Disentangling The Gordian Knot of Income Inequality

Disentangling The Gordian Knot of Income Inequality Name: Frans Folkvord Supervision: Prof. Dr. Wout Ultee Masterthesis Social & Cultural Science Radboud University 15-06-2011 D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 1

Abstract In this paper we tried to disentangle the Gordian Knot of income inequality. We tested economic, political, and sociological theories, to explain the increased income inequality in eleven Westerncountries. Results showed that political developments and differences between countries explain a large proportion of the variance of income inequality, measured as the Gini-coefficient, while economic and sociological characteristics like economic growth, unemployment, and female labour participation, explain only a minor part of the story. Furthermore, we tested a combination of household characteristics and macro characteristics to explain income at the household level. The results showed that education is an important explanation for household income, not only the education of the head and the spouse, but also assortative mating. We also found that being employed is strongly related with a higher income, but being self-employed does not lead to a higher income in every country. The macro characteristics explained the household income to some extent, but conducting future research with more waves would provide us with a clearer picture. In this attempt to disentangle the Gordian Knot of income inequality, we realized that further research is necessary to untie the knot. We found evidence which will hopefully stimulate future research in this topic, not only for reasons of justice, but also to prevent the negative consequences of increased income inequality. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 2

Contents The Gordian Knot page 4 1. Introduction page 4 2. Rising Inequality page 9 2.1 The Gini Index page 9 2.2 Top Incomes page 12 3. Theory and Hypotheses page 14 3.1 Economic Explanations page 15 3.1.1 Economic Growth page 15 3.1.2 Unemployment page 16 3.2 Political Explanations page 18 3.2.1 Neo-liberalization page 18 3.2.2 Social Expenditure page 21 3.2.3 Taxation page 22 3.3 Sociological Explanations page 23 3.3.1 Merits page 23 3.3.2 Changing Demographics page 26 4. Data and Measurement page 28 4.1 Dependent Variable page 29 4.2 Independent Variable page 29 4.2.1 Political Characteristics page 29 4.2.2 Economic Characteristics page 32 4.2.3 Sociological Characteristics page 32 4.2.4 Luxembourg Income Study page 33 4.2.4.1 Dependent Variable page 33 4.2.4.2 Independent Variables page 34 5. Results page 36 6. Discussion page 60 7. Conclusion page 64 8. Bibliography page 66 D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 3

The Gordian Knot In a Greek legend, the Gordian knot was the name given to an intricate knot used by Gordius to secure his oxcart. Gordius, who was a poor peasant, arrived with his wife in a public square of Phrygia in an oxcart. An oracle had informed the populace that their future king would come riding in a wagon. Seeing Gordius, the people made him king. In gratitude, Gordius dedicated his oxcart to Zeus, tying it up with a peculiar knot. An oracle foretold that he who untied the knot would rule all of Asia. Many people tried to undo the knot but all to no avail. In 333 B.C. Alexander the Great had invaded Asia Minor and arrived in the central mountains at the town of Gordium; he was 23. Undefeated, but without a decisive victory either, he was in need of an omen to prove to his troops and his enemies that the outcome of his mission - to conquer the known world - was possible. In Gordium, by the Temple of the Zeus Basilica, was the ox cart, which had been put there by the King of Phrygia over 100 years before. The staves of the cart were tied together in a complex knot with the ends tucked away inside. Having arrived at Gordium it was inconceivable that the young, impetuous King would not tackle the legendary "Gordian Knot". Alexander climbed the hill and approached the cart as a crowd of curious Macedonians and Phrygians gathered around. They watched intently as Alexander struggled with the knot and became frustrated. Alexander, stepping back, called out, "What does it matter how I loose it?" With that, he drew his sword, and in one powerful stroke severed the knot. That night there was a huge electrical storm, which the seers conveniently interpreted to mean the gods were pleased with the actions of this so-called Son of Zeus who had cut the Gordian knot. (www.alexander-the-great.co.uk/gordianknot.htm). 1. Introduction The Greek mythology is often used nowadays, to express the deeper, underlying meaning of these legendary stories. The metaphor in this story about the Gordian Knot can be used with comparison to the problem that we face in this article, the puzzle of income inequality. This paper reviews the empirical evidence on the level and trend in household income inequality in a great variety of countries, and will look for causes that can explain the income position of households in different countries. The increase in economic disparities over the past 30 years has led to extensive research on the causes and consequences of income inequality. The distribution of wealth and income has been studied for quite some time, starting by Plato, and followed by many other philosophers, economist, sociologist, and political scientists. Gerhard Lenski (1966, p. 13) states that.. inequality among societies has been a basic fact of human life for more than five thousand years. Every known society, past or present, distributes its scarce and demanded goods and services unequally. The more rigidly stratified a society is, the less chance does that society have of discovering any new facts about the talents of its members. Where, for instance, access to education depends upon the wealth of one s parents, and where wealth is differentially distributed, large segments of the population are likely to be deprived of the chance even to discover what are their talents. The distribution of wealth is not only an issue of justice, but it also affects many different aspects of a society. Where many scholars and politicians see Adam Smith as the leading economist for the free-market principle and establishing ones own wealth, Smith also recommended that "No society can surely be flourishing and happy, of D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 4

