Rising income inequality – why is it happening?

The early 1980s marked major lows in income inequality in both the US and the UK, and has since risen steadily back to the previous peaks seen in the late 1920s – there has been a particular acceleration since in the 21st century. In the US today, the top 10% earn 50% of all income, and the top 1% earn 20% of all income. In the UK the figures are only a little less unequal. The Davos forum’s 2012 report recently cited income inequality as a global risk for the first time.

In economic terms, the reasons for this increasing inequality lie in the differing forces affecting the demand and supply of low or averagely-skilled workers and highly-skilled workers. At the lower-skilled end of the labour market, there has been an explosion of supply, China and India are estimated to have tripled the number of people in the world seeking industrial jobs – the world market price for such labour has thus come under enormous downward pressure. This is not just in low-tech, assembly manufacturing, but, given the strong emphasis put on education in both these societies, increasingly too in higher-skilled manufacturing and with the rise of the internet, in service sector roles where brain matters more than brawn. India produces 3 million graduates a year, most with good English and strong IT skills, for whom $20,000 is a very attractive salary. This factor, more than anything else, explains why the median real wage in the US is unchanged over 40 years – the standard of living in the US has risen only because more members of the household are working. As real wages have stagnated, it follows that company profits have seen most of the benefits of economic growth in recent decades.

These higher profits have enabled company executives at the top end of the labour market to receive very much higher pay – generally determined by board members who are senior executives at other companies. This has been compounded by two further factors. First, globalisation has enabled successful companies in one country to expand much more easily internationally – the complexity of managing such businesses and the skills required by executives have increased substantially. In addition companies with greater revenues and profits generally pay better. The second is technology and the “winner-take-all” nature of many new industries as the virtual world places enormous premia on the benefits of networking effects. For example, people use Facebook and Twitter rather than any competitors because they already have so many users, and so their dominance over competitors mushrooms. In addition the rise of information technology has greatly reduced the need for many “middle-management” functions in companies, jobs which provided a career ladder for many of the “averagely-skilled” in previous times.

Thus this rising trend in income inequality has been led by global economic forces. Does this matter? Well – the answer is income inequality matters if society thinks it matters, and it may now be getting to that stage. The recent phenomenon of the Occupy movement around the world in recent months, claiming to represent the bottom 99% suggests that this trend is reaching socially unacceptable levels. From an economic perspective, the natural human tendency to create the best opportunities for one’s children, when combined with greater inequality of outcome, tends to create much greater inequality of opportunity for future generations. This does damage the economic potential of a nation.

In the same way that global economic forces have led to rising income inequality, those forces may also make it difficult to address by redistribution away from the richest. The richest (both individuals and large companies) have always been able to afford better tax lawyers than governments, and with many of them being internationally mobile, they are able to choose where they earn their money and incur tax liabilities. 2012 looks likely to be the year when the debate over income inequality comes to a head in the US Presidential elections with Obama determined to campaign on the notion of taxing millionaires more to reduce the deficit, and the Republicans determined to reduce the deficit solely through spending cuts. This is likely (absent foreign crises) to be the key issue in the forthcoming campaign.