Deconstructing global inequality

Peter Pauly is Vice-Dean (Academic), Professor of Business Economics and a research associate at the Institute for International Business at the Rotman School of Management

You have been working with the United Nations on the issue of global income inequality.  How bad is it out there?
By any metric you look at, over the last 40 years or so, income and wealth distributions have shifted dramatically in the Anglo Saxon countries—particularly in the U.S., in the UK, to some extent in Canada and to some extent in Australia.  We have seen a stunning shift towards very high income levels in these countries.  There are lots of different reasons for this: economic developments, changes in the political environment and the designs of these economies, to name a few.  If you were to slice the evidence very thinly, it’s a problem of the top one per cent, but it is actually more about the one per cent of the one per cent; it’s really concentrated at the very high end of earners.

This is happening against a backdrop of dramatic improvements in global health and living standards. Is there a connection between the two?
At the same time that this shift in income distribution has occurred, some   tremendously good things have happened globally. Over the last 30 years a larger share of the global population has been raised out of poverty than at any time in history, and we have seen dramatic improvements in per capita incomes, health, education, societal standing, and gender relations in many countries.  But there is this isolated phenomenon that within certain industrial countries, the gains have not been distributed widely.  

That is why, when one talks about ‘the inequality problem’ in the world, it is important to be very precise about what you mean, because globally, inequality has actually been reduced.  Lots of low-income countries have moved up into the middle class and middle-income countries like Korea, South Africa, Brazil and Russia are close to being industrial countries.  All have made tremendous progress.  Of course, China is the prime example of a country that has dramatically improved its standing in terms of the well-being of its population and its health and education systems.  So there is definitely a dichotomy going on.

You have noted that globalization and technological progress have created ‘labour market segmentation’. Please describe what is happening.
If you think about the causes of what is happening in industrial countries, there are basically three important themes: technological change, globalization and changes in the political environment.  And in a sense, all three interact and reinforce each other.  

With respect to technological change, it’s very clear that innovation has dramatically changed the workplace over the last 40 years.  There has been a continuous trend towards displacing low-income and low-skilled activities with technology—with machines and with ‘intelligent processes’.   Clearly, there have been difficulties for a large part of the workforce that doesn’t have the skills or the education to move beyond these activities.  That’s why economists talk about a ‘skill premium’:  as these things happen, it becomes more and more important to possess the skills that can get you out of those kinds of jobs, whether in manufacturing or in services.  You have to have identifiable skills to be able to escape the trap.  

Of course, globalization has made this process even more dramatic, because it has meant that certain types of activities can easily be outsourced to lower-income countries.  Call centres in India were the first example of this when it became clear that you could have them anywhere in the world.  Why have them in New York City or Toronto—where you pay ten times the rate that you pay in India or anywhere else?  Over time, that phenomenon became more broad.  It used to be only low-skilled jobs that got outsourced, now it’s any job that can be replaced by some automatic process or technology.  

The only jobs and activities that are reasonably safe from these trends are the ones that are local in nature: things that you have to do where you live. If you want to get a haircut, you aren’t going to fly to India; and if you need an MRI done, it will be done locally. However, it can be read and interpreted by somebody somewhere else, because that might be cheaper, and the images can be transmitted easily.  
All of a sudden, in addition to low-skilled jobs being in danger, all sorts of other jobs can be outsourced and are in danger.  That’s why today, there is a premium for doing something that is both high-skilled and has to be delivered locally.  Healthcare jobs cover both aspects: a skill premium and a local premium.  

Another factor in all of this is the political changes that have liberalized our systems in many ways.  We have deregulated our economies, in large part as a result of the increasing political influence of a certain group of high-wealth individuals.  So there is a perpetuating force in all of this, whereby certain groups are taking over legislative power, and that in itself generates additional benefits for these groups.  Economists call this ‘regulatory capture’, and it means, for instance, that Wall Street is having much more influence than it should on what kind of policies are being put in place somewhere far away.  

There seems to be general consensus that some inequality is essential for the effective functioning of a market economy. Do you agree?
Yes and no.  There is a fundamental tenet among economists that there is a certain trade-off to be made between equity and efficiency, and that the goal is to locate yourself in a position where you don’t sacrifice too much market efficiency to achieve overall, broad equity.  You also don’t want to sacrifice too much equity in an economy that is totally deregulated and focuses on efficiency entirely, so there is a bit of a trade-off to be made there.  You definitely don’t want to be positioned at either extreme end: once you begin to favour either equity or efficiency too much, you are in danger of having negative consequences arise. 

