Chapter

5 Equity Issues in a Globalizing World: The Experience of OECD Countries

Editor(s):
Ke-young Chu, Sanjeev Gupta, and Vito Tanzi
Published Date:
May 1999
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Author(s)
Anthony Atkinson

Introduction

Equity issues are fundamental to the formation of international economic policy. As illustrated by the Corn Laws in nineteenth-century Britain, who gains and who loses from trade policy is a central question. Yet, in this century, these issues have tended to fall from view in the economics literature. For example, the word “equity” appears in the index to Paul Krugman and Maurice Obstfeld’s undergraduate textbook International Economics (1994) only in the form of “equity finance.” The recent revival of interest in distributional problems is therefore to be welcomed. The focus has, however, been a rather limited one, being primarily concerned with the impact on wages of increased North-South trade.

The aim of this paper is to both broaden and deepen the analysis. This is an ambitious task, and in order to keep the paper within manageable bounds, I focus on the experience of the countries of the Organization for Economic Cooperation and Development (OECD), particularly those that constitute the seven leading industrial nations (G-7). This experience has considerable relevance to developing, newly industrialized, and transition economies, insofar as they are affected by common economic forces, such as technological change, trade liberalization, and higher real interest rates, and insofar as change in OECD countries affects the rest of the world. But to the extent that OECD experience is mediated by particular social institutions and public policies, or derives from changes in social norms or political values, there is no necessary reason for it to be shared. One of the main lessons I draw from studying distributional change in these countries is that there are dangers in seeking overarching explanations or universal policy recommendations. Moreover, the lessons flow both ways: studies of OECD countries can benefit considerably from the analyses that have been made of developing countries and of economies in transition.

Trade and Income Distribution

The United States, the United Kingdom, and a number of other OECD countries have experienced rising inequality of incomes since the 1970s. Figure 5.1, based on national studies of the distribution of equivalent disposable household income, shows that this has been especially marked in the United Kingdom, where the Gina coefficient (a summary measure of inequality) rose by nearly a half—a very large increase by historical standards. In the United States, Japan, and (West) Germany, increases are more modest. But an increase of one-tenth is significant for a statistic of which Henry Aaron once remarked that “following these data was like watching the grass grow” (1978, p 17). That may have been true in the 1970s (see Figure 5.1), but ceased to be true in the 1980s.

Figure 5.1.Changes in Income Inequality Relative to 1977

(Gini coefficient 1977 = 100, 1975 for France)

Yet inequality increased neither at the same rate nor universally. Over the period shown, inequality did not increase in Canada or France, nor (over the period as a whole) in Italy. The first point that I want to make is that national experience varies considerably, even within the G-7. The same applies if attention is focused on the bottom of the distribution.

Taking the European Commission definition of financial poverty as living below half the national mean, we find that in the European Union, the United Kingdom stands out for its sharp rise in poverty over the 1980s, whereas other countries have seen either a more modest increase or no overall trend (Atkinson, 1998).

The same applies when we look at the distribution of individual earnings (Figure 5.2), which shows the changes since 1977 in the ratio of earnings at the top decile to those at the bottom decile (the decile ratio). The United Kingdom again shows the largest change: a rise of one-fifth in the decile ratio. As is well known, the ratio increased in the United States. For the other countries, the pattern is more mixed, with a rise and then a fall in Canada and a fall then a rise in Italy. As has been observed by the OECD: “No clear tendency emerges of a generalised increase in earnings inequality over the first half of the 1990s. Of the 16 countries … dispersion increased in half, and was either broadly unchanged or declined somewhat in the rest” (1996, p. 63).

Figure 5.2.Changes in Earnings Dispersion Relative to 1977

(1977 = 1; 1979 for Japan, 1981 for Canada, and 1983 for West Germany)

Sources: Canada, (West) Germany, and Japan: Organization for Economic Cooperation and Development (1996), table 3.1. France: Bayet and Julhès (1996), p. 48. Italy: Brandolini and Sestito (1996), table 8. United Kingdom: Atkinson and Micklewright (1992), table BE1, linked at 1990 to U.K., Department of Employment (1997), table A30.2. United States: Karoly (1994), table 2B.2, weekly (consistent) wage and salary income, linked at 1979 and 1987, linked in 1989 to Organization for Economic Cooperation and Development (1996), table 3.1, which refers to male earnings.

