Download 4. Long-term trends of income inequality in Germany: applied theory

Master programme in Economic History
Explaining the evolution of income inequality
in Germany from 1991-2010
Adrian Sonder
[email protected]
Abstract: This thesis examines the evolution of income inequality in Germany from 1991-2010, by
analyzing the literature on labour market theories. It is assumed that human capital, labour market
segmentation and globalization are the main long-term determinants of income inequality. Most
importantly, skill-biased technological change (SBTC) has increased the dispersion of incomes to
the detriment of people at the lower end of the income distribution scale. Evidence suggests that
the rise in market income inequality was the main driving force behind the widening income
distribution since the early 1990s.
Key words: human capital, labour market segmentation, technological change, SBTC, globalization, market income
EKHR61
Master thesis (15 credits ECTS)
June 2013
Supervisor: Anders Nilsson
Examiner: Patrick Svensson
Table of Contents
List of tables .................................................................................................................................3
List of graphs ...............................................................................................................................3
1. Introduction .............................................................................................................................4
1.1 Why is inequality harmful? .......................................................................................................................................... 4
1.2 Income inequality in developed nations and Germany ........................................................................................ 8
2. Theory ....................................................................................................................................12
2.1 Introduction .................................................................................................................................................................... 12
2.2 Globalization, trade and technology ....................................................................................................................... 12
2.3 Labour market segmentation ..................................................................................................................................... 16
2.4 Human capital ................................................................................................................................................................ 17
2.5 Measurement of income inequality ......................................................................................................................... 20
2.6 Conclusions and relevance......................................................................................................................................... 21
3. Empirical results ...................................................................................................................23
3.1 Introduction .................................................................................................................................................................... 23
3.2 Evolution from 1991-2010 ........................................................................................................................................ 24
3.3 Income inequality in the first years after the reunification (1990-1992)..................................................... 26
3.4 Relative stability from 1993 until 1999/2000 ...................................................................................................... 27
3.5 Why did inequality increase sharply around the millennium? ....................................................................... 29
3.6 Decreasing inequality in Germany from 2005 to 2010 ..................................................................................... 32
4. Long-term trends of income inequality in Germany: applied theory ..............................33
5. Concluding remarks and policy recommendations............................................................38
References ..................................................................................................................................41
2
List of tables
Table 1: Inequality measures of before and after government income from 1990-1992
Table 2: Source of Theil I Inequality in Pre- and Post-government Income for reunited
Germany and its Eastern and Western States, 1990 to 1997.
Table 3: Inequality of Disposable Income (2000-2009)
Table 4: Exact decomposition of inequality increase (2000-2006)
List of graphs
Graph 1: Intergenerational social mobility tends to be lower in more unequal societies
Graph 2: Trends in inequality of disposable income (1975-2010)
Graph 3: Evolution of the Gini coefficient (after taxes and transfers) for Germany
Graph 4: Inequality of Household Market Income (Gini coefficient, before taxes and transfers)
Graph 5: Inequality of Household Disposable Income (after taxes and transfers)
Graph 6: Number of marginal employees between 1999-2011
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1. Introduction
1.1 Why is inequality harmful?
In the past two decades several authors have tried to establish a causal relationship between
economic growth and inequality (Persson & Tabellini, 1994; Deininger & Squire, 1998; Li &
Zou; 1998; Stiglitz, 2012). Conventional approaches suggest that inequality is conducive to
economic growth (Aghion & Williamson, 1998, p. 7) because it provides incentives for
investments (Berg & Ostry, 2011). In contrast, Persson and Tabellini (1994) find in their
analysis that inequality leads to politically motivated economic policies that are harmful for
growth. In the context of this study, it is argued that high income inequality has a negative
impact on the functioning of developing and developed economies in the long term. Following
this argument, the next section provides some views on how inequality undermines the
efficiency and the functioning of an economy. However, this analysis does not attempt to
define a specific level of inequality that is harmful for growth. Instead, it provides a set of
explanations showing that excesses of inequality have a negative impact on the economic
system, particularly from a long-term perspective.
Generally, many studies point out that a highly unequal income distribution produces an
unbalanced economic system. First, it is argued that high inequality has the potential to increase
the risk of financial and economic crises (Kumhof & Rancière, 2010) and hence is harmful to
sustainable growth. Second, an unequal income distribution can have negative effects on
political stability and thus is harmful for investments (Alesina & Perotti, 1996). Third,
inequality threatens, among other things, the stability and the cohesion of a society by “making
it difficult for the poor to invest in education“ (Berg & Ostry, 2011, p. 3). Finally, inequality
has important long-term implications with regard to intergenerational mobility.
Inequality and Crises
In the aftermath of the financial crisis, inequality has become a major concern of policy-makers
around the world. Kumhof and Rancière (2010) have analysed the causes of financial and
economic crises by looking at the pre-crisis evolution of inequality. The authors have chosen
the periods 1920-1929 and 1983-2008 in order to show how rising inequality has preceded the
two economic crises in 1929 and 2008 (Kumhof & Rancière, 2010).
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The main question that arises in this context is: why does an unequal income distribution have
the potential to increase the risk of financial and economic crises? The income shift towards the
upper end of the distribution scale reduces the purchasing power of an economy because people
at the lower end of the income distribution generally spend a higher part of their income than
their wealthier counterparts (Stiglitz, 2012). Wisman and Baker (2010, p. 10) found in the case
of the U.S. that the “increased share of income and wealth accruing to the elite was far greater
than could readily be spent, even on the most lavish consumption.” Consequently, one could
observe a decreasing trend of investments in the real economy culminating in a demand crisis.
In this situation, the rapidly growing financial sector tried to stimulate the demand of the
economy by expanding the supply of credit (Wisman & Baker, 2010; Kumhof & Rancière,
2010). The commercial financial institutions were supported by the central banks (e.g. United
States), which lowered the interest rates. These actions have allowed lower and middle income
to sustain their consumption levels and finally resulted in an economic development based on
borrowing (Kumhof & Rancière, 2010).
The described mechanisms have destabilizing macroeconomic effects. From this perspective, it
is argued that inequality produces an unsustainable growth model that is based on speculative
borrowing. The consequences of the financial crisis beginning in 2008 have shown the danger
of an economic system that relies on speculative consumption for growth. Furthermore,
inequality does not only increase the risk of financial crises, it also reinforces their effects to
the detriment of the people at the lower end of the income distribution scale. Therefore,
inequality and crises are linked and reinforce each other and therefore are harmful to the overall
economy.
Inequality, political instability and growth
There is no clear empirical evidence about the direct relationship between income inequality
and political stability. Nonetheless, there is no doubt that political instability impairs
sustainable economic development. In this context, Berg and Ostry (2011) state that an unstable
political situation creates uncertainty and hence could minimize the incentives for investment.
From this perspective, one could argue that a disproportionally high level of inequality has the
potential to destabilize a political system and hinder growth.
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This view is supported by Berg and Sachs (1988) who claim that high income inequality has a
negative impact on the ability of a political system to reform itself. According to Rodrik
(1999), inequality increases political instability and hence lowers the capacity of the political
system to react adequately to external economic shocks. This pattern could be best observed in
Latin America in the 1980s and 1990s. However, one cannot eliminate similar scenarios
becoming relevant in European countries and in the Unites States in the future.
In conclusion, different authors have provided evidence that inequality negatively affects
growth through the channel of political instability. However, it is difficult to find a generalized
framework for quantifying the negative impact of political instability on economic growth.
