Analysis of The Long-term Trends in Economic Inequality

The purpose of this paper is to explain and analyse the long-term trends in economic inequality within developed countries since the Industrial Revolution. This essay focuses on within-country inequalities for the purpose of narrowing the scope, but also because of the lack of consensus in the literature regarding global inequality trends, due to different data sources and research methods. The study of within-country economic inequality also allows for a better empirical evaluation of the role of markets and country-level shocks. Focusing on high-income countries (with similar technological and productivity developments) helps shed light on the role of institutional and policy differences explaining the reasons behind different patterns of income inequality, specifically at the very top.

This essay will make use of the concept of Kuznets wave developed by Milanovic in response to two of the most prominent analyses of long-term trends in economic inequality elaborated by Kuznets and Piketty. The first Kuznets wave occurred from the beginning of the Industrial Revolution to approximately the 1980s, and the second from the 1980s onwards. Both waves are characterized by a period of rise in inequality (in the first wave, inequality culminated between the end of the 19th century and the beginning of the 20th century), followed by a decrease.

This paper will firstly demonstrate that changes in inequality have been influenced by wars and ensuing policy choices. Then, it will analyse the role of capital and taxation in determining long-term trends in economic inequality. Lastly, it will evidence that the labour market and bargaining power have historically impacted economic inequality.

Variations in economic inequality have been influenced by wars and subsequent policy changes. Historically, war has been recognized as an enabler of economic equality. According to Ricardo, government war financing particularly through the taxation of the wealthy increases employment (e.g., of soldiers), augments wages and lowers economic inequality. Piketty argues that there was no structural decrease in inequality before World War I and that economic inequality stabilized at a very high level between 1870 and 1914. Kuznets considers the sharp decrease in inequality in the USA between 1913 and 1948 (the top 10% going from claiming 40-45% of annual national income to 30-35% during this period) to be due to shocks related to the Great Depression and World War II. Piketty proposes a political theory to explain the process through which the two world wars decreased economic inequality within rich countries. According to him, the wars led to higher taxes, as well as the destruction of property and the reduction of large fortunes. For instance, he argues the concentration of capital declined to an irreversible extent after the wars as the largest French fortunes highest-valued estates around the year 2000 were still worth less than before 1914.

Moreover, the endogeneity of wars is an important aspect to consider when analysing the relationship between war and economic inequality. According to Milanovic, the outbreak of the Great War and the reduction of inequality after the war are not to be analysed as an exogenous shock that reduces economic inequality. World War I outbroke in an environment characterized by high domestic inequality, high savings among the rich, poor aggregate demand, and search for new sources of profits that require control of other countries. Therefore, war should be endogenized in the economic conditions predating it.

Furthermore, the policies adopted following the shocks of the war constitute another inequality-reducing aspect of the first Kuznets wave (from the Industrial Revolution to the 1980s). Piketty argues that along the shocks of war, the ensuing shock of socialist and communist parties that led to pro-labor legislation contributed to the decrease of inequality. Moreover, Milanovic considers social pressure through politics (socialism and trade unions), the need for social protection (resulting from having an aging population), as well as widespread education, as enign forces that drove inequality down after World War I. The latter force, as argued by Goldin and Katz, was efficient in lowering inequality during the first Kuznets wave as the inequality-reducing effect of education was greater than the inequality-enhancing effect of skill-biased technological change (which became the stronger effect after the 1980s). These policy shifts thus contributed to reducing economic inequality within rich countries until the 1980s. Therefore, the shocks of the wars as well as the subsequent policy shifts played an important role in decreasing economic inequality during the first Kuznets wave.