which the far greater part of the members are poor and miserable." (Smith, 2008, p. 78). Rising income inequality can be a good thing to the extent that it is crucial to reward work effort, talent and innovation key engines of economic growth and wealth creation (Davis & Moore, 1945). However, there are instances where income inequality reaches excessive levels, in that it represents a danger to social stability while also going against economic efficiency considerations (Wilkinson & Pickett, 2010). Higher income inequality is associated with higher crime rates and lower life expectancy. Higher inequality may also deepen macroeconomic instability in the sense that lowincome households may adjust more slowly to economic shocks. In addition, there are instances where richer groups may secure economically-inefficient advantages, such as distortive taxes or an allocation of public funds that goes against the economic interests of the country as a whole. More fundamentally, when income inequalities are perceived to reach excessive levels, social support for pro-growth policies may be strongly eroded. Already now, there are widespread perceptions in many countries that globalization does not work to the advantage of the majority of the population (World of Work Report 2008). According to the influential historian Tony Judt (2010), an unequal distribution of income and wealth has led to a great variety of problems in Western societies. Income inequality is strongly related to an increase in health- and social problems like number of murders, mentally ill, average life expectation (Judt, 2010a). Wilkinson and Pickett show us that income inequality is also linked to less social mobility, more criminality, lower life expectancy, more teenage mothers, obesity, level of trust, children s educational performance, homicides, and imprisonment rates (Wilkinson & Pickett, 2010). In this study, we will examine how income inequality has evolved over the last three decades, and which underlying dynamics and mechanisms are causing these trends. Income inequality has been examined by researches from three different approaches, which led to a diverse spectrum of explanations that caused the rise in inequality (Atkinson, 2003; Rossides, 1997; Weeden, Kim, Carlo, & Grusky, 2007). We will start with describing these three perspectives. In the first place, economists put several causes forward, like differences in labor market (Gottschalk & Smeeding, 1999; Klein, 2002), employers and employees unionization within countries (Klein, 2007; Marx, 2008; Visser, 2010; Weeks, 2005) minimum wages and the increased wages of high incomes (Green, 2007). Secondly, political researchers focus on the redistribution of taxes, electoral systems within countries (Bergh & Nilsson, 2010; Iversen & Soskice, 2006), and the duration of democracy and socialist legislation of countries (Hewitt, 1977b). The third approach toward causes of inequality comes from the sociologists. Where economists have studied inequality for some time, Green (2007), as an economist, wonders where the sociological researchers have been. The causes and consequences of inequality have been neglected by sociologist for too long. To be fair, there were historical reasons for this neglect (Myles and Myers, 2007). Weeks (2005; p. 1) states that the current discourse on inequality within countries, and especially within the developed market economies of the Organization for Economic Cooperation and Development (OECD), must be placed in historical D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 5

context. Therefore, we will start by describing the historical context that has influenced the income inequality. After World War II, many civilians realized that their life showed more insecurities than they could have imagined before the war (Cornia & Kiiski, 2001; Judt, 2010a). This collective consciousness arose after the World War II, when the cities had to be building up from scratch. This awareness led to a tendency to improve the welfare state to create more security and to build a social safety net for the elderly, the sick and the unemployed (Judt, 2010b; Mak, 2009; Swaan, 2004). This solidarity with the less privileged was a result from the War, that showed what insecurity could do to many people. The people realized what mass unemployment and poorness did to people, like the 1930s in Germany. Of course this was not the only cause for the rise of Hitler, but it was one of the most important causes (Judt1, 2010). The tax rates and the politics of redistribution developed in a manner that the highest income deciles paid more taxes and the lower income deciles received more social welfare after this post-war period. From the end of the Second World War to the end of the 1970s, the distribution of income in most affluent democracies, and in the United States in particular, remained relatively stable (Deininger & Squire, 1996; Kenworthy, 2007; Kenworthy & Pontusson, 2005a). Studying trends in income inequality was like watching the grass grow (Myles & Meyers, 2007; p 579). All this changed around the 1980s, when the secular trend of rising inequality in earnings and family income that began in the 1970s became apparent (DiPrete & Eirich, 2006; Van Dam, 2009; Van Rossem, 1984). Most research that focused on income inequality that started from the 1980 s, was macro-level research, whereby most research was conducted in a narrative way (Wilterdink, 1985, 1995; Wilterdink & Van Heerikhuizen, 1985). Around the 1980s, there was a political trend visible in the Western countries, called neoliberalism, whereby the power of unions decreased and the influence of the economic elite increased (Klein, 2002, 2007; Reich, 2007; Soros, 2008). A clear example of this scenario can be seen in the political decisions of Margaret Thatcher and Ronald Reagan, respectively in the United Kingdom and the United States. Their policy gave less power to unions and more power to employers, lowered the tax collection and decreased the tax redistribution. Many institutions and companies that were state management were privatized, whereby the influence of the state was minimized, according to the theory of Milton Friedman (Achterhuis, 2010; Klein, 2007). These neoliberal policies were seen as extreme changes in most of the other developed countries, but many aspects of these policy changes were acquired by many Western countries as well (Van Dam, 2009). This revolution of political changes, is sometimes called the end of history, whereby it is assumed that there is no struggle between ideologies, the neoconservative simply over won the communistic ideology (Fukuyama, 2006). As a consequence of these political changes, inequality increased during the 1980s till now, whereby rich people became richer and poor people stayed poor. These trends teach us that it is quite remarkable that most sociologists stood on the sidelines, D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 6