Equality of opportunity
Until now the discussion has been mainly concentrated on the negative impact of inequality on
economic growth and macroeconomic balances. Despite the fact that this relationship is of
primary importance for the analysis, one should not forget to focus on the perspective of
developed nations, particularly of those with a democratic background. In this context, it is
important to mention that inequality is not considered as an adverse thing per se, but rather as
the norm. However, modern Western democracies cannot tolerate the drifting apart of the
income distribution. High inequality often puts people at the lower end of the income
distribution at a disadvantage. They do not possess the necessary economic means to carry out
investments in different forms of human capital, especially in tertiary education. Consequently,
the principle of equality of opportunity is violated and this has important implications for the
economic prospects of future generations. Furthermore, high levels of economic inequality
limit intergenerational social mobility and thus create important economic barriers. This
assumption is supported by the fact that intergenerational social mobility tends to be higher in
economies with a more equal income distribution (see graph 1). More specifically, the graph
below shows a correlation between inequality and low intergenerational wage persistence. This
finding has important implications in regard to the equality of opportunity available to every
individual (OECD, 2010). It mainly demonstrates that inequality is not a temporary
phenomenon, but a structural one that persists over a long period of time. Furthermore,
inequality undermines the principle of justice that assures people that their effort in the
economic system will be equally rewarded.
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Graph 1: Intergenerational social mobility tends to be lower in more unequal societies
Source: OECD (2010)
Concluding remarks
It has been demonstrated that inequality creates significant economic, social and political
imbalances. Long-term effects of inequality have the potential to cause a fundamental crisis
within the entire economic system. High inequality negatively affects growth in various ways
and through different channels and conduits, particularly in the long run. For all these reasons,
rising income inequalities pose a serious threat to the foundations of economic systems and
thus they should be tackled by progressive economic policy reforms. Those include
employment-friendly labour market policies, public investments and changes in the tax system.
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1.2 Income inequality in developed nations and Germany
Over the last three decades, nearly all-industrial countries have demonstrated a trend of
increasing income inequality (Biewen and Juhasz, 2010). Wade (2011) observed, for example,
a punctual steep increase in inequality around 1980 and 2000 in both developing and developed
countries. Especially since the mid-90s and around 2000, some countries, such as Germany and
the U.S., experienced a pronounced rise of inequality (OECD, 2008). These findings are
illustrated in the graph below suggesting that the widening gap of income distribution is not a
localized phenomenon, but a general trend following a certain pattern.
Graph 2: Trends in inequality of disposable income (1975-2010)
Source: OECD (2011)
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There are different assumptions as to what factors have caused this development. Gottschalk
and Smeeding (1997) point out that demographic and social factors explain to a certain extent
rising inequality in OECD countries since the 1970s, even though economic factors must still
be considered as the most important ones. Other commentators referred to globalization as one
main cause of rising income inequality in leading countries (Mayer-Foulkes, 2009).
This study emphasizes the importance of three general aspects affecting income inequality in
developed nations:
1. Globalization must be seen as a factor as well as the framework of rising income
inequality. It is argued that increasing trade opportunities put pressure on wages in
developed countries, particularly on wages of low-skilled workers. Consequently, one
could argue that the dispersion between high-skilled and low-skilled wages is at least
partly a result of processes of globalization.
2. Technological progress has led to a considerable productivity increase in many sectors
of the economy. However, this development has destroyed many jobs and industries and
hence contributed to the upward trend in inequality. In this context, it important to note
that low-skilled jobs are especially affected by this phenomenon.
3. The labour market is still considered as the most important channel through which
different factors and mechanisms influence the distribution of income. Theoretical
considerations often emphasize the primary importance of human capital models
explaining income inequality trends. Despite the relevance of these models, they have
important shortcomings with regard to structural aspects of the labour market. From this
perspective, it is often ignored that the labour market is relatively rigid in some
segments and thus an additional investment in human capital does not necessarily lead
to an income increase. In this regard, one must criticize that human capital models
primarily focus on differences among people while ignoring differences among jobs.
Another central aspect focuses on the segmentation of the labour market in a primary
and a secondary market. One major explanation for the rise in income equality is the
pronounced growth of the secondary labour market.
Without a doubt, these three aspects are only part of the full picture, although they provide an
important insight into the dynamics of factors and mechanisms of income inequality.
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Regarding the case of Germany, there is a consensus that income inequality rose significantly
around 2000 (Goebel & Krause, 2007; OECD, 2008; Grabka & Kuhn, 2012). From around
1990 until late 2000 the Gini coefficient (total population) rose from 0,256 to 0,295 in
Germany (OECD, 2011). Data from the OECD database are used in order to provide evidence
for the pronounced rise in inequality that affected the working population (18-65 years) as well
as the population above 65 (see graph 3). However, the working population experienced a
higher increase in income inequality than the retirement age population above 65 (see graph 3).
One possible explanation for this development is that pension schemes and additional transfers
kept inequality low among the elderly retired people above 65.
Graph 3: Evolution of the Gini coefficient (after taxes and transfers) for Germany
Gini coefficient Germany (after taxes and transfers)
0.31
0.3
Axis Title
0.29
0.28
Total population
0.27
Working age population:
18-65
0.26
Retirement age population:
above 65
0.25
0.24
Source: OECD (2013)
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Most of the studies on income distribution in Germany use data from the German-SocioEconomic Panel (GSOEP). This longitudinal survey provides information about the distribution
of income in the Federal Republic of Germany from 1984-2011 (for East Germany since 1990).
Furthermore, it gives an insight into the economic situation in Germany and particularly in the
context of income inequality because it includes a comprehensive set of individual and
household level variables. Therefore, the following analysis of the empirical results is mainly
based on data from the German-Socio-Economic Panel (SOEP).
The overall aim of this study is to assess the factors that influenced the distribution of income
after the German reunification. More specifically, this thesis aims to answer the following
research question: which factors determined the evolution of income inequality from 19912010? The theoretical and empirical chapters of this thesis focus on the labour market as a
potential explanation of income inequality. This type of analysis has substantial limitations
because it does not take into account other possible sources, such as demographic factors and
the tax system, explaining the evolution of the income distribution. However, the labour market
is recognized as the main channel through which the level of inequality is determined. Finally,
it must be pointed out that this analysis cannot claim completeness with regard to the variety of
factors explaining changes in the distribution of income.
First, it is hypothesized that labour market changes played a decisive role in determining the
level of income inequality in Germany, especially with regard to employment outcomes and
labour market returns.
Second, the rise in part-time work and mini jobs is considered as a primary component of the
dispersion of incomes. Hence, it is argued that the segmentation of the German labour market
has led to an increased division of primary and secondary jobs.
Third, widening wage gaps affected the bottom and the top of the income distribution scale
since the mid-1990s. In this context, it is assumed that the pronounced rise in income inequality
around the millennium can be explained by rising market income inequality since the early
1990s.
Fourth, the German reunification had a negative impact on the state of income inequality.
Taxes and transfers could mitigate its effects and kept inequality of disposable income stable in
the 1990. However, these factors will not be considered in the theoretical analysis of this thesis.
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2. Theory
2.1 Introduction
A conceptual and theoretical basis is necessary to explore the causes and mechanisms of
income inequality. Different models and theories have attempted to explain the emergence and
the evolution of income inequality in developed and developing countries. Theories focus, for
example, on the aspects of declining unionization, immigration, outsourcing, technological
change or policy changes. This is only a very small fraction of channels through which
different factors affect directly or indirectly the distribution of income and hence it is necessary
to limit the range of theoretical explanations to the most basic ones. Generally, mechanisms of
inequality are often interrelated and thus difficult to distinguish from each other. In this context,
it is important to note that political and economic forces are the main driving forces behind
rising inequality. However, purely political aspects will not be analysed in this study.
Considering economic theory, one could argue that the labour market is still the most
significant determinant explaining the distribution of income. Therefore, the focus of this
chapter lies on the following aspects: i) globalization, trade and technology; ii) labour market
segmentation; iii) human capital and iv) measurement of inequality.
