Mitigating the Gap Between the Rich and the Poor: Key Trends and Drivers of Redistribution

DOI: 10.1007/s10272-020-0909-x Income Inequality Martin Larch and Philipp Mohl* Mitigating the Gap Between the Rich and the Poor: Key Trends and Drivers of Redistribution The growing inequality of market income has attracted considerable attention; less so the redistribution of income. This article analyses key trends and drivers of income redistribution in the EU and the world. It shows that in the EU increasing redistribution has largely stabilised the dispersion of disposable income since the late 1990s. Only some advanced countries with a dominant free market ideology have recorded an increasing inequality of disposable income alongside a growing inequality of market outcomes. The evidence from panel data shows that the degree of redistribution increases with per capita income and with the share of low-tech, low-income sectors in manufacturing as well as, in line with the median voter model, when more than half of the voters earn less than the average income in countries with a majoritarian electoral system. More redistribution is associated with lower budgetary surpluses or higher deficits. Condemned to live in the shadows of the policy debate for a long time, income inequality has taken centre stage in the wake of the Great Recession of 2007. Academics and policymakers alike have paid increased attention to the growing income gap between the rich and the poor. The post-2007 crisis was only the trigger – not the cause – of the change of heart. Since the 1980s, the distribution of market income has become more unequal in almost all advanced countries. focusing on the insurance motives of public transfer spending, Moene and Wallerstein (2001, 2003) predict a negative relationship, implying that greater inequality in pretax earnings is associated with less, not more, spending on welfare policies targeted to people who have lost their market income because of layoffs, accidents or illness. Finally, some models conclude that redistribution runs from the ends of the income distribution towards the middle class (Stigler, 1970; Dixit and Londregan, 1998; Epple and Romano, 1996). The policy discussion has paid less attention to the evolution of redistribution, which increased significantly over the past decades. Classical median voter models represent the conventional view wherein redistribution is expected to increase with a rising income gap between the mean and the median voter (Meltzer and Richard, 1981). By contrast, Against this background, this paper analyses key trends and drivers of income redistribution in the EU and the world. This study goes beyond the existing literature by exploring a wider range of economic, political and institutional factors. In particular, it offers an empirical test of the median voter model. © The Author(s) 2020. Open Access: This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/). Income redistribution in the EU: Main trends and facts Open Access funding provided by ZBW – Leibniz Information Centre for Economics. * We thank Lucio Pench, Karl Pichelmann and Edouard Turkisch for helpful comments and Leyre Gomez-Oliveros Duran for excellent research assistance. Martin Larch, European Commission, Brussels, Belgium. Philipp Mohl, European Commission, Brussels, Belgium. ZBW – Leibniz Information Centre for Economics Despite the booming interest in distributional issues, the availability and comparability of inequality data remains limited. This paper relies mainly on the Gini index from the Standardized World Income Inequality Database (SWIID), compiled by Solt (2016) and widely used in the literature (e.g. Ostry et al., 2014), and covers a large set of countries (66 advanced and developing countries from the early 1970s to 2015). We measure the degree of redistribution as the difference between the Gini index of market income and the Gini index of disposable income. The first important fact to highlight is how the redistribution of income via fiscal policy has largely offset the trend 245 Income Inequality Figure 1 Distribution of market and disposable income, 19722014 1a. Cross-section arithmetic means, full sample Index 55 Real GDP per head (rhs) 50 30000 45 Gini market income 40 25000 Gini disposable income 35 30 20 12 04 00 96 92 08 20 20 20 20 19 84 80 76 88 19 19 19 19 19 72 10000 1b. Cross-section arithmetic means, EU15 Index 55 US$ 1000 45000 Real GDP per head (rhs) 50 40000 Gini market income 45 35000 30000 40 25000 35 Gini disposable income 30 20000 The global trend towards more unequal market outcomes is visible across all economic areas covered by our sample.1 The relative ranking of economic areas has not changed much since the 1970s with one exception (Figure 2, left-hand panel). The group of non-OECD countries, which had the highest dispersion of market income in the 1970s, has also seen an increase in inequality but significantly less so than in other areas. As a result, their average Gini index of market income is now even slightly below the OECD average.2 The group of non-OECD countries includes low- or middle-income countries (such as Morocco, South Africa and Russia) that are all at different stages of the economic catching-up process. 12 08 20 04 20 00 20 96 20 92 19 88 19 84 19 19 19 19 19 80 10000 76 15000 20 72 25 Sources: SWIID, OECD, IMF. towards increasingly unequal market outcomes in advanced countries. The growing degree of redistribution has been underpinned by significant progress in terms of real per capita income (Figures 1 and 2). The distribution of market income has grown much more unequal. The average cross-section Gini index climbed from around 40 in the early 1970s to close to 50 in 2015. To put this into perspective, a difference of ten points is more than what currently divides Finland and Greece, with Finland being an example of a comparatively low dispersion of market income and Greece as an example of a particularly high dispersion. Alongside the conspicuous surge in the inequality of market income, real GDP per capita has almost doubled, not least thanks to the catching up of lagging countries. A prominent implication of the combined increase, especially in developing countries, is a pattern highlighted by Milanovic (2016): there is income convergence across countries yet divergence of household income within countries. The growing dispersion of market outcomes has to a large extent been mitigated by government redistribution policies. Since the late 1990s, the average Gini index of dis- 246 The second important fact about the distribution of income over time is that different countries and regions reacted differently to the growing dispersion of market income. In advanced economies, differences also reflect diverging ideological views about how much the public sector should intervene into the market process (Figure (...truncated)