Diversity of trends in income distribution has also been reported for non-OECD countries. According to Fiszbein and Psacharopoulos: “Income inequality [during the 1980s] … increased in Argentina, Brazil, and Panama and decreased in … Costa Rica, and Uruguay” (1995, p. 85).

According to Bruno, Ravallion, and Squire: “We find evidence of a systematic worsening of inequality in the transition economies as GDP has declined but observe no simple relationship between growth and inequality in the adjusting countries” (1998, p. 132).

The diversity of national experience may be contrasted with the universality of the explanations that have been offered. Two such explanations have in fact dominated the economic debate.

The first is the explanation in terms of liberalization of international trade and increased competition, as set out, for example, by Wood (1994). Expansion of trade has caused a shift in demand in OECD countries away from unskilled labor in favor of skilled workers. This explanation ties increased inequality in the North to globalization, while expansion of manufacturing exports has reduced inequality in the South.

In the United States and the United Kingdom, this has indeed led to a fall in the relative wage of unskilled workers, but, as shown by Figure 5.2, there has not been a universal rise in earnings dispersion. This divergence—broadly between mainland Europe (below the line in Figure 5.2) and the Anglo-Saxon countries and Japan—is commonly attributed to the existence of effective minimum wage protection in the former, preventing wages from falling at the bottom but causing unemployment instead: “The upward trend in unemployment [in Europe] is the result of market forces that ‘want’ to produce greater inequality of earnings. The collision between these market forces and the attempts of the welfare state to limit inequality then lead to higher unemployment” (Krugman, 1994, p. 31).

The same applies to the second dominant explanation, which sees the shift in demand away from unskilled workers as resulting from technical change biased toward skilled labor with the introduction of automation and information technology. In this case, rising inequality or unemployment is caused not by globalization as such, but by common forces affecting OECD countries.

This line of explanation is summarized in the top part of Figure 5.3—from “world forces,” whether trade or technology or both, to incomes from production—but one of my main points is that the evolution of the distribution of household living standards cannot be explained solely in terms of the market outcomes. Worsening of the labor market for unskilled workers has not led universally to increased inequality of household incomes (as is evident from Figure 5.1). Social protection and other sources of income, as well as household structure, influence the impact on households. And government policy and social institutions more broadly mediate the incomes generated by production, as set out schematically in Figure 5.3. Income from work is not the sole determinant of household living standards. Where, for example, there are income-tested benefits for families, higher transfer payments may moderate the impact of a decline in the wages of unskilled workers, the extent of the offset being governed by the implicit marginal tax rate. These intermediating policies may, in turn, have repercussions for the incomes from production through their effect on work incentives. The minimum wage is, in Krugman’s eyes, an example of negative feedback; in contrast, in-work benefits are often perceived as having positive effects.

Figure 5.3.Schema

The conclusion I draw is that the evolution of inequality cannot be explained solely in terms of market incomes. The divergence of national experience reflects differences in government policy and social institutions. The implication for industrializing countries is that the mechanisms of production and trade do not determine a single distributional outcome. I return to this in the section on capital income below; first, I would like to enrich the analysis of production incomes.

Mechanisms: Enriching the Supply and Demand Story

The precise contributions of trade and technical change to increased wage dispersion in the United States have been widely debated (see Burtless, 1995, for a review), and it is not my intention to discuss this here. Rather, I would like to draw attention to one remarkable feature of the debate between trade and technical change: the extent to which supply and demand considerations hold sway. The whole explanation is to be found in shifting demand curves. The present-day hegemony of the supply and demand story contrasts markedly with earlier writing on wage differentials, where there has been a creative tension between market force and alternative explanations of wage differentials. Sir Henry Phelps Brown, for instance, in his textbook, The Economics of Labor (1962), notes that before the days of collective bargaining and state regulation of wages, there were two forces that prevailed: the forces of convention and of supply and demand. By the former he meant “opinions about what is the right thing to do that are reinforced because most people agree in holding them” (1962, pp. 125–26). Similarly, Sir John Flicks, in the second edition of The Theory of Wages, maintained that “there are important social (and expectational) elements even in the ‘free market’ part of wage-determination. Even there, wages are not simply determined by supply and demand” (1963, p. 319).