2.2 Globalization, trade and technology
The phenomenon globalization
During the last three decades, globalization has changed the structure of the world economy
and affected the functioning of labour markets. From an analytical point of view, the concept of
globalization is not self-explanatory because it is a rather generic term. One possibility is to
capture globalization as “the free movements of goods, services, technology, labour, capital and
politics across borders and over time resulting from lower transportation cost, lower trade
barriers, faster communication technologies, competition and standardizations” (Heshmati,
2005, p. 11). In this study, globalization is described as an economic integration process that
can be characterized, among other things, by three developments affecting directly or indirectly
income inequality. First, one could observe the outsourcing of services and production
processes from developed to developing countries.
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Second, greater trade opportunities have facilitated the exchange of goods and services between
countries all over the world. Third, technological progress has increased productivity and above
all interleaved different parts of the world by the means of communication. Generally, it is
quite difficult to separate these three aspects from each other because they are interrelated.
However, the following theoretical section provides a basic understanding on the effect of trade
and technology on inequality.
Trade and inequality
According to classical economic theory, trade is supposed to be beneficial for the development
of an economy because it fosters, among other things, specialization and competition (Meoqui,
2010). However, one could argue that increasing trade opportunities have fostered the
competition between countries and hence led to rising income inequality within countries,
particularly in developed ones. Developing countries have challenged the industrialized
economies by using their comparative in cheap labour. Consequently, Wood (1998, p. 1463)
has observed widening “gaps between skilled and unskilled workers in wages and/or
unemployment rates” in all developed countries over the last 30 years. There are different
theoretical approaches that attempt to explain this relatively recent development. The most
relevant theoretical approach is the Heckscher-Ohlin model, which focuses on changes in
product prices in order to link trade and wages (Wood, 1995). More specifically, it analyses
two factors (skilled and unskilled labour) in a developed and a developing country in order to
explain general patterns of international trade (Wood, 1998). The model outlines that the North
(developed) has to specialize in its comparative advantage, notably skilled-labour activities, in
order to compete successfully with the South (developing), which has unskilled labour in
abundance (Wood, 1998). The main assertion of the Heckscher-Ohlin model is that the wage
development in a country is linked with its abundant factors of production. Furthermore, there
is one realistic complementary theorem that evolved from the Heckscher-Ohlin model, the
Stolper-Samuelson
(Burtless,
1995).
The
Stolper-Samuelson
theorem
provides
a
straightforward explanation of the effect of trade on wages: “international trade necessarily
lowers the real wage of the scarce factor expressed in terms of any good” (McCulloch, 2005, p.
2).
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Consequently, the decrease in wages in developed economies among low-skilled workers is
mainly driven by the comparative advantage of developing economies in unskilled labour. In
other words, it is cheaper to produce goods made with low-skilled labour in developing
countries. From an overall perspective, the high supply of unskilled labour in developing
countries decreases the demand for unskilled labour in developed nations. In contrast, the
skilled workers in developed nations can maintain their comparative advantage over their
counterparts in the developing world. These considerations have major implications for the
wage structure of developed economies. All in all, these theoretical considerations provide a
basic framework of the effect of international trade on wages in a globalized world.
The central role of technology
Regarding the impact of technology on inequality, Greenwood (1999, p. 2) asks the most
fundamental question: “Did the quickened pace of technological advance lead to greater
income inequality?” Apart from trade, technology must be considered as a very important
factor explaining income inequality. One major reason for this evaluation is that technology
affects a wide range of economic activities and thus is especially interrelated with many factors
causing inequality, particularly with human capital. Furthermore, technological change is
considered as a factor that can “produce not only overall changes in the demand for labour, but
also major structural changes” (Bosworth, Dawkins & Stromback, 1996, p. 149). In this
context, one could argue that technological progress is the main driving force behind the “shifts
in labour demand towards skilled and away from unskilled labour” (Snower, 1999, p. 44) in
developed nations. Following this logic on labour demand, the model below presents a
causality chain linking technological change and income inequality.
The simplified model is based on the assumption that technological change has led to a
considerable productivity growth in the economy. This phenomenon has affected the demand
for skilled and unskilled labour in different ways. It is assumed that the demand for skilled
labour increased while it decreased for its unskilled counterpart. Consequently, one could argue
that this development has fostered the division of the labour market and hence caused structural
changes within it.
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Furthermore, it is argued that the decreasing demand for unskilled labour had a negative impact
on employment outcomes for unskilled workers. More specifically, the shifts in labour demand
caused unemployment, job losses, growth in part-time employment and lower wages among
unskilled labour. These negative effects increase the income dispersion of the skilled and the
unskilled labour market and hence contributed to the overall upward trend in income inequality.
All in all, this model provides a basic understanding of the effects of technological change on
income inequality.
Model
+
Demand for
Skilled
Labour
+
Technology
Productivity
Growth
Income
Inequality
Demand for
Unskilled
Labour
Employment
Outcomes
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Summary
Generally, it is argued that globalization, trade and technology must be taken into consideration
while analyzing the global trend of rising income inequalities in developed countries.
Nonetheless, one major difficulty is to weight the importance of the different factors in order to
categorize them. Various authors have claimed, for example, that technological progress
affected income inequality to a greater extent than processes of globalization (Jaumotte, F.,
Papageorgiou, C., & Lall (2008); Snower, 1999). Apart from the fact that the definitions of
globalization differ considerably from each other, it is also difficult to contrast trade and
globalization because of their numerous interferences. Furthermore, it is still difficult to
quantify the effects of globalization because of their complexity. All in all, must be considered
as the underlying theme explaining rising inequality all over the world. It has reinforced the
effects of trade and technology on the distribution of income.
2.3 Labour market segmentation
According to Reich, Gordon and Edwards (1973, p. 359), labour market segmentation is the
result of a “historical process”, which has been shaped by political and economic actors. The
theory of labour market segmentation dates from the end of the 1960s when it was observed
that specific groups of people were especially affected by unemployment (Hradil, 2001, p. 75).
Theories about this phenomenon state that a uniform labour market does not exist, but instead a
set of labour markets that are quite foreclosed and provide different chances for the workforce
(Hradil, 2001, p. 75). From this perspective, one could argue that the neoclassical theory of a
single competitive labour market is refuted. The neoclassical approach advocates that the
relationship between supply and demand determines the equilibrium wage in a single arena
(Sakomoto & Chen, 1991). Furthermore, it states that the labour market functions like any
other market for goods such as cars or shoes (Henneberger & Kaiser, 2000). In contrast, critics
emphasize the unique characteristics of the labour market such as the specific property rights of
work products and the contractual asymmetries (Henneberger & Kaiser, 2000).
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Furthermore, the basic neoclassical model is criticized because it assumes that the work force
on the labour market is homogenous and the economic individuals act rationally. Additionally,
neoclassical theories ignore non-economic factors as well as the social environment in which
the labour market is embedded. From an overall perspective, neoclassical models do not reflect
the reality because they fail to acknowledge the institutional structure of the labour market.
Consequently, the dual labour market approach provides a realistic scenario of a modern
economy because it takes into consideration the inefficiencies of the market as well as
structural processes. Generally, the dual labour market is divided in a primary and a secondary
market. Primary jobs are well paid, require a higher education and are mostly combined with an
unlimited contract.
Therefore, they guarantee stability and allow people to make future planning. Secondary jobs
are mainly characterized by an instable working environment, low-incomes and an insufficient
workers representation (Hradil, 2001, p. 75). In times of globalization, one could observe an
increasing division of the primary and secondary labour market since the 1980s. Processes of
globalization have reinforced the segmentation of the labour market and hence increased
income inequality in developed countries. In summary, one must conclude that the labour
market segmentation theory emphasizes the weakness of neoclassical explanations for rising
income inequality on the labour market.
2.4 Human capital
Introduction
In recent times, the human capital theory has become the key to explaining why some countries
perform better than others. In this context, Schultz (1961, p. 3) argues that human capital
accounts for the “superiority of the technically advanced countries.” Indeed, one characteristic
of developed nations is that their investment share in human capital is much higher than in
developing economies. Apart from explaining diverging levels of development between
countries, human capital models explain and measure income inequality among employees who
have different characteristics such as age and schooling (Mincer, 1974). This approach will be
used in the following sections in order to draw conclusions about factors and mechanisms of
income inequality.