while many economists tried to account for this development. Part of the story has to do with the shift in focus among sociologist from the structure of inequality to the allocation of individuals to positions within that structure. Social inequality now is thus an unconsciously evolved device by which societies insure that the most important positions are conscientiously filled by the most qualified persons (Rousseau, 2003). Hence every society, no matter how simple or complex, must differentiate persons in terms of both prestige and esteem, and must therefore possess a certain amount of institutionalized inequality. This was what sociologist started to examine, which was already mentioned by Max Weber in the beginning of the 20 th century (Weber, 2009). Put another way, in the 1970s and 1980s, there was a gradual but significant move from investigating how much inequality there is (and why) to examining determinants of attainment (H. Ganzeboom et al., 1987; H. Ganzeboom, Treiman, & Ultee, 1991). The sociologist, who did study the rising inequality, came up with three main developments that occurred at the macro level that led to increased inequality. These three developments are the increased computerization of the labor market, assortative mating and the increased women employment (Milanovic, 2000; Moene & Wallerstein, 2001; Myles, 2003; Myles & Meyers, 2007). Other causes that have been studied by sociological scholars are: technological changes (Berry, Bourguignon, & Morrison, 1983; Leigh, 2004; Toffler, 1990), globalization (Klein, 2007), deindustrialization, de-unionization (Klein, 2002, 2007), a decreasing significance of nation-state democracy (Lincoln, 2007; Reich, 2007), changing demographic (Esping-Andersen, 2007; Leigh, 2004), and welfare state retrenchment (Esping-Andersen, 1990, 2002). Changing demographics, like the increased women s educational attainment, increasing labour force participation of women, educational homogamy, and skill-biased technological change, are sociological explanations for the increased inequality. In this research, we want to focus on the integration of these indicators into a more exhaustive explanation that can explain the relation of sociological, economic, and political aspects with the rise in inequality around the 1980s in industrialized countries. We want to find a causal relation between macro and micro developments that can explain the increased income inequality in some countries and did not increase in other countries. Narrative explanations, like the increased interdependence theory of Wilterdink (Wilterdink, 1985, 1995; Wilterdink & Van Heerikhuizen, 1985) will not suffice, because we want to find causal relations, while we are controlling for other indicators. The descriptive method that is chosen by many scholars is not the method we will use. We will choose for quantitative analyses of the data to examine the causal relations. The countries that we choose are; the United States, the United Kingdom, Australia, Sweden, Norway, Finland, Denmark, Germany, the Netherlands, Canada and France. These countries that we have selected are chosen according recent literature that described the income trends from the 1960s till the middle of the 2006. According to this literature, we can divide these countries into three groups (Cornia & Kiiski, 2001; Weeks, 2005). The first group shows a de-equalizing effect after the Second World War, till the 1970s. After D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 7

this period, we see a strong increase in the inequality in these countries, till the middle of the 21 st century (Leigh, 2004). These countries are Australia, the United States of America, and the United Kingdom, also called the Anglo-Saxon countries (Weeks, 2005). New Zealand is normally included in these Anglo-Saxon countries, forming the Anglo-Saxon-Four, but the Luxembourg Income Study (LIS) has no data for New Zealand. Therefore we decided to leave New Zealand out of analyses. The second group are the Scandinavian countries, with Denmark, Finland, Norway and Sweden as their members. These countries show an enormous equalizing effect of their income inequality, starting after the Second World War, except for Denmark, which shows a relatively minor decline. The third group are Other Western Countries, which show a minor equalizing of the income inequality after the Second World War till the 1980s, followed by a period of minor increase of the income inequality from the 1980s till 2006. For these countries, we will examine three different questions. First of all, we will try to find an answer on the question how the income inequality trends have developed over time in these eleven different countries. We will do this by looking in the first place at the decreased inequality between 1945 till 1980, secondly at the increased inequality after this period (1980-2010). Next, we will try to find an answer which country characteristics explain the Gini coefficients in these countries in the different country-year combinations between 1960-2004/2007. In the third place, we will try to explain how these developments occurred, which dynamics are playing on the background and how these dynamics resulted in the developments that we have found in the first research question. This way, we can integrate the possible explanations from sociological, political, and economic point of view in one thesis, whereby we can look at the different effects of the different variables in the countries that we will examine. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 8