Trade union bargaining and statutory wage determination may be incorporated into the supply and demand framework, and the same applies to monopsonistic behavior by employers. More of a challenge is the view that supply and demand only place limits on the possible wage differentials, with other factors, such as convention, determining where between these limits wages actually lie. Such a “range theory” of wage differentials was advanced by Lester (1952) and has long been implicit in much institutional writing on labor economics, even if it has received less attention in recent years. Within this range, there is scope for notions of fairness or equity, as has been investigated by, among others, Wood (1978) and Carruth and Oswald (1989).

Elements of convention or fairness are particularly important where they function not just within an industry or occupation but across the society as a whole. This is relevant, given the considerable degree of commonality, to the rise in earnings dispersion. Evidence for the United Kingdom is provided in Figure 5.4, which shows how the dispersion of male earnings, measured by the decile ratio (ratio of top to bottom decile), widened between 1979 and 1990 for individual occupational groups. For comparison, I also show the economywide changes for the United Kingdom and four other G-7 countries. As we would expect, the increases within narrowly defined occupational groups are smaller than in the U.K. economy as a whole, but they are sizable—and much more concentrated than the increases by country.

Figure 5.4.Widening of Male Earnings Dispersion in United Kingdom Occupations, 1979–90

(Change in top-to-bottom-decile ratio, 1979 = 100)

Sources: Canada and Japan: Organization for Economic Cooperation and Development (1996), table 3.1. France: Bayet and Julhès (1996), p. 48. Italy: Brandolini and Sestito (1996), table 8. United Kingdom: Department of Employment (1979), table 96, and (1990), pt. A, table 8.

What can explain this pattern? Convention, or social norms, operate in conjunction with supply and demand. They can interact in several ways. One view sees the long-run equilibrium as governed by supply and demand, but with the forces of convention resisting adjustment, so that they influence the out-of-equilibrium wage differentials. Where the long-run equilibrium is itself shifting, social forces may have enduring consequences. As described by Hicks: “The level of wages which is needed to attract labour quickly into an expanding trade is … higher than that which is required to maintain the larger labor force; but, having once risen, the differential does not fall back easily … [A]ctual wage-systems are full of differentials that have lost their economic function, being … the fossilised remains of historical shortages” (1963, p. 320).

A second view formalizes the “range theory” in terms of supply and demand curves coinciding for an interval, which would mean that local shifts could leave equilibrium differentials unchanged, along the lines of the kinked demand curve.

A third view tries to build bridges between social convention and supply and demand, as has been illustrated in theories of involuntary unemployment advanced by George Akerlof (1980) and Robert Solow (1990). Observance of social norms may be consistent with individual rationality, even where it may appear to conflict with economic advantage. Akerlof (1980) describes a model where individual utility depends not only on income but also on reputation and, for those who believe in the social code, on conformity with the code. The loss of reputation depends on the proportion who believe in the code, which is undermined if people cease to observe it. He shows that there may be a long-run equilibrium with the persistence of a “fair,” rather than market-clearing, wage. Solow (1990) uses a repeated game model to argue that it may be individually rational for unemployed workers to try not to undercut the wages of those in employment.

In this way, we are not suspending supply and demand as much as enriching the behavior that lies behind these relations. Among the new implications is that widening wage dispersion can result not just from shifts in the demand for skill but also from changes in social norms and expectations. It may, for exogenous reasons, have become socially acceptable to have larger differentials within the workplace. Or an exogenous shift in demand may have interacted with the endogenous determination of social norms. As more people are remunerated outside the conventional norms, adherence to these norms becomes weaker, or the socially acceptable range widens. A demand shift may have caused a movement from an equilibrium where the norm is low differentials to a high-differential equilibrium.

The incorporation of theories of social norms into the analysis of income determination would scarcely come as a surprise to those versed in the development literature; what is perhaps surprising is the predominance of explanations of OECD wage dispersion that ignore their role.