17
Definition and general remarks
According to the OECD, “human capital is productive wealth embodied in labour, skills and
knowledge” (OECD Statistics, 2013). Trüb (2004) describes human capital, among other
things, as the totality of all knowledge, experience and abilities that are added to the production
process by human beings.
Generally, the human capital theory considers investments in people as the most valuable
strategy to increase the economic and social benefits of a society (Sweetland, 1996). One of the
first economists who acknowledged the central role of human capital in the economy was
Adam Smith when he emphasized the importance of “the acquired and useful abilities of all the
inhabitants or members of the society” (Sweetland, 1996, p. 343). In this context, one could
argue that education and training represent the acquired abilities, while cognitive skills the
useful ones.
Regarding the analysis of factors of income inequality, the focus will lie on the acquired
abilities. One of the most prominent human capital authors, Garry S. Becker (1994, p. 17),
hypothesized: “Education and training are the most important investments in human capital.”
Indeed, the acquired knowledge and skills of people originate from education and are further
developed by training over the whole life cycle. In other words: “we acquire most of our human
capital in school and in formal and informal on-the-job training programs” (Borjas, 2009, p.
236). Furthermore, education and training highly determine the ‘capital’ of people entering the
labour market for the first time. Generally, it is argued that education is the main determinant of
the occupational status and future career prospects on the labour market.
According to Weiss (1995), higher wages are often correlated with higher levels of education
and a certain amount of work experience. One basic idea of this concept is that an additional
year of schooling represents a value added to the productivity of a worker and hence increases
its earnings. Consequently, different levels of education reflect the productivity of workers and
hence explain the distribution of income. Nonetheless, the factors ‘years of schooling’ are not
sufficient in order to explain income differences or a widening gap of wages. There are other
forms of investments in human capital such as the improvement of health services that should
be taken into account (Mincer, 1974), but which will not be discussed here. Generally, human
capital investments in education show their real value in the long run. Therefore, it must be
pointed out that human capital should not be considered as a static final good, but rather as a
long process that is shaped by a variety of factors.
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Is the human capital approach sufficient to explain rising inequalities?
During the last three decades, one could observe a persistent rise in inequality, particularly in
developed nations. One explanatory model is based on theoretical considerations of human
capital identifying skill biased technological change (SBTC) (Giesecke & Verwiebe, 2008) as
the key driver of the widening wage gap.
Despite the fact that this hypothesis cannot explain certain phenomena such as the gender wage
gap (Card & DiNardo, 2002), it serves as an explanation for the general trend of rising
inequality. From this perspective, it is argued that there was an increase of labour demand for
high-skilled relative to low-skilled professionals (Giesecke & Verwiebe, 2008). Furthermore,
high-skilled workers experienced a greater income increase than their counterparts and this
phenomenon was denoted as a qualification based increase in wage inequality (Giesecke &
Verwiebe, 2008). Nevertheless, it must be questioned if the continuous rise in inequality can
only be explained by shifts of skilled labour demand. Hence, it is justifiable to argue that skill
biased technological change cannot entirely explain rising income inequality, although it is an
essential explanatory factor. Nevertheless, the combination between human capital and
technological change influences the distribution of income to the detriment of the people with
lower educational qualifications. Regarding the value of investments in human capital, one
could argue that the economic returns are higher on the primary labour market. According to
human capital models, this argumentation is coherent because it emphasizes the importance of
additional investments. In general, formal educational attainments are evidently not solely
sufficient to explain income differentials between the primary and the secondary labour market.
Therefore, it is argued that there are other structural factors that diminish the objective value of
human capital investments on the labour market. In this context, one could refer to institutional
and structural factors (e.g. labour market segmentation) that lower the importance of human
capital in determining the level of income. Considering the evolution of income inequality, one
could observe that in particular, it is younger and elderly people who are affected. The former
target group lacks work experience, which indicates a lower degree of human capital relative to
older professionals.
Regarding the income inequality among elderly people, one has to point out that human capital
approaches can only be applied in the context of the labour market. Therefore, they cannot
explain why retired people are more affected by income inequality than other groups in society.
19
Despite the fact that pension schemes should be salary-based, there is no sound reasoning for
the overall phenomenon. One possible - rather political - explanation is that pension schemes
differ considerably from each other and thus produce this rise in inequality among the elderly.
However, the human capital approach can coherently explain why older professionals are more
affected by inequality than other age groups.
Generally, it is assumed that labour market returns from human capital diminish over time and
hence older professionals have to lower their wage expectations. All in all, the human capital
approach provides a necessary - but not a sufficient - explanation for rising income inequalities
in times of technological change and globalization.
2.5 Measurement of income inequality
Measures of income inequality serve, among other things, as a tool to assess the distribution of
income within and across countries (Atkinson, 1970). Furthermore, they attempt to answer the
question why developed countries have lower levels of income inequality than developing ones
(Atkinson, 1970). Additionally, measures of inequality try to give an answer to the following
question: “do taxes lead to greater equality in the distribution of income or wealth?” (Atkinson,
1970, p. 244). All these considerations emphasize the fact that inequality measures focus on a
variety of issues that are concerned with economic development. There are basically three
measures of income inequality that will be considered in this study: one-number summary
characteristics (e.g. Gini index, Theil index), share of income or percentile ratios and standard
income distribution variables (personal and household incomes).
One of the most widely used indexes of income inequality is the Gini coefficient (0 = no
inequality; 1 = one person receives the whole income) that measures the deviation from a
perfectly equal distribution (World Bank, 2013). The Gini coefficient is often used as a
standard measure to assess the state of inequality over a certain period of time. This measure is
carried out by constructing the Lorenz Curve that provides basic information about the
inequality of the income distribution (Heshmati, 2004). In this context, it is important to
mention that the Lorenz Curve is used for several inequality measures. From an analytical point
of view, one could criticize that the Gini coefficient does not give a detailed insight into every
part of the income distribution. Is it especially sensitive to changes in the middle of the income
distribution. Furthermore, the structure of the income distribution cannot be analysed
accurately with regard to different groups of the population (Charles-Coll, 2011).
20
Nevertheless, this index of inequality is valuable because it is a good starting and orientation
point for a deeper analysis. The Theil index is considered as an entropy measure that is mainly
based on information theory in order to determine the level of income inequality (Charles-Coll,
2011). In this regard, Theil mainly focuses “on inequality as a by-product of the information
content of the structure of the income distribution“ (Cowell, 2006, p. 348). The Theil index is
always a positive number that normally ranges between 0 and 1. It allows, among other things,
a decomposition of income inequality within and between different groups (Gastwirth, 1975).
Furthermore, the index also accounts for income differences between geographical areas (e.g.
urban and rural areas). Critics mainly point out that the Theil index does not allow a direct
representation and lacks the clarity of the Gini coefficient (World Bank, 2013). However, the
Theil index seems to be an appropriate measure to analyse the composition of inequality.
The advantage of the share of income and percentile ratios is that it captures the distribution of
income at specific points (OECD, 2012). This type of measurement allows a very detailed
observation of changes in the income distribution scale. It is possible to contrast the upper part
of the income distribution scale with the lower one. All in all, the income and percentile ratios
represent a useful measurement of inequality because they show the spread of income across
the population. Furthermore, this type of measurement can demonstrate decomposed changes
of income inequality (Bryan & Martinez, 2008).
One reason why personal and household incomes are often used as variables in income studies
is that they represent best a “proxy for economic welfare” (Cowell, 2007, p. 1). In particular,
household incomes are a popular reference point for policy-makers in order to shape new
policies in this area. These indicators seem to best reflect the reality and they are easy to
compute due to data availability.
