What's wrong with growing inequality

Clemens Fuest - Ten theses on the inequality debate

Hardly a day goes by right now without news of growing inequality making the headlines. According to a study by Credit Suisse, 0.7 percent of the world population owns 45 percent of the wealth. Oxfam claims that the wealth of the rich has increased 44 percent in the past five years and that of the poor has fallen by 41 percent. The French economist Thomas Piketty warns of a society in which incomes are becoming increasingly unequal. In response, many are calling for higher taxation of the 'rich' and an expansion of the welfare state.

Essentially, this debate raises three questions. First, is income and wealth inequality actually increasing, i.e. are the poor getting poorer and the rich getting richer? Second: How is the development in Germany compared to other countries? Third: Should German politicians react, and if so, how?

The most important answer to these questions is: The thesis of increasing poverty and inequality in general is wrong. Global poverty has decreased dramatically in the last few decades and income inequality has decreased. This is a consequence of the rise of the emerging markets. In the rich industrial countries, the inequality of “market incomes” is growing. But ultimately it comes down to the “disposable income”, that is, the income after taxes and transfers that everyone can ultimately spend. The welfare state cushions increasing inequality. In Germany, more is being redistributed than in almost all other countries. The share of the poorest 25 percent of the population in disposable income has therefore remained more or less stable over the past 20 years. Against this background, the current inequality debate seems excessive. Politicians should concentrate on reforming the German welfare state in such a way that it will continue to offer security in the future.

How economic inequality develops and the consequences for German politics can be summarized in the following ten theses:

Global poverty and income inequality are falling

1. Over the past two decades, global poverty and income inequality have not increased but decreased. The integration of the emerging countries, especially China, into the world economy is responsible for this.

The decline in global poverty is one of the most important successes in economic development in recent decades. Those who have to get by on less than 1.90 US dollars a day live in extreme poverty according to World Bank standards. In 1981, 44 percent of the world's population lived in extreme poverty. In 1990 this number fell to 37 percent, in 2012 it was only 12.7 percent. There are still too many. But the progress is enormous.

Global inequality has also decreased above this poverty line. In 1980 the average per capita income in the emerging and developing countries was around 14 percent of the level in the industrialized countries; today it is around 23 percent. That says nothing about the development of inequality within the two groups of countries and within individual countries. The most common measure used to describe inequality is the Gini index. A value of zero means complete equality, a value of 100 means maximum inequality. A recent study by World Bank researcher Branco Milanovic shows that the Gini index of income distribution in the world population fell from 74 to 69 between 1988 and 2008 (Figure 1). He therefore comes to the following assessment: "The period of globalization from 1988 to 2008 brought about the first decline in global inequality since the industrial revolution." ‘The claim that poverty and income inequality are steadily increasing worldwide is not tenable.

Inequality of market incomes is increasing in industrialized nations

2. In developed countries, market income inequality has increased since the 1980s. In the United States, the top ten percent income growth is particularly pronounced.

The driving factor for growing income inequality in the industrialized countries is primarily labor income, not capital income such as interest or dividends. Highly qualified specialists, such as successful managers, doctors or IT specialists, are paid better and better. Medium and low skill wages lag behind. There are various explanations for this. The entry of the emerging countries into the global economy has led to industrial jobs being lost or relocated in high-wage countries. In addition, new technologies are changing the world of work. The power of trade unions has declined. The aging of the population and the increasing number of one- and two-person households also have an influence on the measured income inequality.

According to OECD data, the Gini index of market income in the US rose from 45 in 1985 to 51 in 2011. In the UK, the indicator rose from 47 to 52 over the same period.

In continental Europe and Scandinavia, inequality is traditionally lower. But it has also increased there. In Italy the Gini index rose from 40 in the mid-1980s to 50 in 2011, in Denmark from 37 to 43 and in Finland from 39 to 48. According to these figures, inequality has grown faster than in the US. This picture changes when one looks at the ten percent of the highest-earning households. Their share of total income rose from 27 to 34 percent in Italy between 1985 and 2011 and from 33 to 39 percent in the United Kingdom. In the USA, the share of the top ten percent developed much more dramatically, jumping from 34 to 47 percent.

Income inequality in Germany persists

3. In Germany, market income inequality has also increased, especially between 1995 and 2005. Income inequality has been roughly constant since 2005.

Due to the reunification in 1990, Germany can only be compared with other countries to a limited extent. However, especially in the period between 1995 and 2005, the inequality of market incomes increased here too. A low-wage sector emerged in Germany as early as the late 1990s, long before the Hartz reforms. It saved many people from unemployment, but at the price of increasing wage spreads. The Gini index of market income rose from 44 in 1985 to 50 in 2004 and remained at that level until 2012, the most recent value reported by the OECD.

Taxes and transfers reduce inequality in many industrialized countries

4. Disposable income is more important than market income. The tax and transfer system significantly dampens inequality in most industrialized countries.

Changes in income inequality are mostly discussed on the basis of market income. The decisive factor, however, is the disposable income, i.e. the income minus the taxes paid and plus the transfers received. In most industrialized countries, the increasing inequality of market incomes is cushioned by the welfare state. Nonetheless, disposable income inequality has risen in some highly developed welfare states since 1995, particularly in Sweden and Finland (Figure 2 at the end of the text). In some countries, including the Netherlands and Italy, inequality has decreased.

The German state is a leader in redistribution

5. In Germany, the state redistributes more than in almost all other OECD countries (Figure 3 at the end of the text). As a result, disposable income inequality has increased little since 1995. The proportion of the poorest 25 percent of the population is more or less stable. The share of the top ten percent has increased slightly, but is still lower than the EU average.