Importance of Capital Income

Much of the debate about rising inequality in the United States and the United Kingdom focuses on labor earnings. Wages are indeed the largest part of income from production, but we should not neglect the role of capital income.

This takes us back to the classic question of factor shares, which has been strangely neglected in recent times. Sixty years ago, Bowley’s Law of the constancy of relative shares was espoused enthusiastically by Keynes in a well-known quotation: “The stability of the proportion of the national dividend accruing to labour… is one of the most surprising yet best-established facts in the whole range of economic statistics …. It is the stability of this ratio for each country which is chiefly remarkable, and this appears to be a long-run, and not merely a short-period phenomenon” (1939, p. 48). The constancy later formed one of the celebrated stylized facts of Kaldor (1961), and the constancy of labor’s share in the United States was described as one of the “great ratios of economics” (Klein and Kosobud, 1961, p. 176).

The movements in the nonlabor share in business sector output in the G-7 countries are shown in Figure 5.5. In the United States and the United Kingdom, there does appear to be broad constancy, although even the five-year average figures show some fluctuations. James Poterba (1997), whose data I have used in constructing these diagrams, concludes that there has been a small increase in the United States: the share is ½ percentage point higher in the 1990s than in the 1980s. In Japan, the share falls and then rises; in Canada the reverse is true. The behavior of factor shares in continental Europe is shown in the bottom panel. In Italy and (West) Germany, the share falls then rises, so that it is now back to its level of the 1960s. In France, the rise since 1980 is much more marked. There is a variety of experience, but in the majority of the G-7 countries (five out of seven) the evidence suggests that there has been a shift toward nonlabor income since 1980, with this shift being 5 percentage points or more in Italy, Japan, and (West) Germany, and 10 percentage points in France.

Figure 5.5.Nonlabor Share in Business Sector Output in G-7 Countries

(Percent output, five-year average)

Source: Poterba (1997), table 8 (five-year moving averages of shares).

Viewed in terms of factor returns, real rates of interest increased in the early 1980s and have remained high in the 1990s (Blanchard, 1993). The average rate of return on business assets in the G-7 countries has risen from 13.6 percent in the 1980s to 15.1 percent in the 1990s (Poterba, 1997, p. 23).

Rises in the share of nonlabor income are not confined to OECD countries. Bourguignon and Morrisson (1992, p. 36) found that, except in Malaysia, profits were less affected than wages by stabilization programs in developing countries. Although comparisons are hard to make, the transition in Eastern Europe and Russia appears to have been associated with a fall in the wage share. Conversely, Tanzi argues that “the rapid and sustained growth of many East Asian economies … appears to have been accompanied by an improvement in the functional distribution of income” (1998, p. 361).

Whether a shift toward labor income represents an “improvement” in the distribution of personal income, and whether a decline in the labor share represents a worsening, depends on the link between the factor and personal distributions. This link is more complex than in the days of the classical economists, when different sources of income were identified with distinct social classes. In part, the difficulties in making the connection arise from statistical shortcomings. The personal distribution data typically show money rather than real income, making no allowance for the erosion of capital incomes; in the opposite direction, the data often omit capital gains.

In part, the difficulties in linking functional and personal distributions are analytical. People have income from different sources; and the balance of sources shifts over the life cycle. A typical OECD country worker is not reliant solely on wages but may well receive rent (e.g., through owning a house) and investment income. Higher real interest rates benefit pensioners as well as renters. Companies receive income from abroad and pay dividends to overseas shareholders. There are intervening institutions, so that a sizable proportion of nonlabor income accrues to pension funds and other intermediaries. A rise in the share of profits may lead to higher pensions or it may reduce the costs of employers (with schemes paying pensions on a fixed formula).

Tracing through the distributional implications of changes in functional income shares is an important task. The impact of macroeconomic policies in developing economies, and of transition policies, cannot be read directly from the national accounts. This has of course long been understood in the development literature. Twenty years ago, Irma Adelman and Sherman Robinson noted in their study of Korea: “There seems to be very little connection between the distribution of income by deciles (the size distribution of income) and the distribution of income by classes of recipients (the functional distribution of income). Even though the size distribution in our model is generated from the functional distribution, our experiments indicate that the size distribution is extremely stable whereas the functional distribution varies rather widely” (1978, p. 183). At the same time, they note that the relative position of different groups may vary within the size distribution; this raises the question of different dimensions of equity, to which I now turn.