All in all, every type of measurement shows a different picture of the distribution of income
and thus their combination provides the basis for comprehensive analysis of this phenomenon.
2.6 Conclusions and relevance
The assessment of causes and mechanisms of income inequality is a complex task because it
must take into account the interrelation of a variety of factors. Globalization, trade and
technological change constitute an important driving force behind the rise in inequality across
developed countries. One could argue that processes of globalization have not been beneficial
for every participant of the world economy, particularly for unskilled labour forces.
21
More specifically, increasing trade opportunities and technological progress have caused shifts
in labour demand to the detriment of people with lower qualifications. The diverging patterns
of labour demand are essential for understanding the widening of the income distribution in
recent times. All these factors are very relevant for this study because Germany is an exportoriented country and thus especially effected by a greater economic integration of the world
economy.
Furthermore, globalization, trade and technological change have affected an increasing
segmentation of the labour market. Generally, theories of labour market segmentation must be
considered as a response to neoclassical approaches that ignore the deficiencies of the market.
Advocates of a segmented labour market put an emphasis on institutional and structural aspects
that explain the widening income gap between the primary and the secondary job market. In the
case of Germany, one could observe an increasing share of secondary jobs on the German
labour market in the last three decades. It is argued that this development has contributed to the
upward inequality trend.
Another explanation for changes in the income distribution is based on human capital
formation. One of the main assumptions is that skill-biased technological change has lead to a
rise in income inequality. In this context, it is argued that people with lower qualifications
benefit less from technological change than high-skilled professionals. Furthermore, there
seems to be a threshold of human capital (e.g. years of schooling) determining whether a
person finds himself on the primary or on the secondary labour market. This consideration
emphasizes the fact that human capital formation, especially investments in education, highly
determines the level of income and the structure of the income distribution. Regarding the case
of Germany, one can see the general importance of human capital formation; however skillbiased technological change does not seem to play an essential role for rising income
inequality.
All in all, the theoretical part of this study provides a basic understanding for determinants of
income inequality. Moreover, it serves as a tool to analyse the evolution of income inequality in
Germany from 1991-2010.
22
3. Empirical results
3.1 Introduction
There has been extensive research about the income inequality trends in Germany focusing on
different aspects and dimensions. A large part of the recent literature is concerned with the
pronounced rise in inequality around the millennium (see Goebel & Krause, 2007; OECD,
2008; Giesecke & Verwiebe, 2008; Biewen & Juhasz, 2010; OECD, 2011; Grabka & Kuhn,
2012). It was found, among other things, that inequality and poverty increased more between
2000 and 2005 than in the previous 15 years (OECD, 2008).
However, the focus of this study is not one specific point in time, rather it is the long-term trend
of income inequality since the reunification. Generally, the overall trend in inequality from
1991-2010 can be divided into four periods. In the first years after reunification inequality after
taxes and transfers decreased in unified Germany. Until the end of the 1990s, inequality of the
disposable household income distribution did not vary significantly (Grabka, Goebel &
Schupp, 2012). In opposition to other OECD countries such as the United Kingdom or the U.S.,
income inequality in Germany was relatively stable during that period (Grabka, Schwarze &
Wagner, 1999). Subsequently, the income distribution changed noticeably around the
millennium and inequality increased drastically until the mid-2000s (Grabka, Goebel &
Schupp, 2012). From 2005-2010, the income of German households rose significantly and
inequality decreased in Germany (Grabka, Goebel & Schupp, 2012). All in all, the rise of
income inequality in Germany coincides with the development of increased inequality in most
of the OECD countries that started in the mid-1980s (OECD, 2011).
To understand the changes in the income distribution in Germany, one has to focus among
other things on the income differentials between East and West Germany. The reunification
caused major changes in the distribution of income. It is mainly argued that the reunification
had a negative impact on income inequality. The aim of this empirical part is to offer a broad
overview of the evolution of income inequality in Germany between 1991 and 2010. However
the focus of the review of empirical results will not rely on the following economic factors:
“globalization, technical progress, sectoral change, economic growth, and the growing
importance of capital gains“ (Grabka & Kuhn, 2012, p. 3).
23
3.2 Evolution from 1991-2010
Data from the German Socio-Economic Panel on household market income (before taxes and
transfers) provides evidence that inequality rose in the first years after the reunification in both
East and West Germany. The graph below shows that this development was even more
pronounced in the Eastern (Ost) than in the Western part (West) of Germany. East Germany
experienced a steep rise in household market income inequality until 1996. This view is
confirmed by Biewen (2000) who found that East Germany experienced a pronounced rise in
inequality from 1990 until 1996. In contrast, the household income distribution in West
Germany only changed a little during the time periods 1991-1993 and 1994-1996 (see graph 4).
There was only a steep punctual increase from 1993 to 1994, which can be explained by an
economic recession in the old states of Germany.
Graph 4: Inequality of Household Market Income (Gini coefficient, before taxes and transfers)
Source: Grabka (2012)
From 1995 until 1999, inequality increased slightly in East Germany, while the opposite trend
was observed in its Western counterpart (see graph 4). One possible explanation for this
development is that the older states benefited from a relatively good economic environment,
while East Germany still struggled with the structural problems of its economy.
24
Despite the fact that household market income is an important indicator of the income
distribution, one has to note that it does not take into account the inequality-reducing effect of
taxes and transfers. Therefore, household disposable income (after taxes and transfers) seems to
be a more appropriate measure of capturing the evolution of inequality. Graph 5 shows the
evolution of inequality of household disposable income in East and West Germany from 19912005. In opposition to estimates on inequality of household market income, the graph below
indicates a smoother rise of inequality during the 1990s. This difference can be explained by
the fact that taxes and transfers reduced the dispersion of incomes throughout the 1990s.
Graph 5: Inequality of Household Disposable Income (after taxes and transfers)
Source: Grabka (2012)
Measures of household disposable income and market income (see graph 4 and 5) demonstrate
that inequality started rising sharply around 1999 in Germany. The Gini coefficient for market
income increased from 0,448 to 0,493 between 1999 and 2005 (German Council of Economic
Experts, 2010/2011).
25
This pronounced rise in income inequality could be observed in both West and East Germany
(see graph 4 and 5). In this context, it is argued that rising unemployment was one major
driving force behind this development. Since 2005, one could observe a decreasing inequality
trend that was accompanied by increasing wages. The Gini coefficient for market income
decreased from 0,493 to 0,486 between 2005 and 2009 (German Council of Economic Experts,
2010/2011). However, the decrease in inequality was much more pronounced in East Germany
(see graph 4). The positive trend during this time period is directly associated with a robust
labour market.
In conclusion, it has been demonstrated that income inequality was relatively stable throughout
the 1990s. One possible explanation for this development is that state intervention had reduced
the economic effects of the reunification. However, the increase in market income inequality
since the early 1990s contributed to the upward trend around the millennium. Finally, income
inequality decreased in Germany from 2005 to 2010.
3.3 Income inequality in the first years after the reunification (1990-1992)
Schwarze (1996) uses a Theil decomposable inequality index in order to analyse the evolution
of income inequality in East and West Germany from 1990 to 1992. He focuses on before
government inequality (before taxes and transfers) and after government inequality (after taxes
and transfers) for assessing the impact of the reunification on income inequality. Table 1 shows
that before government inequality increased considerably in the Eastern states between 1990
and 1992, while it only decreased slightly in the Western states. Consequently, one could
observe that before government inequality rose in unified Germany during this period.
However, after government inequality experienced a relatively low increase in East Germany
between 1990 and 1992 (see table 1). Furthermore, after government inequality even declined
slightly in the Western states (see table 1). Most importantly, his empirical analysis
demonstrates that large public transfers lowered the overall level of income inequality in
unified Germany and one could even observe a “drop in After Government income inequality
in Germany between 1990 and 1992” (Schwarze, 1996, p. 1). This finding is supported by
Grabka, Schwarze & Wagner (1999) who found that after government inequality decreased
from 1990 to 1993. This development can mainly be explained by the fact that transfers had a
strong inequality-reducing effect. This finding emphasizes the importance of transfers and
benefits that mitigate the economic effects of the reunification.