Economic inequality variations in advanced economies have also been shaped by capital accumulation and fiscal policy changes. Capital plays an important role in explaining long-term inequality trends in advanced economies. The reduction of economic inequality during the first Kuznets wave was characterized by a decrease in the share of capital income: the US experienced a 17% fall in capital income share between 1916-1939 and 1987-2010; whereas in the UK it went from 60% in 1937 to 20% in 2000. However, according to Bourguignon, since 1980, the income share from capital has been rising faster than that of labor (i.e., wages). This can be partly explained by new technologies increasing the share of and the return to capital. Additionally, as capital income is increasingly concentrated, wealth concentration has become a related problem. The variation in top income shares largely reflects changes in capital income flows. Based on pre-tax and pre-transfer market income per family reported on tax returns, the share of total annual income received by the top 1% has more than doubled from 9% in 1976 to 20% in 2011. The rise in the share of the top 1% has had a noticeable effect on overall income inequality in the US. Moreover, according to Piketty, this increase in inequality reflects an important information: the return of high capitalincome ratios since the 1980s can be largely explained by the return to a regime of relatively slow growth which enhances the risk of divergence in the distribution of wealth. This is because in a slow growth regime, past wealth takes on disproportionate importance (because it takes only a small flow of new savings to increase the stock of wealth) and the rate of return on capital often remains significantly above the growth rate.

Furthermore, fiscal policy plays a crucial role in determining inequality trends. The fact that high-income countries characterized by similar technological and productivity developments have undergone dissimilar patterns of income inequality at the very top supports the idea institutional and policy differences – specifically fiscal policy differences - play a key role in these transformations. Post-1945, tax rates on the top incomes were much higher than today (e.g., tax rates in the US in 2010 were half of 1950s rates) which explains the lower top-income shares at the time. Tax reforms in the name of economic liberalization meant that the highest marginal tax rate fell from 70% to 40% in the US during the Reagan administration (1980-1984) and that in the UK, it fell from 83% to 60% in the very first year of the Thatcher government. These reforms led to a rise in pre-tax incomes (as well as their share and concentration) and the expansion of financial services. Moreover, due to globalisation and information technology, capital has become increasingly mobile, making accurate tax collection - especially from the rich - more difficult, thus perpetuating inequality. Therefore, the rise of inequality post 1980 can partly be attributed to capital accumulation, particularly within top earners, as well as to fiscal policies.

Finally, changes in the labour market and in bargaining power have historically impacted economic inequality trends. The impact of unionization on income distribution - although heterogeneous across countries and often endogenous with respect to income inequality - is an interesting aspect to consider when investigating long term inequality trends. Since the 1980s (i.e., the beginning of the second Kuznets wave), the development of the service sector has led to a wider physical distribution of employment, making workers organizations increasingly more difficult to organize or less relevant, thereby leading to a lower trade union density. The decrease in unionization popularity can also attributed to the Thatcher and Reagan administrations, higher competition lowering the practicality and success of unions negotiating with employers, and disinflation, which leads to individual salary negotiations that ensure greater individual utility as compared to collective bargaining, which would often be based on inflation changes. In the case of the US, Freeman attributes 20% of the rise in earnings inequality among men to deunionisation and, looking at the experience of all workers in 16 OECD countries across the 1980s, shows that the upswing in earnings inequality at the industry level was least pronounced in highly unionised countries.

Furthermore, the shift to service economies has led to the creation of extremely high-paid jobs specifically in the finance sector that benefit from a high bargaining power, which exacerbates inequalities. The deregulation and globalization of finance has had an important inegalitarian effect: in France and in the UK, the financial sector represents 5% of jobs, yet accounts for 18% of very high incomes. Financial liberalisation increased the profitability of financial wealth through an outsized expansion of investment opportunities and in part by inflating the remunerations of the minority directing and managing these innovations. Importantly, while the density and the bargaining power of trade unions decreased, the bargaining power of those at the top highly increased, thereby strengthening the bargaining power of capital, compared to labor. Finally, the extent to which top earners exercised bargaining power may have interacted with the changes in the tax system. When top marginal tax rates were very high, the net reward to a highly paid executive for bargaining for more compensation was low. When top marginal tax rates decreased, high earners began bargaining more aggressively to increase their compensation. Consequently, lowering top tax rates increases top 1% income shares at the expense of the remaining 99%. Therefore, bargaining power and changes in the labour market also play a role in long term inequality trends.

In conclusion, variations in economic inequality have been influenced by three main factors: war and subsequent policies, capital and fiscal policies, and the labour market and bargaining power. The history of the distribution of wealth is therefore due to various economic mechanisms that have in part been shaped by political factors.

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