Are Redistributive Policies Still Economically Possible?

A person who went to sleep the day that J.F. Kennedy was elected president of the United States in 1960 and woke up today would be struck by many changes. One of the most striking is the widely held assumption that governments are now largely impotent in the face of economic forces. In the heady days of the early 1960s, it was believed that governments could choose from a menu of inflation and unemployment (the Phillips curve), that foreign aid programs would speed the development of poor countries, and that governments could redistribute domestically through taxes and transfers. Today, the conventional economic wisdom is that there is a “natural rate” of unemployment, that aid programs are ineffective, and that governments are largely powerless to offset a global trend toward increased inequality.

It is the last of these issues that I address here. If the distribution of labor income becomes more unequal, can this not be offset by a more progressive system of income tax and transfers? The literature on optimal income taxation suggests, for example, that a widening of wage differentials should lead to a compensating rise in the rate of taxation (Atkinson, 1995, p. 9). Income-related family benefits mean that many low-income households face high implicit marginal rates of tax; put in reverse, these should moderate the fall in net household incomes. If the rate of unemployment of unskilled workers rises, then we should expect increased total expenditure on unemployment benefits (even if the replacement rate for each person is reduced).

In the welfare states of the OECD, government policy could indeed be expected to have this moderating effect. Countries differ in the extent and form of their provisions, and this is one reason for the diversity in changes in the distribution of income. Some countries have protected the poorest members of their societies. But there are doubts as to whether this can be sustained. The issues paper prepared by the OECD for a high-level conference in 1996 opened with the statement that “the slowdown in the growth of OECD economies over the past twenty-five years has been accompanied by fears about the sustainability of current systems of social protection” (OECD, 1997, p. 2).

Many people argue that the forces of globalization will limit the capacity of governments to offset trends toward inequality in income from production. Moreover, they may compel the dismantling of social protection, which will independently add to the rise in domestic inequality. This has been seen, for example, in the United Kingdom, where the top rate of income tax was reduced to 40 percent, unemployment insurance largely abandoned, and state pensions linked to prices, not earnings—which means that they will become of dwindling importance over the next decades.

The forces limiting the power of national governments may be direct ones arising from factor mobility. Capital mobility is an example: few can doubt that there is now less scope than in the 1960s for redistribution from capital to labor income (Harberger, 1998, pp. 217–18). But other elements seem less clear. If it is a case of people voting with their feet—moving to pay lower taxes or to get higher benefits—then the experience of the European Union to date does not suggest that substantial migration has been induced by the differences that exist between member states in net-of-tax wage rates. Studies in the United States of “welfare migration” between states suggest that there is a significant effect, but a rather small one. The mechanism could be the location decisions of firms. A national government, by abolishing minimum wages and reducing the level of social protection, can seek to attract inward investment. On the other hand, welfare spending may be productive: higher productivity may more than offset the immediate cost advantage of lower labor costs.

The pressure on national governments may be an indirect one, in that scaling back redistribution is held to be necessary to maintain economic performance—for instance, that the welfare state leads to unacceptably high levels of state spending. Budgetary cost is evidently important, but if it were the only issue at stake, then all forms of government expenditure would be open to the same scrutiny. Welfare spending is not the only activity that can be scaled back—we would have to ask the same questions about military spending. In fact, it is not just budgetary cost that leads people to argue that the welfare state has to be scaled back: they believe that the welfare state in itself is bad for jobs and for economic growth.

What is the evidence for this? Have countries with large welfare states grown more slowly? Obviously, in seeking to answer this question, we must control other influences on economic performance, embedding the analysis within a model of the determinants of growth. A number of statistical studies have examined the role of social transfers in OECD countries, and their results are mixed. Of 10 recent studies reviewed in Atkinson (forthcoming), 2 find an insignificant effect; 4 find that transfers are negatively associated with average growth rates, and 4 find the reverse effect. The U.S. President Harry Truman, who wanted a one-handed economist, would be in despair.

