ZEW President Professor Clemens Fuest Formulates 10 Hypotheses About the Inequality Debate

In a contribution to the "Frankfurter Allgemeine Zeitung" on February 12, 2016, ZEW President Professor Clemens Fuest considered whether the global gap between rich and poor is really continuing to widen.

Barely a day goes by without claims of increasing inequality making the headlines. According to a study carried out by Credit Suisse, 0.7 per cent of the world population owns 45 per cent of all wealth. The organisation Oxfam claims that the wealth held by the world's richest has increased by 44 per cent in the last five years. In the same period, the wealth held by the world's poorest has fallen by 41 per cent. The French economist Thomas Piketty has warned of a society in which incomes are becoming ever more unequal. In response to such claims, many are calling for the "rich" to be subject to higher levels of taxation and for further development of a social state.

This debate throws up three essential questions. Firstly, if income and wealth inequalities really do increase, will the poor become ever poorer and the rich ever richer? Secondly, how do developments in Germany compare to those in other countries? And finally, should the German government take action, and if so, in what form?

The most important thing to note in response to all of these questions is that the claim that poverty and inequality are generally increasing is incorrect. Over the last several decades, levels of global poverty have fallen dramatically. Income inequalities have also reduced. This is the result of advancements in newly industrialised countries. In wealthy industrialised countries, inequalities in "market income" are increasing. But ultimately, "disposable income", income after taxes and transfers which individuals are able to spend, is the most important. The social state cushions the impact of increasing inequalities. In Germany, incomes are distributed to a much greater extent than in nearly any other country. The disposable income of the poorest 25 per cent of the population has therefore remained almost stable over the past 20 years. From this perspective, the current inequality debate seems to be somewhat overblown. Political bodies ought to concentrate on reforming the German welfare state in order that it continues to provide cover in the future.

How economic inequalities develop, and the consequences that this will have for German politics, can be summarised in the following ten hypotheses:

Global Poverty and Income Inequality Are Falling

1. In the last two decades, global poverty and income inequality have not increased, but decreased. This is due to the integration of newly industrialised countries, in particular of China, into the global economy.

The decrease in global poverty is one of the most significant successes brought about by economic developments seen over the last few decades. According to the World Bank, anyone surviving on less than 1.90 US dollars a day is living in extreme poverty. In 1981, 44 per cent of the global population lived in extreme poverty. In 1990, this figure fell to 37 per cent, and by 2012 it was only 12.7 per cent. That is, of course, still a huge number of people, but huge progress has been made.

Above the poverty line as well, levels of global inequality have fallen. In 1980, the average income per head in newly industrialised and developing nations was around 14 per cent of the level in industrialised nations. Today, it is around 23 per cent. This does not, however, give any indication of the development of inequality in the two groups of nations and within the individual countries themselves. The most widely used measure of inequality is the Gini index. A value of 0 indicates complete equality, a value of 100 indicates maximum inequality. A current study carried out by the World Bank researcher Branco Milanovic shows that the Gini index for the income distribution of the global population has fallen from 74 per cent in 1988 to 69 per cent in 2008 (Figure 1). He thus concludes the following: "The period of globalisation from 1988 to 2008 resulted in the first decrease in worldwide inequality since the industrial revolution." The claim that worldwide poverty and income inequality are permanently increasing is not justified.

Inequality in Market Incomes is Increasing in Industrial Nations

2. In industrial nations the inequality in market incomes has been increasing since the 1980s. In the USA, the increase in the incomes of the wealthiest ten per cent of the population has been particularly significant.

The primary factor driving the increase in income inequality in industrial nations is changes in work incomes, not in capital incomes such as interest rates or dividends. Highly qualified professionals, such as successful managers, doctors or IT specialists, are increasingly well paid. The rates of pay for medium to poorly qualified positions remain constant. There are various reasons for this. The entry of newly industrialised countries into the global economy has meant that jobs in industry in high-wage countries are either lost or transferred abroad. New technologies are also changing the work environment. The power of work unions has decreased. The ageing population and the increasing number of one and two person households is also having an impact on income inequality.

According to data from the OECD, the Gini index for market incomes in the USA rose from 45 in 1985, to 51 in 2011. In Great Britain, the indicator rose from 47 to 52 in this period.