2. Rising Inequality 2.1 The Gini-index Our first research question concerns the increased income inequality in industrialized countries. In previous research, it is generally found that income inequality rose in the last three decades for OECDcountries (Bradley, Huber, Moller, Nielsen, & Stephens, 2003; Lemieux, 2006; Nordstrom & RIdderstrale, 2003; Solimano, 2001). The rich become richer, and the poor become poorer (Iversen & Soskice, 2004). We will examine the development of the Gini coefficient for 11 countries that we have chosen and we will examine the distribution of the income of the income elite of 11 countries. These eleven countries are the United States, United Kingdom, Netherlands, Germany, Canada, France, Australia, Germany, Norway, Sweden, Denmark and Finland. In most existing literature, the measure of inequality is presented with the Gini coefficient (Kenworthy & Pontusson, 2005). The Gini coefficient assigns diminishing weights as incomes rise, which can be seen as an advantage if one is inequality-averse (Weeks, 2005). The major drawback is that it is relatively insensitive to changes in the middle range of a distribution. Many measures are used in empirical work, and our presentation restricts itself to the Gini coefficient, not particularly because of its superiority over other calculations, but because of the frequency of its use and its easiness to understand. Therefore, we will look for the Gini coefficients over time for the different countries. Besides this Gini coefficient, many scholars have described the increased inequality by studying the income distribution for the elite, especially the top 0,1 %, 1 %, 5 % and 10 % of a country. When these groups have acquired a larger peace of the cake, the income inequality will automatically increase. After we described the Gini coefficient, we will look for these shares in each of the country over time. The Gini coefficient is mathematically based on the Lorenz curve, which plots the proportion of the total income of the population that is cumulatively earned by the bottom percentages of the population. The Gini coefficient can then be thought of as the ratio of the area that lies between the line of equality and the Lorenz curve over the total area under the line of equality. The Gini coefficient can range from 0 to 1, or 0 to 100. A low Gini coefficient indicates a more equal distribution, with 0 corresponding to complete equality, while higher Gini coefficients indicate more unequal distribution, with 1 corresponding to complete inequality. To be validly computed, no negative goods can be distributed. Thus, if the Gini coefficient is being used to describe household income inequality, then no household can have a negative income. When used as a measure of income inequality, the most unequal society will be one in which a single person receives 100% of the total income and the remaining people receive none (G=1); and the most equal society will be one in which every person receives the same percentage of the total income (G=0). The Gini coefficient's main advantage is that it is a measure of inequality by means of a ratio analysis, rather than a variable unrepresentative of D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 9

most of the population, such as per capita income or gross domestic product. It is sufficiently simple that it can be compared across countries and be easily interpreted. General Domestic Product (GDP) statistics are often criticized as they do not represent changes for the whole population; the Gini coefficient demonstrates how income has changed for poor and rich. If the Gini coefficient is rising as well as GDP, poverty may not be improving for the majority of the population. Therefore, the Gini coefficient can be used to indicate how the distribution of income has changed within a country over a period of time, thus it is possible to see if inequality is increasing or decreasing. To get a clear picture of how the inequality evolved over the last three decades, we used data from the World Institute for Development Economics Research of the United Nations University (UNU-WIDER), but because of lack of data in some years we used linear polation to estimate the years for which we did not have any information for. If we look at the Gini coefficients for the 11 different countries that we selected, we immediately notice three different groups. The first group that we selected is the Anglo-Saxon countries, with Australia, United Kingdom and the United States. If we look at these three countries in Figure 1, we can see that the three countries show the same trend, beginning with a decline of the inequality around the middle of the 1960 s for the United States, in the middle of the 1950 s for the United Kingdom and in the beginning of the 1950 s for Australia. This trend continued till the end of the 1970 s and the beginning of the 1980 s, where we see a strong increase in the Gini coefficient in all three countries, till the beginning of the 20 th century. In the beginning of the 20 th century, we see a small decline for Australia and the United Kingdom, but for the United States of America we see still an increase. What is not in this graph, but nevertheless is very remarkable, is that the United States had a Gini coefficient of 47 (highest every reported) in 2007. Figure 1: Gini coefficients between 1942 and 2006 for the Anglo-Saxon Countries. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 10

In Figure 2 we see the Scandinavian countries and their Gini coefficient over the last 60 years. We see that the Scandinavian countries started with a high inequality coefficient after the second world war, but show a strong negative trend; their Gini coefficient declined in 60 years. Especially Sweden showes an enormous decline of the Gini coefficient over these 60 years. The same accounts for Norway and Finland, may it be to a lesser extent. The Gini coefficient of Denmark shows a somewhat different trend, by first showing a minor decline between 1942 and 1966, a small increase between 1966 and 1978, a second somewhat stronger decline between 1978 and 1990, followed by a second, stronger increase between 1990 and 2003. Denmark differs significantly from the other three Scandinavian countries if we compare these trends. Figure 2: Gini coefficients between 1942 and 2006 for the Scandinavian Countries. The Other Western Countries show the same pattern as the Scandinavian countries, where it be that they show a somewhat different pattern from the beginning of the 1980 s. All four countries show an enormous decline of the Gini coefficient if we compare with the 1940 s till the middle of the 1980 s. After this decline, we see a small increase in the Gini for Canada, the Netherlands and Germany. France shows the same trend as the Scandanavian countries, from the start of the 1960 s till the beginning of the 21th century we see a decline of the Gini coefficient. If we look at the Netherlands, Canada, and Germany, we see that they show a increase from the 1980 s and the beginning of the 1990 s. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 11

