Why is it that 20-century tools are ill-suited for fighting income inequality in the 21st century? And what does the idea of a welfare state represent in the era of globalization. These related questions are key to understanding what is going on today and vital for building future social and economic paradigms.
The remarkable period of reduced income and wealth inequality in the rich countries, roughly from the end of the Second World War to the early 1980s, relied on four pillars: strong trade unions, mass education, high taxes, and large government transfers. Since the increase of inequality 20 or more years ago, the failed attempts to stem its further rise have relied on trying, or at least advocating, the expansion of all or some of the four pillars. But neither of them will do the job in the 21st century.
Why? Consider trade unions first. The decline of trade union density, present in all rich countries and especially strong in the private sector, is not the product of more inimical government policies only. They might have contributed to the decline but are not the main cause of it. The underlying organization of labor changed. The shift from manufacturing to services and from enforced presence on factory floors or offices to remote work implied a multiplication of relatively small work units, often not located physically in the same place. Organizing a dispersed workforce is much more difficult than organizing workers who work in a single huge plant and share a single interest. In addition, the declining role of unions is a reflection of diminished power of labor vis-à-vis capital, which is due to the massive expansion of wage labor (that is, labor working under capitalist system) since the end of the Cold War and China’s reintegration into the world economy. While the latter was a one-off shock, its effects will persist for at least several decades, and may be reinforced by future high-population growth rates in Africa, thus keeping the relative abundance of labor undiminished.
Mass education was a tool for reduction of inequality in the West in the period when the average number of years of schooling went up from four or six in the 1950s to 13 or more today. This led to a reduction in the skill premium, the gap between the college-educated and those with only high or elementary school, so much so that the famous Dutch economist Jan Tinbergen believed in the mid-1970s that by the turn of the century, the skill premium will be zero. But mass expansion of education is impossible when a country has reached 13 or 14 years of education on average simply because the maximum level of education is bounded from above. Thus, we cannot expect small increases in the average education levels to provide the equalizing effect on wages that mass education once did.
High taxation of current income and high social transfers were crucial to reduce income inequality. But their further increases are politically difficult. The main reason may be a much more skeptical view of the role of government and of tax-and-transfer policies that is now shared by the middle classes in many countries compared to their predecessors half a century ago. This is not saying that people just want lower taxation or are unaware that without high taxes, the systems of social security, free education, modern infrastructure, etc. would collapse. But it is saying that the electorate is more skeptical about the gains to be achieved from additional increases in taxes imposed on current income and that such increases are unlikely to be voted in.
So, if high underlying inequality is a threat to social homogeneity and democracy, what tools should be used to fight it? It is here I think we need to think not only out of the box in purely instrumental fashion, but to set ourselves a new objective: an egalitarian capitalism based on approximately equal endowments of both capital and skills across the population. Such capitalism generates egalitarian outcomes even without a large redistributionist state. To put it in simple terms: If the rich have only twice as many units of capital and twice as many units of skill than the poor, and if the returns per unit of capital and skill are approximately equal, then overall inequality cannot be more than two to one.
How can endowments be equalized? As far as capital is concerned, by deconcentration of ownership of assets. As far as labor is concerned, mostly through equalization of returns to the approximately same skill levels. In one case, it passes through equalization of the stock of endowments, and in the other, through equalization of the returns to the stocks (of education).
Let us start with capital. It is a remarkable fact, to which little attention has been paid, that the concentration of wealth and income from property has remained at the incredibly high level of about 90 Gini points or more since the 1970s in all rich countries. This is, to a large extent, the key reason why the change in the relative power of capital over labor and the increase in the capital share in net output was directly translated into a higher interpersonal inequality. This obvious fact was overlooked simply because it is so … obvious. We are used to thinking that as the capital share goes up, so must income inequality. Yes, this is true – but it is true because capital is extremely concentrated and thus an increase in a very unequal source of income must push overall inequality up.
But if capital ownership becomes less concentrated, then an increase in the share of capital that may be (let’s suppose) inevitable because of international forces, such as a Chinese move to capitalism, does not need to lead to higher inequality within individual rich countries.
The methods to reduce capital concentration are not new or unknown. They were just never used seriously and consistently. We can divide them into three groups. First, favorable tax policies (including a guaranteed minimum rate of return) to make equity ownership more attractive to small and medium shareholders (and less attractive to big shareholders, that is, a policy exactly the opposite of what exists today in the United States). Second, increased worker ownership through Employee Stock Ownership Plans or other company-level incentives. Third, use of inheritance or wealth tax as a means to even out access to capital by using the tax proceeds to give every young adult a capital grant (as recently proposed by Tony Atkinson).
What to do with labor? There, in a rich and well-educated society, the issue is not just to make education more accessible to those who did not have a chance to study (although that, too, is obviously important) but to equalize the returns to education between equally educated people. A significant source of wage inequality is not any longer the difference in the years of schooling (as it was in the past), but the difference in wages (for the same number of years of education) based either on the perceived or actual difference in school qualities. The way to reduce this inequality is to equalize the quality of schools. This, in the US, and increasingly, in Europe as well, implies improvement in the quality of public schools (a point argued by Bernie Sanders in the recent US election). This can be achieved only by large investments in improved public education and by withdrawals of numerous advantages (including tax-free status) enjoyed by private universities that command huge financial endowments. Without the leveling of the playing field between private and public schools, a mere increase in the number of years of schooling or the ability of a rare child of lower middle class status to attend elite colleges (that increasingly serve only the rich) will not reduce inequality in labor incomes.
