Which Policies Reduce Income Inequality?

BERKELEY – US President Barack Obama that growing income inequality and the inequality of opportunity that it creates are the defining challenges now facing America. These problems have risen to the top of the political agenda in the United States, but they are not uniquely American problems.

in the US in the late 1970’s, and the trend spread to Europe by the late 1980’s, affecting even countries with long egalitarian traditions by the start of the new century. On the eve of the Great Recession of 2008-2009, income inequality had reached all-time highs in the US and most developed countries.

The recession and the painfully slow recovery have caused , especially for children and young people entering the labor market. The fact that widening income inequality is a common feature of developed economies suggests common causes which are still not well understood.

It is widely believed that America’s income distribution is the most unequal among developed economies; but reality is more complicated. Income can be measured in two ways: market income before taxes and transfer payments, and disposable income after taxes and transfer payments. Surprisingly, inequality of market income before taxes and transfer payments in the US is , including those with egalitarian reputations like Sweden and Norway. Britain and even Germany have higher inequality of income before taxes and transfers than the US.

Among developed countries, the US does have the most unequal distribution of disposable income after taxes and transfer payments. That is ; indeed, its tax system is considerably more progressive than those of most European countries, Canada, and Australia, all of which rely on regressive value-added taxes as an important source of revenue.

But, among developed countries, the US has the least generous and progressive transfer system. The US spends a much smaller share of GDP on family-assistance programs – including cash transfers, tax breaks, and direct government services – than its developed-country counterparts, where reliance on regressive consumption taxes to fund progressive transfer programs has kept income inequality significantly lower.

Over the last 30 years, US economic policy aggravated rather than ameliorated income inequality. Both taxes and transfers became less progressive as market-income inequality widened. Indeed, according to a , the decline in tax and transfer progressivity accounts for about 30% of the growth in post-tax-and-transfer income inequality in the US during this period.

The US needs a more progressive and redistributive tax and transfer system to combat rising inequality in market incomes. But this is unlikely, at least in the near term. Republicans are implacably opposed to increases in social-welfare programs and higher taxes on the wealthy to finance them. And there is bipartisan opposition to a value-added tax, with Democrats fearing its regressive consequences and Republicans dreading its revenue-generating effectiveness.

To combat market-income inequality, the US also needs faster economic growth to boost the pace of job creation and reduce unemployment. The economy has been growing at less than half the rate that it did in previous recoveries, and the labor market has improved at an agonizingly slow pace.

Indeed, the unemployment rate, at 7%, remains elevated, despite a . About four million workers have dropped out of the labor force since the Great Recession began. Roughly eight million are working part-time, because they cannot find a full-time position.

Prolonged labor-market slack means falling real wages for most workers, with the negative effect growing as one moves down the wage distribution. The result is greater market-income inequality. From 2007 to 2012, , with larger losses for those holding lower-wage jobs. By contrast, real wages increased, albeit at a much slower pace than before the recession, for those in the top 30% of the wage distribution.

In his inequality speech, Obama reiterated several proposals to accelerate growth: increasing exports, reforming the corporate tax code, and investing more in infrastructure, R&D, and education. These proposals are both growth-enhancing and equity-enhancing. Yet Congressional approval is unlikely, and overall fiscal policy remains strongly contractionary, reducing growth by about 1.5 percentage points this year.

Obama also called for an increase in the minimum wage to combat income inequality. Here, prospects for Congressional approval look more promising, owing to strong voter support, with surveys showing that of Democratic, independent, and Republican voters support an increase.