Figure 3: Gini coefficients between 1942 and 2006 for Other Western Countries 2.2 Top Incomes We have seen that there are some differences regarding the Gini coefficients between the eleven countries. To study these distributions more specifically, we can also look at the income distribution of the top incomes and try to recognize a pattern. In this section, we want to describe the distribution of the total income over the years between the 1980s till now, looking especially at the incomes of the top 0,1 %, 1 %, 5 % and 10 %. This is importantly because many scholars have found that these groups earn more and more money, while the rest of the society falls behind (Krugman, 2006; Wilterdink, 1995). If we find that these groups show a strong increase in income, we may conclude that these countries are not meritocratic, but oligarchic (Dew-Becker & Gordon, 2005). According to Wilterdink (1995), there is an increase of the socioeconomic inequality in the prosperous societies since the end of the 1970 s, especially in the United States. The economic position of large parts of the population deteriorated, mainly the lower income deciles, whereas the already privileged minority improved their position substantially. In the USA, there was a decline of the average real family income of the least earning half of the American population fell by 7 %, and that of the lowest decile by 15 % (Wilterdink, 1995). On the other hand, between 1977 and 1988 the average real after-tax family income of the most prosperous 10 % of the American population rose by 16 %, that of the top 5 % by 23 %, and that of the top 1 % by hardly less than 50 %. Comparable trends took place in other Western countries, for example in Great Britain, where the income of the highest income decile rose by 30 % between 1979 and 1990. In France, Germany, the Netherlands and Sweden we see the same pattern. In the Netherlands between 1983 and 1991 fell the average real D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 12

disposable income of the poorest 20 % by about 10 %, while the average income of the most prosperous 20 % increased with 12,5 %. In the United States the trend towards more inequality increased started earlier and was more profound than on the European continent. Despite the international differences one can speak of one international trend common to western societies in general towards more inequality in the income distribution (Wilterdink 1995). Krugman (2006) described the increased incomes of America s oligarchs in the New York Times, whereby he stated that the economic growth of the recent decades was distributed mainly under a few lucky ones. From 1972 till 2001, he sees an increase of the income at the 90 th percentile of the income distribution of only 34 %, which means that their income increased with 1 % on average each year. The income at the 99 th percentile rose with 87 %; the income group at the 99,9 th percentile rose with 181 percent; and income at the 99,99 th percentile rose 497 % percent. These large differences point out that only a few have profited a lot from the economic growth that we have faced during the last three decades, while many others have seen their income decline, remain stable, or increase with a small percentage. As we have seen, the increased income inequality is very much driven by the top pulling ahead of the rest (Esping-Andersen, 2007). The ratio between the top and the middle decile rose from 1.8 to 2.2 in Britain, from 2.6 to 3.0 in the United States, and from 1,5 to 1.7 in Sweden. The bottom is now losing ground in the United States, Finland, Germany, Sweden, and the United Kingdom, but anything that approximates de factor polarization is limited to the United Kingdom and United States (Esping-Andersen, 2007). Young adults face an erosion of relative wages at all skill levels while being hugely overrepresented among the unemployed and those with precarious, short-term employment contracts (H. Ganzeboom, Kalmijn, & Peschar, 1995). The deteriorating position of young workers in combination with the rise in lone parenthood helps account for growing child poverty. According to calculations by Esping-Andersen (2007), the Scandinavian countries have succeeded in stemming the tide but elsewhere, child poverty has risen sharply; by from 4 to 7 percentage points in Germany, the Netherlands, the United Kingdom; and the United States, starting at a very high level (19 % in 1980), saw child poverty growing an additional 3 points. In contrast, the top earners are leaping ahead in many countries. In Britain and the United States, the topmiddle decile ratio rose by 15 % to 21 %. This happened not only in the three English speaking countries; in the Netherlands and Sweden with 8 %, in Germany with 7 %. Wage erosion at the bottom is less severe and also less common. The bottom decile has lost ground in Germany and Sweden (a 6 % to 7 % decline relative to the middle) and more substantially so in the Netherlands, the United Kingdom, and the United States (a 9 % to 11 % decline). Now we have seen that in the United States and the United Kingdom the top incomes show enormous increases of their income, while the lower incomes have to face a decline or stable income, other countries show a different picture. In the next section we will examine which dynamics and mechanisms can explain these developments. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 13

3. Theory and Hypotheses Now we have answered our first research question, we want to examine the explanations of the different trends in income inequality. Coming back to the Greek myth, the Guardian Knot, we want to examine how this knot is made and how we can try to untie it. Put it in a scientific context: we want to describe which macro-indicators can explain the trends in inequality. Therefore, we will tests political, sociological, and economic factors that may contribute to inequality in countries. There have been three basic approaches to the assessment of how global income distribution has evolved in the latest era of globalization (Torres, 2008). The first approach involves a consideration of within-country inequality; this approach takes into account the income distribution within countries using measures such as the Gini index to illustrate the entire income distribution of a country. Recent studies, including this study, find that within-country inequalities have increased over the past two decades or so, especially in the Anglo-Saxon countries. A second way of measuring inequality is the international inequality; this method measures differences in average incomes across countries. There are no references made to income distribution within each country as it is assumed, in this method of measuring inequality, that people have the mean income of their countries. According to Torres (2008), international income inequality has tended to decline. A third approach is global inequality; an approach that takes into account both within- and between country income inequalities. In this section, we will examine the within-country inequalities whereby we will look which factors explain Gini coefficients of the selected countries. This will provide us with an answer on the second and third research questions, respectively which factors explain the Gini coefficients and which factors explain household income in the different countries. For the second question, we will use macro explanations, while we will use household and cross level interactions to examine the third question. We will examine whether the macro-explanations that we assumed to have a relation to the Gini coefficients do have a causal relation with the Gini coefficients for the Anglo-Saxon countries, the Other Western countries, and the Scandinavian countries. Secondly, we will examine factors that underlie the within-country inequality for households, whereby we will examine the factors that explain the income inequality on the household level within Canada, France, United States, United Kingdom, Netherlands, Germany, Sweden, Denmark, Norway, Finland, and Australia, over a time period of three decades, controlled for contextual factors at the country level. Within-Country Inequality In this section, we will describe theoretical assumptions and empirical findings that explain the withincountry income inequality. We will start with economic explanations, followed by political explanations, and end with sociological explanations. The explanations that are hypothesized to relate to the increased income inequality are described and translated in hypotheses which we will test in chapter 5. Because we will use different data sets, it might be helpful to explain here that we made a D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 14