In continental Europe and Scandinavia, inequality is traditionally lower. Even in these countries, however, inequality has increased. In Italy, the Gini index rose from 40 in the mid 1980s, to 50 in 2011. In Denmark, the indicator increased from 37 to 43, and in Finland from 39 to 48. According to these figures, inequality has increased to a greater extent here than in the USA. One gains a slightly different picture, however, if the top ten per cent of earning households is taken into account. The share of total income received by these households in Italy rose from 27 per cent in 1985 to 34 per cent in 2011. In Great Britain, this figure rose from 33 to 39 per cent. In the USA, however, the increase in the share of total income earned by the top ten per cent of earning households was considerably more dramatic, jumping from 34 to 47 per cent.

Income Inequality in Germany Remains Constant

3. In Germany, inequality in market income has also increased, with the greatest rise being seen between 1995 and 2005. Since 2005, however, levels of income inequality have remained fairly constant.

In view of the reunification in 1990, comparison of Germany with other countries is somewhat limited. Particularly in the period between 1995 and 2005, inequality in market income also increased. Towards the end of the 1990s, long before reforms were made to the social welfare payment system, a low-pay sector had already developed in Germany. This development protected many people from unemployment, the cost, however, was an increase in the spread of wages. The Gini index for market income rose from a value of 44 in 1985 to 50 in 2004. According to the most recent figures published by the OECD, the index remained at this level until 2012.

Taxation and Transfers Reduce Inequalities in Many Industrialised Nations

4. Disposable incomes are in fact much more important than market incomes. The taxation and transfer system serves to significantly reduce inequalities in the majority of industrialised nations.

Changes in income inequality are generally discussed in terms of market income. What is crucial, however, is the disposable income, that is income minus any taxes paid and plus any received transfers. In the majority of industrialised countries, increasing inequalities in market income are absorbed by the social state. Despite this, in certain nations with highly developed welfare states, inequalities in disposable incomes have increased since 1995. This is particularly the case in Sweden and Finland (Figure 2 below the text). In some countries, including the Netherlands and Italy, inequality has decreased.

Germany Leads in Terms of Wealth Redistribution

5. In Germany, the state redistributes more wealth than almost any other country included in the OECD data (Figure 3 below the text). Since 1995, inequality in disposable incomes in Germany has therefore increased to only a very small extent. The proportion of the population included in the poorest 25 per cent of the population has remained generally stable. The proportion included in the wealthiest 10 per cent of the population has increased slightly, but remains below the EU average.

Even in countries such as Germany with a welfare state which favours reallocation of wealth, increasing inequality in market incomes cannot be fully neutralised. The cushioning affect achieved by such reallocation is, however, considerable. Particularly revealing is the development of the proportions of "rich" and "poor" in the population in terms of disposable income. According to data from Eurostat, the proportion of the population included in the poorest 25 per cent of households totalled 11 per cent in 1995, 11.5 per cent in 2010, and 10.5 per cent in 2014. The percentage has thus remained fairly constant. The popular claim that poorer segments of society are excluded from general developments in wealth is not consistent with this data. The proportion of the population earning the highest 10 per cent of incomes in Germany was 22 per cent in 1995, 23.4 per cent in 2010, and 23.6 per cent in 2014. The proportion has therefore slightly increased, but is still surprisingly stable and remains below the EU average (Figure 4 below the text).

Wealth Inequality More Difficult to Measure than Income Inequality

6. It is more difficult to measure wealth inequality than income inequality. According to available studies, in comparison to other countries, the wealth of households in Germany is low. This wealth, however, is very unevenly distributed. Such studies provide a distorted view, however, as they fail to take pension claims into account. These are more significant in Germany than in many other countries.

A data collection carried out by the European Central Bank in 2013 had some surprising findings. The survey claims that, at 195,000 euros per household, wealth in Germany is well below the eurozone average of 230,000 euros per household. Allegedly, the distribution is also more uneven than in any other country. An investigation carried out by the OECD for 18 industrialised countries found that the wealthiest ten per cent of the German population holds 60 per cent of all wealth. This proportion was shown to be higher only in Austria, the Netherlands, and in the USA. Data held by the Federal Statistical Office shows that, in fact, the wealthiest ten per cent of the German population owns only just above 50 per cent of all wealth. The distribution of German wealth seems to have remained fairly constant over time. According to data from the German Socio-Economic Panel, the Gini index for income distribution fell slightly between 2002 and 2012. Other data sources, however, suggest a slight increase over this period.

