The market creates income inequality; governments reduce it through taxes and social transfers. That’s the conventional picture -- only it doesn’t work as well as it used to, and new ways of fighting inequality are needed, likely focusing on moving more people into better-quality jobs.

In a recent paper (and a shorter blog post), two economists at the Organization for Economic Cooperation and Development, Orsetta Causa and Mikkel Hermansen, explored how traditional redistribution has worked to cut inequality. Between the mid-1980s and mid-1990s, taxes and transfers erased half the growth in market inequality in the developed world. Then, Gini coefficients -- used to measure the income difference between the richest and the poorest -- slowed down, but taxes and transfers were no longer as helpful as they used to be. Governments were no longer shelling out as much money in social support, especially to the unemployed. In some countries -- Finland and Israel are two examples -- the tax and transfer systems actually contributed to growing inequality.

Obviously, the efficiency of transfer systems in leveling incomes varies sharply between countries. Cash transfers, income taxes and social security contributions mitigate about a quarter of the market income inequality in OECD countries, but that the average of a wide range -- from 5 percent in Chile to 40 percent in Ireland. Yet, government transfers have stagnated or shrunk except in countries afflicted by especially high unemployment rates -- such as Spain, Greece, Portugal and Ireland. Governments share the blame for that, along with demographic change.

Since the early 2000s, many wealthy nations have pushed people to get jobs by making it increasingly difficult to keep drawing unemployment insurance. It also became easier for employers to hire temporary workers and to fire employees. Germany’s Hartz reforms are a much-praised and indeed rather successful example of such policies. They caused a dramatic drop in unemployment, because they gave people a strong incentive to look for work -- but, as a group of International Monetary Fund economists pointed out in a 2015 paper, they also reduced their wages on reentry to the workforce.

At the same time, birth rates decreased and life expectancy went up, so older people remained longer in the workforce. That worked to reduce both inequality and social transfers.

Today, unemployment rates in most of the developed world are near record lows, though Southern Europe still hasn’t recovered from the shock of the global crisis. Within the existing tax and transfer systems, government’s ability to mitigate inequality is melting away. Even if they raised taxes on the rich, there wouldn’t be enough out-of-work poor on whom to lavish the extra revenues -- unless governments wanted to make unemployment look like an attractive option. Obviously, they don’t.

In recent years, the focus of redistributive systems has switched to helping low-income workers rather than the unemployed -- largely through lower taxes and social security contributions. This trend is in line with the idea of “predistribution,” put forward by Yale University professor Jacob Hacker. Its point is to attack the market forces that foster inequality. According to this approach, getting employers to raise wages (including through minimum wage increases) and lowering taxes on the working poor works better than taxes and transfers. But reforms aimed at making work pay haven’t been bold enough. “Overall, the contribution of net transfers to disposable income among bottom 40 percent working households remains either null or negative because taxes paid exceed transfers received,” Causa and Hermansen write.

Inequality-leveling systems are stuck in the middle. On one end is the old tax and transfer model that worked well in the 1980s. On the other is the new, somewhat self-contradictory model that creates millions of wobbly jobs (the gig economy is one example) and tries half-heartedly to help people make a living wage. A bolder push in the “predistribution” direction is needed, with lower taxes for more relatively low-income workers and increased government spending on training, apprenticeships and education to help people move up the pay scale. At the same time, governments ought to be more serious about incentivizing businesses to create quality jobs, not just any jobs.

If the wealthy need to contribute more of their income -- and in some rich countries with high inequality levels, such as the US and the UK, they likely do -- let that money be spent on making sure people are more adequately compensated for work. Then aberrations like the recreational vehicle parks next to Big Techs Silicon Valley headquarters, populated by the working homeless, have a realistic chance at disappearing. 


Leonid Bershidsky
Leonid Bershidsky is a Bloomberg columnist. -- Ed.

(Bloomberg)