26
Table 1: Inequality measures of before and after government income from 1990-1992
Source: Schwarze (1996)
3.4 Relative stability from 1993 until 1999/2000
Data from the German Socio-Economic Panel demonstrates that inequality of disposable
household income increased around the years 1992/1993 in West and East Germany (see table
2). However, inequality decreased in the mid-1990s and remained stable until the end of the
decade. Grabka, Schwarze & Wagner (1999) focus in their study “How Unification and
Immigration Affected the German Income Distribution” on the impact of unification and
immigration on income inequality. The authors assess the state of inequality in Germany
between 1990 and 1997 by decomposing a Theil index of inequality. They find that pregovernment inequality (before taxes and transfers) increased from 0.9856 to 1.1306 between
1993 and 1997 (see table 2). However, the rise in inequality was more pronounced in East than
in West Germany (see table 2). Regarding post-government income inequality, evidence
suggests a decreasing trend in the Eastern and the Western states. Consequently, the overall
level of inequality decreased from 0.1230 to 0.1159 from 1993 to 1997 (see table 2).
All in all, these findings provide evidence that the German safety net has been an important
guarantor for a stable level of inequality during the 1990s (Grabka, Schwarze & Wagner,
1999).
27
Table 2: Source of Theil I (=) Inequality in Pre- and Post-government Income for reunited
Germany and its Eastern and Western States, 1990 to 1997.
Source: Grabka, Schwarze & Wagner (1999)
Data from the Luxemburg Income Study (LIS) suggests that income inequality decreased
between 1994 and 2000. The Gini coefficient for disposable household income decreased
slightly from 0,27 to 0,266 over this period (LIS). Furthermore, the 90/50-percentile ratio
decreased from 1.816 to 1,788, while the 80/20-percentile ratio fell from 2.153 to 2.08 (LIS).
These findings are confirmed by data from the German Council of Economic experts for the
period 1995 to 2000. It has been calculated that the Gini coefficient for household net income
decreased from 0,262 to 0,260 in this period (German Council of Economic experts,
2009/2010). However, it must be pointed out that income inequality rose in East Germany,
while it decreased in the Western part of the country. Hence, one possible explanation for the
overall decreasing level of inequality is the income convergence between East and West
Germany.
28
In conclusion the slight increase in income inequality in the 1990s is mainly the result of a
lower redistribution through taxes and transfers (Birkel, 2004). One of the main arguments is
that the prior increase of market income inequality has led to a delayed income spread of
disposable incomes (Birkel, 2004).
3.5 Why did inequality increase sharply around the millennium?
After a decade of little fluctuation in income inequality, one could observe a clear upward trend
around the year 2000. This development was accompanied by a sharp rise in unemployment
that increased the risk of poverty and high inequality. Consequently, different inequality
measures show a widening gap of market and disposable income between 2000 and 2006.
Estimates of disposable income (see table 3) indicate a significant and persistent increase of the
MLD, Theil and Gini coefficients from 2000 to 2006.
Table 3: Inequality Of Disposable Income (2000-2009)
Source: Grabka & Kuhn (2012)
29
According to Goebel & Krause (2007), the driving force behind this development was the
increasing dispersion of household incomes since the early 1990s. The authors argue that the
redistributive measures of the welfare state could not mitigate the effects of rising household
income inequality, as in the case of the 1980s and 1990s (Goebel & Krause, 2007).
Furthermore, it was found that decreasing real wages and the polarisation of the income
distribution were additional important determinants of rising inequality, particularly in East
Germany (Goebel & Krause, 2007). The OECD (2008) confirms these findings and emphasizes
the importance of labour market changes for rising income inequality. In this regard, widening
income gaps since the mid-1990s and an increasing number of jobless households were
identified as important determinants of the steep increase in inequality around 2000 (OECD,
2008). These considerations suggest that rising wage inequality led to a polarization of the
income distribution and hence the increased dispersion of incomes.
A study by Giesecke & Verwiebe (2008) demonstrates an increased dispersion of incomes
between 1998 and 2005. This development was caused by a negative wage trend at the bottom
of the income distribution and a positive one at middle and the top of the distribution (Giesecke
& Verwiebe, 2008). Furthermore, it is stated that the occupational status plays an important
role in explaining rising income inequality (Giesecke & Verwiebe, 2008). The authors find that
people who have a weak position in the labour market are disproportionally affected by
declining wages (Giesecke & Verwiebe, 2008). This result suggests that the lower part of the
income distribution was more affected by the negative wage trend than the upper one.
The study “Understanding Rising Income Inequality in Germany” by Biewen and Juhasz
(2010) provides the most comprehensive overview of factors determining the evolution of
income inequality around the millennium. The authors focus on the period from 2000 to 2006
in order to identify the driving forces behind the clear upward trend in income inequality.
Regarding the possible sources of increasing inequality, Biewen and Juhasz (2010) use the
following components for their analysis: i) changes in the distribution of household types; ii)
changes in the distribution of socio-economic characteristics; iii) changes in employment
probabilities conditional on characteristics; iv) changes in market returns to characteristics and
v) changes in the tax system.
30
Table 4 shows the exact decomposition of inequality increase on the basis of different measures
of inequality. It has been suggested that “changes in household structures and other household
characteristics have played a much smaller role” (Biewen and Juhasz, 2010). The authors find
that changes in employment outcomes, market returns and the tax system mainly account for
the increase in inequality in Germany between 2000 and 2006 (Biewen and Juhasz, 2010).
Table 4: Exact decomposition of inequality increase
Source: Biewen and Juhasz (2010)
Another study by Grabka & Kuhn (2012) assesses the evolution of income inequality in
Germany and Switzerland from 2000 to 2009. This comparative analysis is mainly concerned
with possible explanations for income inequality while contrasting the experiences of the two
neighbouring countries. Grabka & Kuhn (2012) put an emphasis on the aspects of government
redistribution and demographic factors. The authors find that the inequality-reducing effect of
government distribution declined since 2000 and hence income inequality rose considerably
(Grabka & Kuhn, 2012). Furthermore, one could observe that the dispersion of market incomes
led to a more unequal income distribution (Grabka & Kuhn, 2012). Finally, demographic
factors (larger share of elderly people, single households, and childless couples) also account
for the upward trend of inequality around the millennium.
31
In conclusion, it has been demonstrated that the combination of rising wage inequality and
declining government redistribution are the essential determinants of the upward trend in
income inequality around the millennium. Moreover, changes in the tax system have reduced
the inequality-reducing effects of transfers and benefits. Furthermore, one has to note that the
rise in unemployment had a negative impact on employment outcomes and hence contributed
significantly to the upward trend in inequality. Finally, one could observe an overall decrease in
market and disposable incomes from 2000 to 2005/2006.
3.6 Decreasing inequality in Germany from 2005 to 2010
Following a sharp rise in income inequality around the millennium, evidence suggests that the
income gap started to narrow in 2005 (The Economist, 2013). Grabka (2012) observes a
decrease in market income inequality from 2005 to 2010. This development was more
pronounced in the East than in the Western part of the country. Market incomes increased in
West Germany by almost 1.000 euros, while they rose in the East by 2900 euros over the
period from 2005 to 2010 (Grabka, Goebel & Schupp, 2012). However, the household
disposable income inequality only decreased in West Germany, while it remained at a relatively
stable level in the Eastern part of the country (Grabka, 2012).
Data from the German Council of Economic Experts indicate that income inequality decreased
from 2005-2009. The Gini coefficient for market income decreased from 0,493 to 0,486 over
this time period (German Council of Economic Experts, 2011/2012). The same trend could be
observed in the case of the Theil 0-coefficient, which decreased from 0,962 to 0,909 between
2005 and 2009 (German Council of Economic Experts, 2011/2012). This significant decrease
in income inequality suggests among other things that the lower end of the income distribution
scale could increase its income relative to the upper part.