Even a strongly redistributive welfare state like the German one will not completely neutralize growing inequality in market incomes. The cushioning effect is nevertheless high. It is revealing how the shares of the “rich” and “poor” in total disposable income have developed. According to Eurostat data, the share of the poorest 25 percent of households was 11 percent in 1995, 11.5 percent in 2010 and 10.5 percent in 2014. So it is practically constant. The widespread assertion that the poorer sections of the population are left behind by the general development of prosperity is incompatible with this finding. The share of the ten percent highest income in Germany was 22 percent in 1995, 23.4 percent in 2010 and 23.6 percent in 2014. So it rose slightly, but in the end it was also surprisingly stable and lower than the EU average (Figure 4 at the end of the text).

Wealth inequality is more difficult to measure than income inequality

6. Wealth inequality is harder to measure than income inequality. According to available studies, household wealth in Germany is low in an international comparison, but it is very unevenly distributed. These studies paint a distorted picture because they neglect pension entitlements, which are more important in Germany than in other countries.

In 2013, a survey by the European Central Bank came to astonishing results. At 195,000 euros per household, the wealth of Germans is below the euro zone average of 230,000 euros. The distribution is more unequal than anywhere else. A study by the OECD for 18 industrialized countries came to the conclusion that the richest ten percent of the German population own 60 percent of the wealth. The share of wealth in this class is only higher in Austria, the Netherlands and the USA. However, data from the Federal Statistical Office show that the wealth share of the richest ten percent is closer to just over 50 percent. Over time, the German distribution of wealth appears to be fairly stable. According to data from the Socio-Economic Panel, the Gini index of income distribution fell slightly between 2002 and 2012, while other data sources diagnose a slight increase.

What follows from these observations? While income is comparatively easy to record statistically, there are considerable valuation problems and gaps in the measurement of wealth. For Germany, the following point is crucial: For many households, pension entitlements are an important part of wealth. This is illustrated by the comparison between a freelancer who saves EUR 500,000 for a post-tax retirement pension and a civil servant who will receive a pension of EUR 50,000 per year but only save EUR 25,000 until retirement. In fact, the civil servant is wealthier than the freelancer, because the pension has a capital value of over 600,000 euros. Most studies on wealth inequality neglect pensions. You would diagnose that the freelancer is twenty times as rich as the civil servant. It has nothing to do with economic reality. In Germany, assets in the form of pension entitlements play a greater role than in other countries. According to a recent study by the OECD, this wealth of average earners in Germany is twelve times the gross annual income. The EU average is 8.9. Pension rights are very widely distributed among employees. If you take that into account, wealth inequality in Germany is much less dramatic than the above figures suggest.

How should German politics react to the developments in income and wealth distribution described above?

A net wealth tax does not pay off

7. If politicians decide to expand redistribution through taxes, instruments should be chosen that minimize damage to growth and employment. A net wealth tax is therefore not advisable. Among the wealth-related taxes, a land value tax would be less harmful.

Whether it is desirable to redistribute even more through taxes than before is ultimately a question of political assessments. Parts of German politics are calling for the introduction of a net wealth tax. That would be a mistake. It would lead to capital flight from Germany, investments would decrease and jobs would be lost. The same would apply to inheritance tax if the burden was further increased. Among the wealth-related taxes in Germany, a higher burden on land alone offers scope for more redistribution. For example, a land value tax could be introduced which is based on the standard land values ​​and which cannot be passed on to tenants via the utility bill. Land cannot migrate abroad, and the restriction to land values ​​would ensure that investment in housing is not affected. Certainly the landowners would feel discriminated against other property owners and would appeal to the Federal Constitutional Court. If this is to be avoided, the only option left is to increase the income tax progression. However, five percent of taxpayers already pay 42 percent of their income tax - increasing their share also has its limits.

Investments in education make the difference

8. Investment in education plays a key role in limiting labor income inequality. Public funds should go to kindergartens and elementary schools to a greater extent. Income-based tuition fees should be charged to college students.

The central importance of education and training for professional success and protection against unemployment is undisputed. The course for a successful school and training career is set in early childhood. Failures in education and upbringing in early childhood are an important reason why children from educationally disadvantaged backgrounds often have difficulties in training and careers. This speaks in favor of directing public funds more into the area of ​​early childhood education. Increases in the education budget will not be possible indefinitely. Reallocations within the education budget could be made possible by the reintroduction of income-related tuition fees at universities.

Private pension provision is an obligation to combat poverty in old age

9. To combat poverty in old age, everyone should be obliged to build up a private pension plan. Government support for private retirement provision should focus on those in need.

Wealth inequality in Germany results in part from the fact that many low-income households save little and rely on state, pay-as-you-go pensions. This is not a big problem as long as that pension is high enough. However, due to the growing number of pensioners, the state pension will decrease significantly in the next few years. It is therefore imperative that all households make more private provision. The existing state funding for old-age savings is fundamentally wrongly constructed. It mainly benefits households with middle and higher incomes and increases inequality. It would make sense to oblige everyone to make private pension provision. State subsidies should only be given to those whose income is so low that it is unreasonable to expect compulsory saving without help.

Minimum wages and rent controls are inefficient distribution measures

10. Interventions in pricing such as statutory minimum wages or rent brakes are not an efficient instrument of distribution policy.

State intervention in the formation of prices in markets only achieves the desired distributional effects at the price that some of those who are actually supposed to be helped are discriminated against. It is true that minimum wages increase the incomes of those who are employed. However, the state cannot order that enough jobs be created at the minimum wage. The rent brake helps everyone who has or is getting an apartment, but the state cannot order that enough living space be made available. In fact, as a result of the rent brake, there will be less availability. Distribution goals should not be pursued with price regulation, but with taxes and transfers.