differentiation in our hypotheses. Hypotheses that are formulated about the Gini coefficient are hypotheses that we will examine in a regression analysis and are used to test whether these macro variables also influence income on a household level. Hypotheses that are formulated about household income will be tested with multilevel analyses in LIS-files, with macro variables as context effects. 3.1 Economic Explanations The distribution of income is a key issue for economic scholars. Searching for economic explanations to explain the income inequality brings us to models concerning economic growth, unemployment rates, real wages, productivity, and wage shares. If people want to become more prosperous and wealthier, economic growth is seen as an important factor to achieve this. Economic policy advices politicians to develop a reform that stimulates the economy to grow. This is the main idea behind the great economic reforms that occurred, from socialism to Nazism (Achterhuis, 2008). The same is happening nowadays, where the liberalization of the economy should lead to more economic growth and more wealth (Chang, 2010). The liberalization was implemented to make people run faster, because they would run for their own income, and the faster you ran, the more income you would generate (Achterhuis, 2010; Chang, 2010). This should lead to economic growth, less income inequality, less unemployment, higher real wages, higher productivity, and fairer wage shares (Torres, 2008). Because the income inequality did not decrease, but increased in most of the countries, we will examine the mirror image of economic factors that should lead to less income inequality but led to an increased inequality. 3.1.1 Economic Growth It is evidently in contrast with the law of nature however one may define - that a child orders a greybeard, that a fool leads the wise, and that a handful of people go beyond abundance, while the mass is suffering from hunger and shortage. (Rousseau, 2003)(own translation) Deininger and Squire (1996) state that there is a systematic link between economic growth and changes in aggregate inequality; like the Gini coefficient. This means that if economy grows, its gross domestic product (GDP) per capita increases, which will lead to more redistribution and will reduce poverty in a country. If the GDP increases, the market value of all final goods and services made within the borders of a country increase. If economies grow, poverty will reduce in a country because the lower deciles earn more, unemployment will be lower and the productivity will increase due to investments (Chang, 2010). When more people are working, tax collection is higher and the social expenditure is lower. When countries grow in economic sense, it will be also more accepted that the government will extend the social welfare to build a stronger safety net for the elderly, sick and unemployed. This will lead to a decrease in the income inequality. Paul Krugman stated it as follows (1990, p.9) Productivity isn t everything, but in the long run it is almost everything. A country s ability to improve its standard of living over time depends almost entirely on its ability to raise its D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 15

output per worker. The essential arithmetic says that long-term growth in living standards depends almost entirely on productivity growth. When productivity in a country increases, the average production per capita increases, contributing to an economic growth because the price of products will decline and the ability for people to buy commodities increases. The relation between living standards and income is linear, and in most countries with a high income inequality, we also see that more people are living under the poverty line, have a lower life expectancy, poorer physical health, and more violence (Wilkinson & Pickett, 2010). There most of the countries have shown a trend of economic growth over the last three decades, we would expect that the income inequality has decreases over the last three decades (Chang, 2010; DiPrete & Eirich, 2006; Torres, 2008). The hypothesis concerning economic growth is that we expect that economic growth relates negatively with income inequality. According to a wide range of authors, this is where the theoretical assumptions provide us with false predictions of the consequences in real life (Achterhuis, 2010; Dew-Becker & Gordon, 2005; Torres, 2008). A basic tenet of economic science is that productivity growth is the source of growth in real income per capita, which will lead to less income inequality. In a very detailed and thorough research, Dew-Becker and Gordon found that only the top 10 percent of the income distribution enjoyed a growth rate of real wage and salary income equal to or above the average rate of economy-wide productivity growth (Dew-Becker & Gordon, 2005). Put it differently, only the most successful people have enjoyed the productivity growth of the society as a whole (Chang, 2010). Just as economic and sociological studies of internal labor markets have been central to the study of wage and earnings inequality, we believe studies of compensation practices at the very top, and corporate governance institutions more generally, should be of increasing relevance to the study of rising income inequality (Wilterdink, 1995). According to Dew-Becker and Gordon (2005), too much emphasis has been placed on skill-biased technical change and too little attention on the incomes of superstars, like the CEOs, sports stars, and entertainment stars. As these economists and sociologists have shown, economic growth is not shaded out evenly. The larger share of the economic growth and the prosperous consequences are mainly distributed to the top of the income population. We therefore hypothesize that economic growth is positively related to income inequality. 3.1.2 Unemployment In the 1970 s, global economic power relations started to change towards less favorable results for the western societies. Rising costs at the one hand, and stagnation of sales due to intensified international competition on the other led to many problems for companies (Judt, 2010b). Internationalization was necessary to survive as a company, moving parts of the production to countries where labor costs were lower. In this period, nothing extraordinary happened with internal economies (Wilterdink, 1995). This changed in the 1980 s where many inhabitants became unemployed. Unemployment was rising to double digit levels, employees became more unilaterally dependent on employers for work, and labor D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 16