It has become a truism to say that the welfare state is under stress from the effects of globalization and migration. It will help to understand the origin of this stress if we go back to the origins of the welfare state.
As Avner Offer has recently reminded us in his excellent book (co-authored with Daniel Söderberg), the origin of social democracy and the welfare state is in the realization (and financial ability to deal with it) that all people in their lives go through periods where they are not earning anything, but have to consume. This applies to the young (hence children’s benefits), to the sick (health care and sick pay), to those who had the misfortune to get injured at work (worker’s accident insurance), to mothers when they give birth (parental leave), to people who lose jobs (unemployment benefits), and to the elderly (pensions). The welfare state was created to provide these benefits, delivered in the form of insurance, for either unavoidable or very common conditions. It was built on the assumed commonality of behavior or, differently put, cultural and often ethnic homogeneity. It is no accident that the prototypical welfare state born in Sweden in the 1930s had many elements of (not used here in a pejorative sense) national socialism. In addition to commonality of behavior and experiences, the welfare state, in order to be sustainable, required mass participation. Social insurance cannot work over small parts of the workforce because it then naturally leads to adverse selection, a point well illustrated by the endless wrangles over US health care. The rich, or those who are unlikely to be unemployed, or the healthy ones, do not want to subsidize the ‘others’ and opt out. The system that would rely only on the ‘others’ is unsustainable because of huge premiums it would require. Thus, the welfare state can work only when it covers all, or almost all, the labor force, i.e., when it is 1) massive and 2) includes people with similar conditions.
Globalization erodes both requirements. Trade globalization has led to the well-documented decline in the share of the middle class in most Western countries and income polarization. With income polarization, the rich realize that they are better off creating their own private systems because sharing the systems with those who are substantially poorer implies sizeable income transfers. This leads to ‘social separatism’ of the rich, reflected in the growing importance of private health plans, private pensions, and private education. The bottom line is that a very unequal, or polarized, society cannot maintain an extensive welfare state.
Economic migration, to which most rich societies have been newly exposed in the past 50 years (especially so in Europe), also undercuts the support for the welfare state. This happens through inclusion of people with actual or perceived differences in social norms or life-cycle experiences. It is the same phenomenon as dubbed by Peter Lindert lack of ‘affinity’ between the white majority and African-Americans in the US that rendered the US welfare state historically smaller than its European counterparts. The same process is now taking place in Europe, where large pockets of immigrants have not been assimilated and where the native population believes that the migrants are getting an unfair share of the benefits. Lack of affinity need not be construed as some sinister discrimination. Sometimes, it could be indeed that, but, more often, it may be grounded in correct thinking that one is unlikely to experience the life-cycle events of the same nature or frequency as the others, and is hence unwilling to contribute to such an insurance. In the US, the underlying fact that African-Americans are more likely to be unemployed probably led to less generous unemployment benefits; similarly, the underlying fact that migrants are likely to have more children than the natives might lead to the curtailment of children’s benefits. In any case, the difference in expected lifetime experiences undermines the homogeneity necessary for a sustainable welfare state.
In addition, in the era of globalization, more developed welfare states might experience the perverse effect of attracting less skilled or less ambitious migrants. Under ‘everything being the same’ conditions, the decision of a migrant of where to emigrate will depend on the expected income in one country versus another. In principle, that would favor richer countries. But we also have to include migrants’ expectations regarding where in the income distribution of the recipient country she expects to end up. If she expects to be in the low-income deciles, then a more egalitarian country with a larger welfare state will be more attractive. An opposite calculation will be made by the migrants who expect to end up in the higher ends of recipient countries’ income distributions. If the former migrants are either less skilled or less ambitious than the latter (which is reasonable to assume), then the less skilled will tend to choose countries with more developed welfare states. Hence, the adverse selection.
In very abstract terms, the countries that would be exposed to the sharpest adverse selection will be those with large welfare states and low income mobility. Migrants going to such countries cannot expect, even in the next generation, to have children who will climb up the income ladder. In a destructive feedback, such countries will attract the least skilled or the least ambitious migrants, and once they create an underclass, the upward mobility of their children will be limited. The system then works like a self-fulfilling prophecy: It attracts ever more unskilled migrants who fail to assimilate. The natives tend to see migrants as generally lacking in skills and ambition (which may be true because these are the kinds of people their country attracts) and hence as ‘different’. At the same time, failure to be accepted will be seen by the migrants as confirmation of natives’ anti-migrant prejudices, or, even worse, as religious or ethnic discrimination.
There is no easy solution to the vicious circle faced by developed welfare states in the era of globalization. This is why I argued for 1) policies that would lead toward equalization of endowments so that, eventually, taxation of current income can be reduced and the size of the welfare state be brought down, and 2) that the nature of migration be changed so that it be much more akin to temporary labor without automatic access to citizenship and the entire gamut of welfare benefits.
