Insights & Analysis

May 20, 2021

Income inequality part one: what drives the gap and why it matters

A virus may be amoral but its impact in society is not. This past year has been defined by more than disease; it has also been defined by inequality—the gap between low and high-income individuals, and those who have had the ability to work from home versus those who have had to “show up” to work, often those in lower skill and lower wage roles. As lower income families were more likely to lose work and pay, many higher income families simply changed into more casual clothes to work from home. The same divergence has been seen with respect to health: poorer neighborhoods and workplaces more likely to employ low-income individuals have been ravaged by the virus with a virulence not seen among the work-from-home crowd. 

In this series on inequality, we seek to better understand the gap between low- and high-income earners and its potential consequences in Canada. 

First, we will take a step back to consider the concept of inequality more broadly, and to better understand when and how it becomes an issue. For simplicity, we will focus on inequality of income in this first commentary. In future commentaries, we will explore the distinction between income and wealth inequality, inequality in Canada (Is it a problem? Is it increasing?) and whether all Canadians actually have a fair shot at economic prosperity. Finally, we will circle back to the devastation of the past year to consider how recent events may be changing the inequality conversation in Canada and around the world. 

Commentary Series on Inequality: each individual commentary will cover a different facet of this important topic:
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This past year has brought issues of inequality into sharp focus. Explore the drivers of inequality and how and when it becomes an issue in part one of this series on income inequality and social mobility. Click To Tweet

The role of income inequality

Though this past year has brought the economic and social challenges associated with income and wealth inequality into sharp focus, it’s worth noting the existence of inequality is not, necessarily, a bad thing. It is a result of an economic system that rewards talent, skill, training, and innovation. This is why a surgeon is paid a higher wage than a concession worker. And rare as they are, many of the wealthiest in society became so because of some elite skill, or significant economic or cultural contribution to society—think Connor McDavid, Cardi B, or Steve Jobs.

Ultra-wealthy individuals aside, the most common driver of inequality is how an economy values different kinds of labour. It is a dance of supply—the number of people willing and able to do a particular job at a given wage—and demand—the number of people that businesses want to employ at that wage.

A range of factors affect both the supply and the demand. If a job is dangerous or unappealing, if it has extensive education or training requirements, if it involves isolated work in remote areas, or if it requires rare skills, factors like these will reduce the overall supply of willing, qualified labour, causing the wage for that labour to rise.

Meanwhile, demand for workers is driven in large part by consumers. The more highly consumers value and are willing to buy a given product or service, the more businesses need the workers who produce them. Other factors on the demand side include how productive or skilled a worker is, and how easily those skills can be replaced with technology (e.g., the cost of installing a self-checkout machine at a grocery story instead of hiring a cashier).

The neat thing about markets is, through these mechanisms, they help to ensure that, over time, we generally have the right number of workers for each job. Barring some policy intervention, if there are not enough individuals willing and able to do the work, wages will usually rise; if there are too many, wages will tend to fall.

Also, the prospect of higher incomes encourages individuals to further their education, tackle society’s biggest challenges, and take risks—activities which benefit society and drive economic growth.

But the market, like the virus, is amoral. It does not consider the intrinsic value of a job apart from the balance of supply and demand. Connor McDavid may make millions because he’s the world’s best hockey player, but not many people would argue that he provides more social benefit than, say, a trauma counsellor or an elementary school teacher. On top of that, markets can fail. Socioeconomic, cultural, or systemic barriers can limit economic opportunity and participation. Markets also typically do not consider other equity factors such as the amount of money needed to cover rent, groceries and other basic needs.

A rise in income inequality in advanced economies

Though there has not been a universal increase in the gap between low and high-earners globally, many advanced economies, though not all, have seen an increase in inequality over the last few decades, and the issue has gained prominence as a result. This trend is especially pronounced in the US, which has seen strong growth in the incomes of high-earners and low growth in the incomes of low-earners.

This has led to a push for more governmental support of low-income earners including: significant minimum wage increases across North America; advocacy for living wage laws, which ensure all workers are paid a certain annual income to cover basic needs; as well as a universal basic income, which would give a certain amount of income to all residents, regardless of employment status. There is also a related push to increase the progressivity of the tax system, whereby higher income individuals pay more as a percentage of their income. This was the intent behind recent announcements in the 2021 federal budget which includes taxes on luxury cars, yachts, and personal aircraft.   