unions lost power, prestige, and members (Visser, 2010; Visser & Hemerijck, 1998). Policy changes could not reduce the unemployment, but they made rising profits possible. During the recession of the first half of the 1980s, growing unemployment and decreasing investments went hand in hand with growing capital incomes and rising share prices (Wilterdink, 1995). In the second half, growing employment did not result into more equality, because of the stagnation of the real wages in the lower deciles, to compete with countries that have lower labor costs, and social benefits from being cut (Klein, 2007). When the national unemployment rate is high, compared to other years, the pressure to lower the welfare state benefits increases. As more workers in different countries compete for the same jobs, the negative pressure on wages in the comparatively prosperous countries grows, which leads to a decline in wages in the prosperous country (Checchi, Visser, & van de Werfhorst, 2010; Visser, 2010). The costs to take care of the unemployed increased when the total number of unemployed rise, which will enlarge the social expenditure. In times of high unemployment, it is not wise to raise taxes, because this will lead to a decline in the consumption, which will enforce the unemployment rate. This will not be the policy change that people will hope for. What we see in most of the countries nowadays, is that they cut social expenditure. For example, the age of retirement is becoming higher in almost every Western country, the budget for the unemployed is declining, the expenditure for the mentally ill and handicapped decreases. This increase in unemployment will be followed by a retrenchment; otherwise the pressure of a negative account on the general expenditure in a country becomes too great. Especially considering the regulations for participation to the Euro, it is wise to have a balanced national budget. We therefore hypothesize that if the overall unemployment is high, the income inequality will be higher, due to pressure on the welfare state and the need for retrenchment. If the unemployment in a country is high and concentrated among the lower educated, bargaining power for wages and labor conditions for the employees will decline. Earlier experiences suggest that the job losses entailed by systemic financial crisis have been especially strong, with long lasting effects on vulnerable groups. Unemployment will also rise significantly as a result of the investment slump and this may further intensify income inequalities. The supply and demand is unbalanced, where there are many people who want a job, while there are not many jobs to be distributed. This will lead to lower wages, which have to be accepted by the unemployed; otherwise they will have no income at all. To summarize, lower educated will feel being unemployment more intense than people who are higher educated. We therefore hypothesize that, unemployment for lower educated is stronger related to income than the relation between unemployment and income for higher educated. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 17

3.2 Political Explanations Concerns about growing inequality in incomes (and also earnings and wealth inequality) have fueled social and political debates in many OECD countries (Gottschalk & Smeeding, 1999). According to a wide range of authors, the political system plays a key role in the inequality in a country (H. Ganzeboom, et al., 1991; Hewitt, 1977a; Iversen & Soskice, 2004; Lenski, 1966, 2005; Ultee, Arts, & Flap, 2003; Van Dam, 2009). Politics and institutions are able to inhibit or facilitate the effects of economy, not only by redistribution of taxes but also by the opportunity to unionize, improve labor relations and labor standards, but also to increase the social safety net for the employed and unemployed (Chang, 2010; Jalee, 1970; Julien, 1969; Visser, 2010; Visser & Hemerijck, 1998). In this section, we will describe how the politics have evolved over the last three decades and which consequences occurred due to these developments, according to the narrative articles and books by many scholars. 3.2.1 Neo-liberalization We noticed that the Anglo-Saxon countries show an enormous increase in the income inequality during the 1980 s till 2006, while the Scandinavian countries and the Other Western Countries do not show this trend and show a minor rise of inequality or a decline in income inequality. The absence of a global pattern is strong prima facie evidence that trends and non-trends reflect policies, not inexorable forces beyond the influence of governments (Weeks, 2005). Countries with centralized wage-setting institutions (Germany, the Netherlands), a high union density and adequate minimum wages (France) contained the pressure towards higher earnings inequality. In contrast, countries with decentralized wage negotiations and flexible labour markets experienced the largest increases in earnings inequality (United States and United Kingdom). An increase of the share of financial rents, urban land rents and profits contributed to the growing dispersion of total incomes. The fairness of the tax and transfer systems declined, as transfers fell relative to gross domestic product and personal income tax became less progressive (Wilterdink, 1995) As we have seen in Figure 1, 2 and 3, there are clear differences in the trends between the Anglo-Saxon countries, the Scandinavian countries, and the Other Western Countries. After World War II, a consensus between the leaders of mainstream parties in the developed countries arose that the two great authorial political systems of the century, fascism and communism, had in no small part arisen from the consequences of instabilities inherent in market economies (Achterhuis, 2010; Weeks, 2005). Soon after the second world war, the prominent economist Rothschild made this connection in what was perhaps the profession s leading periodical (Weeks, 2005). The economic journal, wherein he described the tendency towards concentration of economic power in major international markets as the most violent aspect of the oligopolistic struggle, the attempt of the biggest oligopolistic groupings to regroup their forces on a world scale (Rothschild, 1947; p. 318). He went on that Fascism has D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 18

