Increasing economic inequality

Richard Pomfret (2011) declared the 20^th century as “The Age of Equality”. This appellation, however, does not seem to apply to its last decades. As Anthony Atkinson and Thomas Piketty (2010) and other researchers have shown at length, income inequality rose sharply since the 1980s in the United States and in the most other Anglo-American countries. Therefore, the current level of income inequality in the United States reaches levels prevailing just before the beginning of World War I.

For some years past, also Germany and other European countries experienced increasing income inequality that has not ended yet. Although the inequality in Germany since German Reunification did not rise as much as in the United States, this process accelerated in the last decade.

The increasing economic inequality has a high number of facets, not only including the development of income and wealth, whose distribution is becoming more and more unequal, but also a variety of demographic subgroups, for which the inequality is documented. The nature of this development, its causes and diverse consequences are nowadays in the centre of a growing and productive research initiative, which is promoted by economists and social scientists worldwide.

 

Challenges for Research in Public Economics

Especially the research in Public Economics is encouraged to study a number of complex questions. These questions lay the ground on which this Ph.D. program shall be built on.

Questions on related topics are for example: How successful are welfare states in limiting the rising poverty risk today? How and by what means is the government to counteract the increasing inequality of wealth and of opportunity? Which distributional aims can be realised by national taxation and social policies and when is it necessary and possible to coordinate transnationally, e.g., amongst the states of the European Union?

To answer these questions using scientific methods is of prime social importance. Eventually, the maintenance and the ongoing development of the European market economy model combined with welfare states depend on a comprehensive reply to such questions. Besides, it is not only important to answer theoretical questions but also to find empirical foundations for policy recommendations.

 

Recent theoretical and empirical developments

The topic of Public Economics and growing inequality is addressed by a growing literature evolving even more rapidly in the last years. Particularly the empirical works by authors like Anthony Atkinson and Thomas Piketty as well as Anders Björklund, Jonathan Gruber, Emmanuel Saez and many others led the research field to be in spotlight again.

The dimension of the inequality increase found and the quite recently high quality of analysed data convinced many researchers to devote themselves to this topic with great zeal. In the centre of their work is the application of empirical methods, whereby this research era differs from the research of the 1970s and 1980s.

Encouraged by the new findings on inequality, the development of theoretical approaches experiences a continuous innovation, nonetheless. In the age of theoretical Public Economics, normative as well as positive approaches are developed to uncover the interplay between inequality and public institutions. Based on the early papers by James Mirrlees and Joseph Stiglitz on the theory of the Second Best, more realistic models have been developed, including, e.g., the results of experimental Game Theory and Behavioral Economics.

The research progress of the last years simultaneously revealed the gaps existing both in the theoretical and the empirical domain and, consequently, for policy advice. The Ph.D. program shall contribute in filling these gaps.

 

Need for research

The current need for research in terms of equality and tax-benefit systems, especially in Germany, is substantial and concerns different aspects. In our assessment, the accurate assessment of central empirical facts takes precedence.

Former research could only unveil parts of the various dimensions of economic inequality in Germany, e.g. investigations on the development of wage inequality such as those by Dustmann et al. (2009), Fuchs-Schündeln et al. (2010) and Gernandt and Pfeiffer (2007). The analysis of income inequality has also become more informative by taking into consideration longer periods like in the paper from Bönke et al. (2010) that deals with the income of the elderly.

Furthermore, due to the exploration of micro data from the tax statistics a fairly comprehensive picture of the income distribution in Germany exists, particularly regarding the very high incomes – see Bach et al. (2009). In the area of income distribution in Germany, progress was also made by Frick et al. (2010).

Although important results were achieved within the empirical inequality research during the last years, some of the most important aspects of inequality received only little attention.

Inequality over the lifecycle

A particularly severe lack of knowledge exists concerning the development of income inequality over the lifecycle. It is common knowledge that the influence of age on personal is high and not constant at all. A pure cross-sectional analysis of inequality therefore only provides limited and biased insight into long-term inequality. Moreover, the examination of repeated cross-sections over time cannot depict the inequality of long-term income and wealth.

