Discussion about skills biased technical change as a possible explanation for widening income inequality seems to be in vogue at the moment, so I thought I’d touch upon the subject. In a nutshell the theory postulates that technological progress raises the marginal productivity of certain segments of the labour force disproportionately more than others. Furthermore since you earn what you produce (in economics terminology, each worker is paid a real wage equal to his or her marginal product assuming efficient capital markets), those workers who are now producing a higher proportion of overall output get a greater share of total pay. This is as basic an overview as possible as I don’t want to get into too much detail, with many others having already given very succint accounts of the theory elsewhere (see for instance Noah Smith and Mark Thoma).
What I did want to discuss is something else in the data that has always intrigued me. First of all, what’s the general picture in terms of the actual structure of income inequality over the last few decades? Well, lets take the US as an example. Fig.1 shows the percentage of total income going to income bands of 1/5th.
As has been much discussed, the share of the overall pie going to individuals in the top 20% of incomes has been increasing steadily since the early 1970s as everybody else’s incomes have generally stagnated or fallen. What is most worrying is the explosion of the share of GDP going to those in the top 5% of incomes. This is again well documented, but what intrigues me is the precise timing of the increase. As we can see from fig.1, the share of income going to these individuals suddenly takes off in 1980, and increases rapidly up to around 1994, while the share of GDP going to the lowest 80% decreases.
So what’s with the sudden divergence of the top 5%in 1980? Yes, deregulation of the financial sector would have contributed to the take off, but financial services had been undergoing gradual deregulation over a period well before the sudden upward tick. But what about macro stabilization policy at the time? Take a look at fig.2 below which plots the annual percentage change in the CPI.
As is clear, inflation was running well above acceptable levels prior to 1980. However, following the turn of the decade and the ensuing Volcker disinflation, inflation was brought down to around 2% within 3-4 years from a peak of almost 15%. With the huge tightening of monetary policy that the Fed instigated in 1980 coinciding almost perfectly with the sudden upward tick in the share of income going to the top 5% of incomes, is it not beyond the realm of possibility that such a significant tightening of policy impacted certain households and workers disproportionately more?
Here is how I could see such a scenario playing out. First of all, if low skilled labour is in greater abundance than high skilled labour (which it is and was) then in the face of lower firm revenues those with the highest skills have the greater bargaining power when it comes to maintaining wages at their current level than lower skilled labour. Hence, rather than losing a highly skilled worker (who is not easily replaced) due wage reductions in the face of a negative aggregate demand shock, it may well be less costly for employers to cut the wages and the employment of lower skilled workers (cut the wages of or fire 10 cleaners rather than fire/reduce the salary of 2 analysts) and maintain the wages going to those already at the higher end of the pay scale.
Indeed, comparing figures 1 and 2 again, we can see that the next time after the 1980 episode when inflation was reduced by a significant margin over a short time frame, those with the top 5% in terms of incomes experienced a similar jump in the share of overall GDP which they received. That is between 1991 and 1993 when inflation was brought down from approximately 6% to just over 2.5%, we can see from fig.1 that the share of income going to the top 5% jumped significantly again.
Of course, this could all be due to a third factor influencing both variables simultaneously. However I find it hard to reconcile with the fact that despite such a significant reduction of inflation over the 2 entirely separate periods highlighted, the share of GDP going to the top 5% suddenly increased at a rapid rate.
I certainly don’t see technological factors having such a significant short-term impact.