been largely brought into power by (the) struggle of the most powerful oligopolists to strengthen through political action, their position on the labour market and vis-à-vis their smaller competitors, and finally to strike out in order to change the world market situation n their favour (Rothschild, 1947; p. 318). Rothschild s major fear was that this would occur again if there were no solutions found for the deregulation of the power of oligopolistic market leaders. The commitment of post-war leaders to preventing the international rise of uncontrollable corporate power had its domestic aspect, which was pursued with even greater zeal (Judt, 2010b; Weeks, 2005). Along with the concern that the rise of corporate power was a threat to democratic institutions went the closely linked view that excessive concentrations of private income and wealth was a manifestation of that threat at the household and individual level (Reich, 2007). The primary concern for companies was to make profit, not to take care of their employees and the civilians (Soros, 2008). The broad political support for policies to restrict the concentration of wealth came from strong trade union movements in most of the countries, which, again, at the beginning of the twenty-first century seems an anachronism (Weeks, 2005). In contrast, the rivalry between the Soviet-Union and the United States, between the Communism and Capitalism, reinforced the political commitment in the free world to policies limiting inequality, with the political leadership in Washington recognizing a need to demonstrate the superiority of the market system in providing for the welfare of its citizens, according to the free market principle of Friedman (Achterhuis, 2010; Fukuyama, 2006; Klein, 2007; Weeks, 2005). This is exactly what happened during the end of the 20 th century, according to Klein (2002; 2007). The leaders of the United States and the United Kingdom, respectively Ronald Reagan and Margaret Thatcher, reinforced the laissez-faire ideology in the 1970 s and 1980 s. Many state owned companies became privatized and in the hands of large corporate companies, whereby the main difference lies in the fact that state owned companies focus is to fulfil their duty to take care of the citizens, while privatized companies focus is to make profit, preferable as much as possible. Klein (2002; 2007) argues that the neo-liberalization led to more power for major market leaders and less power to unions and employees in many industrialized countries. The economic reforms that led to a free movement of commodities and of capital resulted in less power for people working in the centre of the economic world. Weeks (2005), postulated that the increased inequality in some countries supports the conclusion that the deregulations of markets, resulting in the concentration of economic power, is the fundamental cause as well as the gross manifestation of inequality of both income and wealth. If this conclusion is true, it should be the case that countries that developed this laissez-faire theory more extensively should have a greater inequality than countries that did this in a lesser extent. According to Klein (2002; 2007) and Weeks (2005), we can conclude that the Anglo-Saxon countries can be divided from the other countries, whereas they have followed the free market principle in a lesser extent. D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 19

Three important facts that support this theory, concerning that the neo-liberalization of government is an important indicator for the rising inequality, are described by Weeks (2005). The first argument that Weeks (2005) discusses is that it should not be controversial to state that the three Anglo-Saxon countries pursued a broadly similar policy programme that has come to be called neoliberal. All three the countries, United Kingdom, United States, and Australia, followed broadly the same economic and social policies, with labour market deregulation perhaps being the most important policy. This les to a decrease in the share of wage employees in trade unions, the union density. The advantages of unionization for workers, for example, reduction of mutual competition, possibility of collective action, standardization of agreed upon conditions of employment, have no, or limited application at the international level (Checchi, et al., 2010). Unions remain bound and oriented nationally, much more so than corporations. Secondly, the countries that show an enormous increase in especially the 1980s and in the beginning in the 1990 s, manifested this broadly similar policy agenda most vigorously in the 1980 s and in the beginning 1990 s. The last argument is that before this period in each of these countries set pace, the inequality was lower in the period pre-liberalization then it is in the liberalized period. The major instruments that can be used by governments to restrict the accumulation of wealth an income in a few hands are progressive taxation, universal entitlement programmes and collective bargaining. These instruments mediated the link between labour and product market competition and the distribution of income, such as what has happened in the 1950 s and 1960 s in the Anglo-Saxon countries, and over a longer period in the Western-European and Scandinavian countries. Low crosssectional inequality, low income insecurity, and nevertheless open and dynamic economic structures were thus a joint outcome of, especially, social democratic and corporatist welfare regimes in Europe (Gangl, 2005). But in the years of neo-liberalization, these instruments were regarded as socialist and communistic, like in the Soviet-Union (Judt, 2010b; Rossum, 1984). Empirical evidence supports the view that in countries in which inequality increased, this was primarily the results of the decline in the importance and bargaining power of organized labour, aggravated by unemployment and reductions in government expenditure (Weeks, 2005). Weeks shows us that it is possible to measure the amount of neoliberalistic changes in a country, which would explain the Gini coefficient of a country for 96 percent. On the other side, we see that Esping-Andersen has provided us with proof that having a social-democratic government reduces the inequality. The countries that do have a long tradition in social-democratic governments are Norway, Sweden and Finland. The central question, not only for neo-marxist, but for the entire contemporary debate on the welfare state, is to what extent, and under what conditions, the class divisions and social inequalities produced by capitalism can be undone by parliamentary democracy (Esping-Andersen, 1990). According to Esping-Andersen (1990), parliamentary class mobilization is a means of the realization of the socialist ideals of equality, justice, freedom and solidarity. In other words, the social safety net will be greater in the Scandinavian D i s e n t a n g l i n g T h e G o r d i a n K n o t o f I n c o m e I n e q u a l i t y Pagina 20