Countries have different ways of deciding where they want to position themselves on the continuum.  European countries are certainly slightly more equitable and slightly less efficient than, say, North American economies.  This is a societal choice and within a range, that is fine.  As indicated, the issues only arise if you move too far in either direction.

You warn that poorly-designed efforts to reduce inequality can actually be counterproductive.  Can you provide an example?
This all flows from that trade-off between equity and efficiency.  As you worry more about inequality, you have to be really careful that you don’t dampen vitality, entrepreneurial spirit or productivity.  For example, we have learned that in the Scandinavian countries, prohibitive taxation (in the 90 per cent range or so for companies) stifles innovation and entrepreneurship by taking incentives away.  You need to have policies in place that don’t stifle innovation or dis-incentivize entrepreneurial activity, because at the end of the day, that’s what drives productivity and well-being.  

You also don’t want to impose policies that impose burdens on one group over another.  For example, there’s a lot of talk lately about raising the minimum wage.  This sounds like a great idea to most people, and within a range, it is; but it also puts all the costs of providing a living income onto companies’ shoulders, and if you overdo that by setting the minimum wage too high, some firms will be driven out of business.  At the end of the day, by raising the minimum wage to $16.00 or $20.00, you might not achieve what you want, because you might drive some people out of a job.

The alternative is to say, ‘We can all agree that that there has to be a minimum income for citizens (not a minimum wage), so let’s find a way to achieve that by sharing the burden across society’.  For example, in the U.S. they have something called the negative income tax, which is essentially just that: if your income is less than a certain minimum, you receive a subsidy, or you don’t pay any taxes at all.  As a result, everybody in society participates in supporting a certain group of workers, and this spreads the burden widely across the economy.  Some of us feel that’s a smarter way of doing it.  

Is there such a thing as a ‘societally-optimal level’ of inequality?
I wouldn’t use the word ‘optimal’, but where societies choose to locate themselves on the trade-off continuum reflects deep societal preferences.  I don’t think anyone can say that the Scandinavian way is optimal, or the French or the German way.  What we can say is that within a range, there are different sets of preferences that lead to reasonable outcomes.  For example, there are differences in the attitude towards leisure in Europe and in North America:  Europeans obviously place a higher importance on the leisurely life that doesn’t exist in North America or most of Asia.  No one can say what is optimal or not; it only becomes a problem when you go to the extremes—as has occurred in some industrial countries.

What can individual leaders do to address inequality?
Globalization is a fact of life, and there are lots of good things about it.  What individuals can do is to equip themselves with knowledge and skills that allow them to be flexible as the world is changing.    And public policy-makers essentially have the same objective and task: they need to make sure that in their society, there are opportunities to develop skills, an education system that allows individuals to develop themselves, an economic system that does not disadvantage any of the members of society and allows for upward mobility.  

The unfortunate thing is that there are no short-term fixes: these are long-term, structural problems.  The one thing that is really insidious about existing inequality is the tendency for it to persist and to kind of feed on itself.  If you’re born into the lowest percentile of the income distribution, it is getting harder to move up into higher percentiles and to eventually end up being Bill Gates or Mark Zuckerberg.  These things still happen, but not as frequently as they once did.  

I think we can all agree that in the end, what we really want to do is preserve opportunity.  Obviously there is something distasteful about the high incomes we’re seeing at certain levels; some of them are well-earned, and some not, and there’s not much we can do about it. We could impose prohibitive taxation and cut a few billion out of Bill Gates’ bank account; that might make us feel better for a few days, but it’s not going to fix societal inequalities.  Whatever we do has to have a generational perspective to it, so that over the longer haul, opportunity exists and there are ways for people to achieve their individual objectives in life.

Peter Pauly is Vice-Dean (Academic), Professor of Business Economics and a research associate at the Institute for International Business at  the Rotman School of Management. He served as the School’s Interim Dean between July 2013 and July 2014.  Rotman faculty research is ranked in the top ten worldwide by the Financial Times.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]