To answer the fundamental questions regarding long-term inequality, it is necessary to consider the inequality from a lifecycle point of view. Questions include the evolution of individual income and wealth mobility and their volatility as well as the options of welfare states to reduce income inequality and uncertainty at different stages of life. E.g., we need to study systematically representative occupational biographies in order to assess the hazards of poverty in old age in Germany in the future.

For this purpose, the current development of new datasets – in particular from the statutory pension insurance and the Institut für Arbeitsmarkt und Berufsforschung (IAB) – provides an opportunity for promising research.

Bönke et al. (2011) made first contribution and showed that life-time income inequality of males from the baby boom generation will surpass the inequality experienced by their statistical fathers by approx. 80 %.

High incomes

Another dimension of inequality, where research is needed, concerns the top of the income pyramid. This group is a crucial object of the scientific analysis because of their economic power captured by their income and wealth. On the one hand, this minority can exert essential influence on political and social developments by virtue of their economic power (Hartman, 2009). On the other hand, the increase of income concentration has led to a significant weight of this group for tax revenues in total. Bach et al. (2011) show that the top 1 % incomes – a very small group of the highest incomes – contribute approx. 27 % of the tax revenue.

It is often somewhat difficult to gain access to data on high incomes and its recipients. This is not least the result of some institutions lacking the willingness to cooperate. Due to this restriction, the research in the field of high incomes is still in its early stages.

For example, it has not been explored yet to which extent the group of people with the highest incomes changes over time. This would contribute important insights on the persistence and permeability of Germany’s economic elites.

Meanwhile, it is useful to study the vertical mobility of the top incomes using the new Taxpayer-Panels, which comprises income declarations from 2001 to 2006 and is accessible via the Research Data Center of the Federal Statistic Office.

Equality of opportunity and intergenerational mobility

The international literature on equality of opportunity and intergenerational mobility draws attention to a further need of research on this subject in Germany. John Roemer’s (1998) contributed decisively to initiate the high research activity in this area; Björklund and Jäntti (2009) provide a very good overview for the empirical literature on income mobility.

For Germany, multiple studies on intergenerational mobility referring to levels of education exist indeed, such as the study by Heineck and Riphahn (2007). But dimensions extending beyond, especially with respect to income and wealth, are explored hardly so far. New empirical studies should contribute to obtain a better understanding of the process of intergenerational mobility and its mechanisms perpetuating the economic and social position amongst families.

Recent research for France showed that the relative weight of individual work income on the one hand and inherited wealth on the other side do not exhibit a linear development historically (Piketty, 2011). Rather, it seems that the personal labor market performance for the birth cohorts of the first three decades of the 20^th century is of greater importance than for the previous and following cohorts.

The potential implications of such results for taxation and social policy are far reaching, e.g., with respect to taxation of inheritance and potentially higher taxes on capital income or work income. Additionally, empirical findings on equality of opportunity over generations are of exceptional interest to education and wage policies. Comparable studies for Germany are still lacking.

Taxation and social policy

Particularly for Germany, another substantial need for research lies in the empirical modelling of the effects of tax and social policy alternatives in view of increasing inequality. The aim of this research is to evaluate effects of different policies quantitatively, such as impacts on disposable income or life satisfaction. A preferably disaggregated quantification – e.g. according to income category, level of qualification, household type, region – supports the analysis of the implications for the development of inequality in Germany.

These models should not only illustrate the effect of alternative tax-benefit systems on disposable income under given steady market incomes. A crucial challenge for this kind of research is the modelling of effects of tax and social policy instruments on market outcomes and especially on results in factor markets. Thereby, not only the effects on the supply side are included, but also volumes and price and wage formation. This is the only way to constitute in its entirety the relation of primary to secondary distribution.

The literature highlighted numerous mechanisms of incidence of taxes and benefits, whereas empirical knowledge lags behind the theoretical one. Different market structures come along with different transmission mechanisms with respect to taxes and benefits. The total effect of progressive taxation on the income distribution depends, e.g., on the strength of unions in wage formation process. The volume by Agell und Sorensen (2006) contains a comprehensive documentation of possible interdependencies between taxation and labor market.

