Figure 16). Public investments in particular have been declining in most advanced and emerging countries (see Figure 12). As a result, general purpose research has diminished, and public capital has decreased.
Figure 16: Executives’ perception of quality of roads
Source: World Economic Forum, Executive Opinion Survey.
By re-igniting public and private investment in infrastructure, education and innovation, countries would not only enhance productivity growth but also further support employment and broaden aggregate demand. The global economy has entered a long-term economic slump since the 2008 financial crisis, and many economists foresee a near-term recession. While the debate on public investments raises questions about resources and the sustainability of potential fiscal deficits, investments cost relatively less in a low-interest-rate environment, and consensus on greater fiscal stimulus to foster investments is growing. Economists are also making the case for specific public investment in science as important and unique to channel resources in a sector that produces high returns to countries’ economies and their citizens.67 As the limits of monetary policy to spur economic growth have become apparent (see Chapter 1), targeted fiscal policy towards productivity-enhancing investments and incentives could represent an important instrument to revive productivity growth while rebalancing income distribution over the next few years.