What can be concluded from these observations? In comparison to wealth, income is statistically easier to measure. When it comes to measuring wealth, there are significant obstacles to evaluation. In the case of Germany, the following is extremely significant – in many households, pension claims constitute a significant part of the household's wealth. This is clarified through comparison of a self-employed worker, who saves 500,000 euros in a pension scheme subject to downstream taxation, and a civil servant, who will receive an annual pension of 50,000 euros, but who saves only 25,000 euros before retirement. The civil servant is technically wealthier than the self-employed worker, because the pension has a capital worth of over 600,000 euros. But the majority of studies fail to take pension payments into account. Such studies would consider the self-employed worker to be twenty times richer than the civil servant. This does not at all reflect economic reality. In Germany, wealth in the form of pension claims and payments plays a much greater role than it does in other countries. According to a recent study carried out by the OECD, wealth in this form totals twelve times more than the net annual income of average earners in Germany. The EU average is 8.9 per cent. The value of pension claims varies considerably amongst workers in Germany. If one takes this into account, the wealth inequality in Germany is much less pronounced than the figures quoted above seem to suggest.

How should German policy-makers react to the developments in income and wealth described above?

A Tax on Net Wealth Isn't Worth While

7. If policy-makers decide to increase redistribution of wealth through taxation, then they must choose an instrument which minimises potential damage to growth and employment. In this respect, it's advisable to steer clear of a tax on net wealth. Amongst all taxes based on individual wealth, a land value tax would be the least damaging.

Whether or not it is desirable to redistribute wealth through taxation to an even greater extent than is currently the case, is a political question. A number of German politicians are calling for a tax on net wealth to be implemented. The implementation of such a tax would be a mistake. This would result in a loss of capital from Germany, investment levels would fall and jobs would be lost. Increases in the rate of inheritance tax would have similar impacts. Of all wealth taxes, it is only higher rates of land tax which offers room for manoeuvre in the German tax redistribution system. A land tax might be introduced for example, which is calculated according to the ground value and which cannot be passed onto rental tenants in the form of subsidiary costs. Land cannot be exported abroad, and the limits on land value would mean that investments in residential property would not be negatively effected. Land owners would of course feel discriminated against and may well appeal to the Federal Constitutional Court. If this is to be avoided, the only remaining option is to raise progressive income tax rates. Five per cent of those liable to pay tax, however, already pay 42 per cent of income tax – increasing these rates also has its limits.

Investments in Education Are Crucial

8. Investments in education play a central role in limiting income inequalities. Larger amounts of public funding should be invested in nursery and primary schools. Universities should charge tuition fees based on students' incomes.

There is no doubt that school and further education play a key role in ensuring career success and preventing unemployment. The seeds for success at school and in further training are often sown in early childhood. Failure to provide children with proper schooling and education opportunities in their early years can be a root cause of the difficulties which children from underprivileged backgrounds often face later on in their education and career. This is a strong argument for increasing public investment in education for young children. Of course, it will not be possible to increase investment in education without end. A shift of funds within the education budget, however, might be achieved by reintroducing income-based tuition fees for university students.

Private Pension Schemes are Imperative in the Fight Against Old-age Poverty

9. In order to prevent poverty in later life, all individuals should be obliged to invest in a private pension scheme. Efforts by the state to encourage investment in private pension schemes should target those most in need.

Wealth inequalities in Germany mean in part that many low-income households save very little and rely on state, pay-as-you-go pension payments. This is a not a problem, provided that state pensions remain high enough. The increasing number of pension claimants, however, means that the value of state pensions is likely to fall significantly in the coming years. It is thus crucial that all households invest more heavily in private pension schemes. The existing state system designed to encourage saving for later life is intrinsically flawed. The system primarily benefits households with medium or high incomes, therefore increasing inequality. It would be sensible to oblige all individuals to pay into a private pension scheme. However, state subsidies should be paid only to those who have such a low income that mandatory saving would be impossible without additional help.

Minimum Wage and Rent Controls are Inefficient Tools of Redistribution

10. Interventions in price mechanisms such as a state-set minimum wage or rent controls are not efficient tools for redistributing wealth.

State interventions in pricing mechanisms in markets have the effect of achieving the intended redistribution of wealth at a cost – a proportion of the population which the intervention should help are actually discriminated against. Minimum wages indeed increase the income of those who are employed. The state is, however, unable to ensure that enough jobs paid at the minimum wage are created. Controls on rent prices help those who have, or are given a flat. The state cannot ensure that a sufficient number of residential properties are provided. In fact, as a result of controls on rent prices, fewer properties are made available. Efforts to redistribute wealth should draw on taxation and transfers, rather than on price controls.