Last week I posted on how much inequality has increased in the last 4 decades. The main conclusion then was that demand for skills, recently polarized by computerization, had driven much of the increase in wage inequality. Figure 1 shows that skills are actually rewarded all over the world, so this story is potentially not unique to the US. Cognitive skills are substantially rewarded across all 22 countries, with an average return of 18% for a "unit" (one standard deviation) of skills. The US is at the top of this with a premium of around 28%, implying a difference of around 50-60% between some one standard deviation above and someone one standard deviation below the average. If wages were determined mainly by luck, beauty or family connections, we would expect to see little connection between cognitive ability and wages. The high returns to skills all over the world confirm that this is not the case. And so inequality of income, is most likely highly related to inequality of skills on top of the demand shifts I explored last week.
Figure 1: Wage returns to skill, 2011-2013.
Education attainment has increased substantially in the US during the previous century, but it appears that has not been enough to catch up with the high increase in demand for some of those skills. For example, from 1963 to 1982 the fraction of hours provided by by college educated workers grew by around 1% per year. But since 1983 this increase has reduced to less 0.5%, which could partially explain the steep increase in the college premium (and particularly the post-college premium). Why has this happened? One hypothesis is that the Vietnam War might have over-boosted college attendance as it helped people skip the draft. However, this sharp (and unnecessarily high for the market) increase in supply of highly educated workers reduced the wage of college educated workers. As the returns to college became smaller, the following young generations may have been misled to believe that college was not worth it. Even nowadays, there are claims of a "college bubble" where young people are wasting too much money to get a degree. Even though it is possible that some the knowledge acquired is not useful, the market rewards it. Figure 1 showed that skills are rewarded, and Figure 2 shows that these rewards outweigh the extra costs of college. The net value of college is at its peak. Nowadays, the message of the need to get more education appears to have gotten through as the supply of college graduates has started to increase faster.
Figure 2: Lifetime value of college relative to high school degree, net of tuition cost.
But if inequality itself - through the difference in wages - is what partially leads young generations to educate themselves, what is wrong with it? A market economy may need inequality to provide incentives but this may have other costs. Intergenerational mobility is a way to evaluate the degree to which individual economic fortunes depend on their parents - for example the likelihood that children born to a low-income family become high-income adults and vice-versa. High economic inequality need not have low intergenerational mobility if the society is dynamic, with lots of movement up and down the economic ladder. But one concern is that high inequality at one point in time may serve to reduce mobility over time, and hence create a dynastic society if currently wealthy households are able to "buy" success for their children. This way inequality could become self-perpetuating, even if it originally starts from simple high market returns to skill. Figure 3 shows that this is a real concern, as societies with more income inequality have lower intergenerational mobility. And countries with higher college premiums also tend to display lower mobility.
Figure 3: Income inequality and intergenerational mobility.
Original figure is from Corak (2013)
When the return to education is high, children of better-educated parents have two advantages. They are more likely to receive a higher education and they are more likely to be more rewarded for that when they become adults. And recent work by Chetty and others (also in a previous post), suggested that intergenerational mobility does not seem to have improving over time in the US. I think this is the biggest risk of inequality. Inequality per se is not the problem. The problem is poverty and lack of opportunities, but inequality could be a big driver of the persistence of these issues among a group of people who are "doomed" from the very beginning of their lives.
Based on an article by Autor.
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