Generally, it is assumed that falling unemployment increased market incomes and hence caused
a downward trend in income inequality from 2005 to 2010. The number of people subject to
social insurance contributions increased from 26.178.266 to 27.710.487 during this time period
(Federal Employment Agency, 2012).
32
4. Long-term trends of income inequality in Germany: applied theory
In the case of Germany, widening market income gaps account to a great extent for the general
trend of rising income inequality over the period from 1991 to 2010. There are different
theoretical explanations explaining income differentials between the bottom and the top of the
income distribution. The theoretical part of this study has mainly covered three long-term
causes of inequality: i) globalization, trade and technological progress; ii) labour market
segmentation and iii) human capital.
Despite the fact that globalization, trade and technological progress highly influence the
dispersion of incomes, they have not been taken into account in the empirical studies that have
been revisited in this chapter. However, these factors are crucial to understand the evolution of
income inequality over the last decades. From a methodological point of view, one can assume
that it is difficult to decompose these factors in order to quantify their overall importance.
Jaumotte, F., Papageorgiou, C. & Lall (2008) emphasize the importance of technological
progress for inequality and economic growth. This consideration is supported by the fact that
the major shift in labour demand towards high-skilled labour was caused by technological
progress (Snower, 1999). Therefore, it is argued that technological change has shaped the
functioning of the German labour market with regard to employment outcomes. Moreover, this
development has eliminated jobs, particularly in the low-skilled sector.
Jaumotte, F., Papageorgiou, C., & Lall (2008) establish the hypothesis that trade globalization
has a positive impact on income inequality. Different studies have explored that wage
inequality is somehow linked with export activities (Baumgarten, 2010; Jaumotte, F.,
Papageorgiou, C., & Lall, 2008), even though there seems to be a lack of empirical evidence.
Regarding the case of Germany, empirical results suggest a rather ambiguous relationship
between trade globalization and inequality. Hesse (2013) analyses in his paper “Inequality In A
Global Economy - Evidence From Germany” the dispersion of incomes among full-time
employees at the lower and at the upper part of the income distribution scale between 2000 and
2008. The author uses German linked employer-employee data in order to carry out regression
analyses of wage inequality. From a methodological point of view, this strategy provides the
statistical basis to assess the “change in trade openness with and without industry specific
controls” (Hesse, 2013, p.2).
33
It is suggested that increasing trade openness has a negative impact on wages in an autarkic and
a perfectly open economy. However, the author states that “wage inequality first increases and
then decreases with gradual trade liberalization” (Hesse, 2013, p. 10). It is pointed out that the
initial level of trade openness determines the evolution of wage inequality (Hesse, 2013). In the
case of Germany, the Theil index provides evidence of a rising wage inequality trend during the
time period 2000-2008 (Hesse, 2013). This finding suggests that trade liberalization was still in
an early stage in Germany with regard to the period of study. Therefore, trade probably had a
negative impact on the evolution of wages in the first decade of the 2000s. Consequently, trade
liberalization has contributed to the upward trend in income inequality between 2000 and 2005.
In conclusion, one could argue that globalization has affected the export-oriented economy of
Germany (Grabka & Kuhn, 2012). Furthermore, technological change and trade are supposed
to have rather negative effects on income inequality. These aspects must be taken into
consideration while explaining the evolution of income inequality in Germany from 1991 to
2010. Finally, it is assumed that an increased economic integration of the global economy has
influenced the upward inequality trend around the millennium.
Another possible source of income inequality that has been described in the theoretical part of
this study is the segmentation of the labour market. It is argued that a rising segmentation of the
German labour market has increased the dispersion of incomes over the period from 1991 to
2010. One could observe an increasing share of secondary jobs on the German labour market in
the last three decades. The number of people with a part-time or a mini job rose from three to
eight million since 1984 (Wehler, 2013, p. 71; OECD, 2011). Furthermore, the number of
marginal employees increased from around 3.6 to 4.9 million between 1999 and 2011 (see
graph 6). A rising share of part-time work, temporary employment and decreasing or stagnating
real incomes can explain this phenomenon of the ‘working poor’. All these aspects are relevant
in the case of Germany for explaining the evolution income inequality since the reunification. It
was observed that the pronounced rise in mini jobs from 1999 to 2005 (see graph 6) coincided
with the sharp rise in income inequality starting around the year 2000. This consideration
supports the fact that a rising segmentation the labour market led to an increase of income
inequality in Germany between 1999 and 2005. Furthermore, this observation suggests that
there is a link between marginal employment and income inequality.
34
All in all, empirical evidence has demonstrated that labour market segmentation explains the
rising trend of income inequality between 1991 and 2010, especially around the millennium.
Graph 6: Number of marginal employees between 1999-2011
Source: Grabka (2012)
Finally, human capital approaches try to explain the evolution of income inequality by using
the concept of skill-biased technological change (SBTC). In this regard, different authors
(Giesecke & Verwiebe, 2008; Antonczyk, DeLeire & Fitzenberger, 2010) focus on wage
inequality in order to demonstrate the impact of human capital and technological change on the
distribution of income. From a theoretical point of view, SBTC causes an increase of labour
demand for high-skilled relative to low-skilled professionals (Giesecke & Verwiebe, 2008).
Consequently, the bottom of the income scale distribution drifts away from the upper part. The
question that arises in this context is: does empirical evidence support this theoretical
assumption in the case of Germany?
35
Giesecke & Verwiebe (2008) assess the evolution of wage inequality between 1998 and 2005
by using data from the German Socio-Economic Panel (GSOEP). Their analysis is based on
three economic and sociological theories explaining wage inequality: i) human capital; ii)
discrimination and iii) social structures (Giesecke & Verwiebe, 2008). According to Giesecke
and Verwiebe (2008), human capital approaches, particularly the skill-biased technological
change SBTC hypothesis, are the most widely used in the economic literature. The authors
carry out regression analysis in order to capture changes in wage inequality (percentile ratios).
Generally, the empirical results suggest that inequality rose significantly over the period from
1998 to 2005 (Giesecke & Verwiebe, 2008). However, this rise in wage inequality cannot be
explained by the SBTC hypothesis (Giesecke & Verwiebe, 2008). The most surprising finding
is that human capital depreciation seems to be relevant in explaining the rising wage inequality
trend in Germany around the millennium (Giesecke & Verwiebe, 2008). This consideration
refutes the SBTC hypothesis, which is widely considered as the major explanation for rising
income inequality. Finally, it is also pointed out that human capital approaches account less for
the rise in wage inequality from 1998 to 2005 than other theoretical models (Giesecke &
Verwiebe, 2008). For all these reasons, it is argued that the focus on educational attainments is
insufficient for explaining changes in the wage and income distribution. Consequently, one has
to include structural and institutional approaches in order to explain the evolution of income
inequality in Germany.
Antonczyk, DeLeire & Fitzenberger (2010) analyse trends in wage inequality in the U.S. and
Germany during the period from 1974 until 2004. The main purpose of their analysis is to show
how wage inequality patterns in the U.S. and Germany differ from each other. The authors state
that wage inequality started rising in both countries in the late 1970s (Antonczyk, DeLeire &
Fitzenberger, 2010). One explanation for this development is the widely known skill-biased
technological change (SBTC) hypothesis. From a methodological point of view, various
quantile regressions are used in the empirical part in order to identify major changes in the
wage distribution and assess the importance of SBTC (Antonczyk, DeLeire & Fitzenberger,
2010). It has mainly been found that the development of the German wage structure is
consistent with the SBTC story until the mid-1990s (Antonczyk, DeLeire & Fitzenberger,
2010). This finding is highly relevant for explaining the evolution of income inequality in
Germany from 1991-2010. SBTC caused a strong polarization of employment and the wage
distribution in the mid-1990s and early 2000s. The described pattern contributed to the upward
trend in income inequality around 1999/2000.