Meanwhile, on the business side, concerns about inequality have led to movements such as stakeholder capitalism, which encourages companies to think about success longer-term and more holistically, beyond short-term profits and share prices. The idea of stakeholder capitalism is that a business should consider the needs of all stakeholders—workers at all levels, customers, partners—and society at large.

Looking ahead, automation and digitization are likely to decrease employment opportunities and wages for those on the bottom end of the spectrum while they reward those at the top end. This would further exacerbate inequality in countries already seeing this trend. In fact, a recent report by the World Economic Forum named persistent inequality and unfairness as one of the greatest global risks of the next ten years, with negative consequences to economic growth and prosperity.

When inequality becomes a problem

Because of the essential nature of differences in wages and income in a market economy as described above, many economists were long wary of calling inequality a problem, separate from poverty. It was thought that if basic needs were being met, inequality was largely irrelevant. In other words, if you’re doing okay, does it really matter if a billionaire buys another yacht?

Increasingly, however, economists and policymakers have found that the income gap can be an issue itself. 

How can it be that inequality is both a driver of economic growth and potentially harmful to it? It is likely that scale matters, as well as the underlying equity of the system. When a society becomes too unequal, or the system is perceived as unfair, things start to break down, in a couple of ways: 

Prosperity starts to seem unattainable.

If the inequality gap is perceived to be too big, and insurmountable, this can start to change incentives. For instance, if only the most highly skilled individuals are rewarded, it could lead others to think that the chances of success are so small that they may as well not bother to go to school for another year or take a shot with a start-up. This theory has been proven by research which found low-income students are more likely to drop out of school in places where the income gap is highest. This squanders the potential of society—its creativity and intellectual possibilities wasted. And becomes a self-reinforcing process.

The system only works for some.

That dynamic is amplified if the factors that determine who is rewarded are perceived to be based not on factors like work ethic, grit, passion, or expertise but on personal characteristics like race, gender, social class, or background. A system built on racism, sexism, and discrimination—i.e., systemic inequality—limits a society’s potential. If the system discourages certain populations from ambitious pursuits and relegates them disproportionately to lower levels of income, these groups are also likely to see poorer health and social outcomes—a terrible recipe for shared prosperity and economic growth.  

Disenfranchisement grows and threatens democracy.

Taken together, this breeds a lack of trust in government and disenfranchisement. If the system is deemed or felt to be unfair, many may become apathetic or decide to go beyond the legal market to earn a living. Even worse, there is evidence that individuals eventually withdraw from the democratic process altogether, feeling that their voice will not be heard in a system that is “rigged”. It is worth noting that a growing income gap can lead to disenfranchisement even if lower-income individuals are not necessarily worse off; some argue that our sense of social well being is affected not just by whether our incomes are growing, but also by whether we are falling behind our neighbours.

Due to this breakdown, it may not be surprising that the amount of income inequality in a society can predict social outcomes such as life expectancy, mental illness, imprisonment, and literacy and math skills better than average measures of income like GDP per capita. Meanwhile, increasing levels of income inequality eventually start to eat away at economic growth in rich countries, for the reasons detailed above. In other words, the research is clear: too much inequality is an issue in itself.

How policy plays a role

This is where policy comes into play. In Canada, as elsewhere, the government can and does moderate the gap between low and high-income earners through differences in taxation and rebates, targeted income supports, minimum wage and worker organization laws, and access to, and quality of, education. Overall, policy softens the impact of the market, bringing the accordion of low to high-income earners closer together. 

There is a fine balance here. On the one hand, there are clear social and economic consequences to excessive levels of income inequality. On the other, the prospect of earning higher wages encourages hard work, risk-taking and the pursuit of higher education.

In future commentaries, we will dive into these, and other issues in more detail. First, we will look into the scale and trends of income inequality and redistribution in Canada to better understand: is inequality a problem in Canada? We will also examine the question of whether or not all Canadians truly have a fair shot at prosperity, the policies needed to ensure they do, and whether or how COVID has changed that equation.

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