The empirical modelling that is necessary to specify the importance of taxes and social policy in the light of increasing inequality shall take into consideration both the repercussions of tax and social policy measures on the primary distribution and the market structure. Aim of such modelling is not only the ex post evaluation but also the ex ante evaluation by means of empirically based microsimulation models. In this context, exemplary applications for Germany can be found in Fossen (2009) and Steiner and Wrohlich (2008).

 

Expectations towards the Ph.D. program

The state of international research shows that important progress in this field is within grasp. On the one hand, empirical models depicting behavioral responses better than before being based on experimental Game Theory and social psychology, should be developed. Examples are hyperbolic discounting, habits, interpersonal comparison of consumption and loss aversion. On the other hand, empirical models that are able to illustrate uncertainty by means of current theoretical approaches shall be developed.

In this context, prominent examples are the introduction of non-stationary stochastic processes – which is moving in the direction of “Knightian Uncertainty” – and the consideration of “endogenous” shocks –particularly in view of imperfect financial markets – and systematic risks as a consequence thereof.

These two desiderata – introduction of elements of Behavioral Economics and of realistic uncertainties – are notably relevant for the illustration of occurrences in the labor market. Therefore, one can hope for a much better acquisition of interdependencies between tax-benefit systems and the primary distribution.

The participants of the Ph.D. program are expected to contribute a better understanding of both the opportunities and limits of taxation and social policy at a time of increasing inequality by means of innovative research in the fields mentioned above.

 

References

Agell, J. and P. B. Sorensen (2006), Tax Policy and Labor Market Performance, MIT Press, Cambridge MA.

Atkinson, A. and T. Piketty (2010), Top Incomes – A Global Perspective, Oxford University Press, Oxford.

Bach, S., Corneo, G. and V. Steiner (2009), From bottom to top: The entire income distribution in Germany, 1992-2003, Review of Income and Wealth 55, 303-330.

Bach, S., Corneo, G. und V. Steiner (2011), Effective taxation of top incomes in Germany, Diskussionspapier 2011/18, Fachbereich Wirtschaftswissenschaft, FU Berlin.

Björklund, A. and M. Jäntti (2009), Intergenerational income mobility and the role of family background, in Salverda, W., Nolan, B. und T. Smeeding, The Oxford Handbook of Economic Inequality, Oxford University Press, Oxford.

Bönke, T., Schröder, C. and K. Schulte (2010), Incomes and inequality in the long run: The case of German elderly, German Economic Review 11, 487-510.

Bönke, T., Corneo G. and H. Lüthen (2011), Lifetime earnings inequality in Germany, IZA Discussion Paper 6020.

Dustmann, C., Ludsteck, J. and U. Schönberg (2009), Revisiting the German wage structure, Quarterly Journal of Economics 124, 843-881.

Fossen, F. (2009), Would a flat-rate tax stimulate entrepreneurship in Germany? A behavioral microsimulation analysis allowing for risk, Fiscal Studies 30, 179-218.

Frick, J., Grabka, M. and R. Hauser (2010), Die Verteilung der Vermögen in Deutschland, Edition Sigma, Berlin.

Fuchs-Schündeln, N., Krueger, D. and M. Sommer (2010), Inequality trends for Germany in the last two decades: A tale of two countries, Review of Economic Dynamics 13, 103-132.

Gernandt, J. and F. Pfeiffer (2007), Rising wage inequality in Germany, Jahrbücher für Nationalökonomie und Statistik 227, 358-380.

Hartmann, M. (2009), Eliten, Macht und Reichtum in Europa, in Österreichische Nationalbank, Dimensions of Inequality in the EU, Österreichische Nationalbank, Wien.

Heineck, G. and R. Riphahn (2009), Intergenerational transmission of educational attainment in Germany: The last five decades, Jahrbücher für Nationalökonomie und Statistik 229, 36-60.

Piketty, T. (2011), On the long-run evolution of inheritance: France, 1820-2050, Quarterly Journal of Economics 126, 1071-1131.

Pomfret, R. (2011), The Age of Equality, Harvard University Press, Cambridge MA.

Roemer, J. (1998), Equality of Opportunity, Harvard University Press, Cambridge MA.

Steiner, V. and K. Wrohlich (2008), Introducing family tax splitting in Germany: How would it affect the income distribution, work incentives and household welfare? Finanzarchiv – Public Finance Analysis 64, 115-142.