Master programme in Economic History

Explaining the evolution of income inequalityin Germany from 1991-2010

Adrian Sonderadrian.sonder.465@student.lu.se

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

EKHR61Master thesis (15 credits ECTS)June 2013 Supervisor: Anders Nilsson Examiner: Patrick Svensson

Table of Content

s

List of tables.................................................................................................................................3

List of graphs...............................................................................................................................3

1. Introduction.............................................................................................................................41.1 Why is inequality harmful?............................................................................................................................................41.2 Income inequality in developed nations and Germany.........................................................................................8

2. Theory....................................................................................................................................122.1 Introduction.......................................................................................................................................................................122.2 Globalization, trade and technology.........................................................................................................................122.3 Labour market segmentation.......................................................................................................................................162.4 Human capital...................................................................................................................................................................172.5 Measurement of income inequality...........................................................................................................................202.6 Conclusions and relevance...........................................................................................................................................21

3. Empirical results...................................................................................................................233.1 Introduction.......................................................................................................................................................................233.2 Evolution from 1991-2010...........................................................................................................................................243.3 Income inequality in the first years after the reunification (1990-1992)......................................................263.4 Relative stability from 1993 until 1999/2000........................................................................................................273.5 Why did inequality increase sharply around the millennium?.........................................................................293.6 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

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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.

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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).

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

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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.

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

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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.

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,

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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.

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)

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Source: OECD (2011)

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

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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.

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

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around 1990

mid-90s

around 2000

mid-2000s

late-2000s

0.24

0.25

0.26

0.27

0.28

0.29

0.3

0.31

Gini coefficient Germany (after taxes and transfers)

Total populationWorking age population: 18-65Retirement age population: above 65Axis Title

Source: OECD (2013)

Most of the studies on income distribution in Germany use data from the German-Socio-

Economic 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 1991-

2010? The theoretical and empirical chapters of this thesis focus on the labour market as a

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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.

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, 12

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.

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,

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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).

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

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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.

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

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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.

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Productivity Growth

Technology

Demand for Skilled Labour

+

Demand for Unskilled Labour

-

Income Inequality

-

+

Employment Outcomes

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).

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

17

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.

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 18

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.

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 19

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.

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

20

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).

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

21

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.

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 export-

oriented 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. 22

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 skill-biased

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.

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,

23

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).

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)

24

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.

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 1991-

2005. 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)

25

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).

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 26

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.

Table 1: Inequality measures of before and after government income from 1990-1992

27

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 pre-

government 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).

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.

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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.

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).

29

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)

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).

30

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.

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).

31

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.

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

32

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).

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

33

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).

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

34

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.

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

35

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?

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

36

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.

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 long-

term perspective.

Spitz (2004) focuses in her paper on the rise of skill requirements on the West German labour

37

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 low-

skilled 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 low-

skilled 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.

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

38

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.

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

39

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.

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 know-

how 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 40

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.

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