36
From this perspective, one could argue that SBTC had a delayed negative effect on income
inequality. This interpretation questions the validity of the empirical results found by Giesecke
and Verwiebe (2008) because it emphasizes the fact that SBTC must be analysed from a longterm perspective.
Spitz (2004) focuses in her paper on the rise of skill requirements on the West German labour
market during the period from 1979 to 1999. She uses the “Qualification and Career Survey”
by the German Federal Institute for Vocational Training and the Research Institute of the
Federal Employment Service in order to demonstrate the rising importance of high-level
education and information technology at the workplace (Spitz, 2004). The empirical results
mainly show the negative impact of education and technological change on the wages of lowskilled workers (Spitz, 2004). Furthermore, it has been found that low-skilled workers have to
achieve a minimum level of skills for not being marginalized in the labour market (Spitz,
2004). All these considerations emphasize the fact that the SBTC hypothesis has been
consistent with reality over the period from 1979 to 1999. The empirical findings of this paper
indicate that SBTC has affected the wages of workers in the 1990s, particularly those of lowskilled workers (see Antonczyk, DeLeire & Fitzenberger, 2010). Furthermore, it is assumed
that there was a similar trend for East Germany. Consequently, the SBTC hypothesis explains
the rise in market income inequality at the lower end of the income distribution scale
throughout the 1990s.
The presented studies provide empirical evidence for the consistency of the SBTC hypothesis
with regard to the evolution of income inequality in Germany from 1991 to 2010. First, it has
been demonstrated that the evolution of wage inequality in the 1990s is consistent with the
SBTC hypothesis (see Antonczyk, DeLeire & Fitzenberger, 2010). Second, the pronounced rise
in wage inequality from 1998 to 2005 can be explained by a delayed effect of SBTC starting in
the 1990s. However, Giesecke and Verwiebe (2008) criticize justifiably that other theoretical
approaches must be included to understand the evolution of wages in Germany. Finally, there
are no empirical findings for testing the SBTC hypothesis for the period from 2005 to 2010.
37
5. Concluding remarks and policy recommendations
This thesis examines the literature on theoretical explanations of income inequality in
Germany. Analyzing the trends in income inequality in Germany, the Gini coefficient has
considerably increased from 1991 to 2010. However, the rise in income inequality has not been
constant over the last two decades. One could observe a continuous dispersion of household
market incomes between 1991 and 2005. This development can be considered as the main
driving force behind the clear upward trend in income inequality around the millennium.
Furthermore, it is important to note that the income distribution became less unequal from 2005
to 2010. Regarding the differences between East and West Germany, one can note that the
inequality trend was very similar, even though some developments were more pronounced in
East than in West Germany and vice versa.
Different theoretical approaches have been assessed in order to determine the major factors
explaining the evolution of income inequality in Germany. It must be pointed out that these
theoretical considerations have a significant explanatory value in the long run. In this regard,
human capital approaches demonstrate that education and training are essential components
determining the level of income. Empirical studies provide evidence that skill-biased
technological change (SBTC) explains to a great extent the rise in income inequality between
1991 and 2010. One of the most important findings is that the negative effect of SBTC on
income inequality can be best observed over a longer period of time. Nevertheless, it must be
criticized that the human capital approach primarily focuses on differences among people and
less among jobs in order to assess income differentials. The segmentation of the labour market
has institutionalized certain barriers for people with different jobs and educational background.
In the case of Germany, one could observe an increasing segmentation of the labour market
since the 1980s. The growth in part-time and marginal employment has contributed to the
upward trend in income inequality, particularly around the year 2000. In this context, it is
important to mention that trade globalization and technological progress are important factors
increasing the segmentation of the labour market in Germany. They had a negative impact on
the demand for low-skilled workers and hence caused a more unequal income distribution.
Finally, processes of globalization are supposed to be the underlying theme that is crucial to
understand the evolution of income inequality. In conclusion, all these theoretical approaches
are necessary to understand the evolution of income inequality in Germany, particularly from a
long-term perspective. Nonetheless, they are not sufficient to capture the whole picture.
38
Apart from these long-term trends of income inequality, one has to include alternative
economic factors that have not been covered in the theoretical part of this thesis. This
consideration emphasizes the fact that the presented labour market theories are not sufficient to
explain the evolution of income inequality in Germany from 1991-2010. Empirical studies
provide evidence that taxes and transfers guaranteed the stability of the income distribution
during the 1990s. They reduced the effect of the market income dispersion starting in the early
1990s. However, the redistributive effect of taxes and transfers was reduced in in the late 1990s
by political reforms. The inequality-reducing effect of the German tax-benefit system decreased
from 33% to 29% from 2000 to 2008 (OECD, 2011). Furthermore, unemployment insurance
coverage was reduced considerably and therefore the dispersion between in-work and out-work
income increased since the early 2000s (OECD, 2011). The combination of these punctual
policy changes and rising unemployment is considered as the main determinant of the
pronounced upward trend in income inequality between 1999/2000 and 2005. Consequently,
falling unemployment and rising wages reduced the dispersion of incomes over the period from
2005 to 2010.
In conclusion, it is pointed out that long-term labour market trends explain to a great extent the
evolution of income inequality in Germany. Nevertheless, other factors must be taken into
account in order to capture the whole picture of changes in the income distribution.
In recent years, policy makers have tried to tackle increasing income inequality by carrying out
a set of different labour market policies. Generally, one can make the difference between
passive and active labour market policies (IMF, 1997). Passive policies are known as costly
because they focus on redistribution as well as insurance (IMF, 1997). This type of policies is
relatively popular because they suggest that the redistribution of wealth automatically reduces
income inequality. In contrast, active labour market policies rather focus on specific problems
and therefore they are easier to categorize (IMF, 1997). Regarding the efficiency of labour
market policies, one has to note that the amount of expenditures does not have a significant
impact on income inequality (IMF, 1997). More specifically, the success of labour market
policies depends on their efficiency and not on the overall level of expenditure.
Following this logic, the OECD (2011) outlines key policy recommendations for OECD
countries. First, it is pointed out that “employment is the most promising way of tackling
inequality” (OECD, 2011, p. 2). This consideration clearly emphasizes the importance of active
labour market policies.
39
Second, investments in human capital are considered as long-term investments reducing
income inequality (OECD, 2011). From this perspective, education policies are key to promote
equality of opportunity and reduce future level of inequality. Generally, investments in knowhow seem to have an inequality-reducing effect in every society (IMF, 1997). Third, tax and
transfer systems have an immediate impact on the redistribution of wealth in society and
therefore they are efficient in reallocating financial resources (OECD, 2011). Furthermore, one
should eliminate tax reliefs for high-income groups in order to reduce the level of income
inequality. Finally, the OECD (2011, p. 2) recommends the “provision of freely accessible and
high-quality public services, such as education, health, and family care” in order to promote
equality of opportunity for every individual.
Regarding the case of Germany, it is argued that tax reforms would help to reduce the level of
income inequality. Taxes should be increased for high-income people and certain tax reliefs
(reduced taxation of capital gains) eliminated. However, changes in the tax system can only
serve as complementary measures for reducing income inequality on the labour market. In this
regard, the state should allocate its financial resources more efficiently. It is pointed out that
investments in education are still too low and therefore the state has to increase its efforts in
this field. Especially low-skilled workers must receive additional support (education and
training) in order to mitigate the effects of skill-biased technological change (SBTC).
Finally, the state should promote employment by reducing the number of secondary jobs on the
German labour market, particularly the number of mini-jobs. The increasing labour market
segmentation is one of the biggest obstacles that must be tackled by policy reforms. In this
context, it will be important to create better jobs in order to stop the increasing segmentation of
the labour market.
40
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