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The Two Main Drivers of Income Inequality in the World

Updated: Sep 22, 2020

Today, in most discussions and publications concerning the global phenomenon of globalization, the concept of ‘inequality’ is raised. It is a multidimensional concept, encompassing aspects of income, wealth, nutrition, education, gender, health, environmental sustainability, as well as poverty. Income inequality is particularly interesting because of “its relevance to consumption, business, politics, and geopolitics.” The most common way to measure it is through the Gini coefficient, a statistical calculation, which ranges between zero (when income is evenly distributed across a given population) to 100 (all income accrues to one individual or household in a given population); this can be applied to measurements of across and within-country inequality.

Across countries, inequality has decreased since the turn of the twenty-first century, and this is mainly attributed to the growth of the “global middle class” (people living on at least $4 a day). Meanwhile, income inequality has increased within a given country. There is a plethora of drivers for this phenomenon, such as foreign-direct-investment (FDI), the growth of wealth accumulation, changes in taxation, and the rise of emerging economies. However, in my view, the two main drivers are technological change and trade and financial deepening: two aspects that are very interesting due to their interrelated nature.

According to an IMF study “technological progress alone explains most of the 0.45% average annual increase in the Gini coefficient from the early 1980s” to the mid 2000s, which measured income inequality within countries. Over the past four decades, technology has reduced the costs of transportation, improved automation, and communication dramatically. New markets have opened, lifting people out of poverty. New information technology has led to improvements in productivity and well-being by leaps and bounds, but has also played a central role in driving up the skill premium, resulting in increased labor income inequality. This is because technological changes can disproportionately raise the demand for capital and skilled labor by eliminating many jobs via automation or reforming the skill level required to attain/keep those jobs.

This is seen in both China and India - two so-called ‘tiger’ economies that are expected to to grow middle-class markets that will exceed those of Europe and America by 2027 - as there has been a sharp increase in inequality within each respective country. Data for China indicate that most of the increase is attributable to yawning disparities within urban areas, and between rural and urban areas; the same can be observed for India. Deng Xiaoping famously stated: “Let some people get rich first”, namely those located in the CBD (central business district). The trickle-down theory comes to mind: where increased wealth for the upper class means benefit for the lower class - wealth that is invested in the ‘core’ of a nation will eventually have a positive influence on the periphery. This economic theory, however, requires decades to actually ensue.

All of this suggests that new technology tends to favor skilled workers, thus exacerbating the so-called “skills-gap”. The same can be observed in OECD countries: technological advances have been found to account for nearly a third of the widening gap between the 90th and the 10th percentile earners over the last 25 years. According to Thomas Piketty and Emmanuel Saez, income inequality “was larger in Europe than in the United States a century ago” but “ it is currently much larger in the United States”. This is mainly due to the rise in innovation and the R&D spending of businesses, which decreases the reliance on human capital. Although the UK's income inequality is lower than that of the US, it is still significantly higher than it used to be: the UK had one of the lowest income inequalities, but in 1979 Margaret Thatcher became Prime Minister and changed the economy (laying off the mining industry). They wanted to develop the tertiary sector of the economy (financial services especially), hence the inequality increased at a ballooning rate.

The second main driver of income inequality is trade and financial deepening. Trade has been an engine for growth in many countries by promoting competitiveness and enhancing efficiency. Nonetheless, high trade and financial flows between countries, partly enabled by technological advances, are commonly cited as driving income inequality. In MEDCs (more economically developed countries) the ability of companies to adopt capital intensive technologies and offshoring has been cited as an important driver of the decline in manufacturing and risking skill premium; this exacerbates the inequality among countries by shifting low-skilled jobs from wealthier countries to poorer countries.

Trade openness could potentially have mixed effects on the wages of unskilled labor in advanced countries. It raises the skill premium, but could also increase real wages by lowering (import) prices. At the same time, increased trade flows could lower income inequality in MEDCs by increasing demand and wages for abundant lower-skilled workers. Thus, disentangling the impact of trade on inequality is challenging as it mainly depends on productivity differences across countries, and the extent to which individuals obtain income from wages or capital. Financial deepening can provide households and firms with greater access to resources to meet their financial needs, such as saving for retirement, investing in education, capitalizing on business opportunities, and confronting shocks, thus it may lower income inequality. Theory, however, suggests that financial development could benefit the rich in the early stages of development, but the benefits become more broadly shared as economies develop. Indeed, some studies have found that financial development, measured as the relative share of the banking and stock market sectors in the economy, boosts top incomes the most in the early stages of development. Moreover, inequality can increase as those with higher incomes and assets have a disproportionately larger share of access to finance, serving to further increase the skill premium, and potentially the return to capital.

This relates to the upsurge of so-called high-net-worth-individuals (or ‘millionaires’). Such individuals have either inherited or raised large sums of money over their lifetime, investing and saving, thus acquiring more capital, in a facile manner (domino effect). North America and Asia-Pacific are the regions with the largest numbers of HNWIs. “The countries with the most billionaires on the Forbes list are the United States (536), China (213), Germany (103), India (90), Russia (88), Hong Kong (55), and Brazil (54), meaning that the distribution of wealth at the very top is more skewed in the BRICs than in the United States, Europe, or Japan.”This suggests that financial deepening and trade is a driver of income inequality given the fact that the BRICs countries are still developing at an alarming rate.

This opinion piece crystallizes how technological change and trade and financial deepening - fueled by globalization - has helped decrease income inequality across countries, triggering a race for the purse of the new, rising middle classes of countries like Brazil, China, India, and other emerging economies. However, inequality within a given country is growing at an alarming pace, as the small proportion of HNWIs accumulate wealth at an accelerating rate, thereby exacerbating the gap between rich and poor. The UN and OECD respectively are engaging activities aimed at trying to minimize the inequality - the most notable example being the Sustainable Development Goals. Nonetheless, only time will tell the extent to which the chasm will be contracted.

Contributed by Odyssia Sifounaki

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