What about unemployment? Again there have been interesting cross-country studies seeking to explain why unemployment today is higher in Europe than in most other OECD countries (e.g., Nickell, 1997; and Siebert, 1997). However, there are many differences between European and other societies, and I am not convinced that one can reliably attribute the difference in unemployment to one particular element (social protection). In principle, unemployment benefits can allow people to be more choosy about returning to jobs, and hence increase the length of time out of work, but there are administrative sanctions against job rejection. Social security has positive as well as negative effects on incentives: in particular, it may facilitate restructuring of the economy. People may be more willing to take risks, to retrain, and to change jobs in a society in which there is adequate social protection. Moreover, contributory unemployment insurance acts as a positive incentive for people to enter the labor force. The welfare state is a system of checks and balances, not just payment checks.

In my view, the economic constraints are exaggerated. Politicians have more room to maneuver than they like to admit. If globalization has limited the power of national governments to redistribute, then this limit is largely political in origin. Albert Hirschman (1970) distinguished between “exit” and “voice” as reactions to economic change. Workers who perceive that taxes are lower in other OECD member states may not migrate but seek instead to exercise political power (voice) to achieve lower taxes at home. Comparisons of tax rates with those in other member countries may become an important restriction on the freedom of national governments to carry out social protection.

Are redistributive policies still economically possible? In my judgment, the answer is yes. OECD welfare states undoubtedly need reform, but it is reform rather than dismantling that is indicated by economic necessities. At the same time, there remains the question: Are redistributive policies still politically possible?

Equity Has Many Dimensions

Amartya Sen has argued that “the central question in the analysis and assessment of equality is … ‘equality of what?’” (1992, p. ix).

Contemplation of statistics such as those in Figure 5.1 might suggest that we are concerned only about the distribution of household incomes. But income is only one of several important aspects. To this, I would add, Among whom? Ranking of households is only one way of viewing the distribution.

These considerations point to the need for a multidimensional analysis of inequality, which may cause us to view differently the impact of global changes on G-7 countries. It is not enough to say that expanded North-South trade has damaged the earnings and employment prospects of unskilled workers in the North. We have to ask how the earnings received by individuals in Figure 5.2 relate to the household incomes shown in Figure 5.1. Low earnings do not necessarily imply low household incomes. The outcome depends on other sources of income and on the contributions of other household members. Here we need to consider not just the household as a unit, but also the distribution within the household. If the male breadwinner has lost his job, and his female partner has taken up work to restore the household income, what has been the incidence of trade-induced shock?

Low income, in turn, is not the same as low standard of living, where our concern may be with the access to resources or, more broadly, with the capacity to function. The time dimension then becomes important. If the impact of trade is temporarily to induce lower wages or higher unemployment during a period of adjustment of industrial structure in G’7 countries, this is different from a permanent loss of earnings capacity. The adjustment may have a life cycle dimension. Employment rates in Europe have fallen, particularly among those aged under 25 and over 55. Depending on the household structure, the existence of family support may mean that this has fewer serious lifetime welfare consequences than would a fall in employment among those aged 25–54. On the other hand, the obverse of reliance on family support is that it perpetuates inequality of opportunity.

Viewed from a lifetime perspective, inequality has both generational and gender dimensions. It is not simply a matter of rich and poor. Are those who have lost their jobs or earnings in G-7 countries the same workers who benefited from the “golden years” of the 1950s and 1960s? Are they also going to be adversely affected by the cutbacks in state pensions and services for the elderly? Has the change in industrial structure benefited women, whose employment rates have risen?

These questions are among those that have led to concerns for a wider concept of human development in the development literature and to concerns about social indicators in assessing transition in Eastern Europe and Russia. The analysis of OECD economic performance could well benefit from what has been learned in these fields.

Summary

The main points made in this paper about the experience of G-7 countries are the following:

  • National experience with regard to income and earnings inequality has varied considerably;

  • The evolution of inequality cannot be explained solely in terms of income from production: the divergence of national experience reflects differences in government policy and social institutions;

  • Widening wage dispersion can result not just from shifts in the demand for skill, arising from trade liberalization or from skill-biased technical change, but also from changes in social norms;

  • There has been a significant shift toward nonlabor income; the implications for the distribution of personal income are not self-evident;

  • The economic constraints on national governments are exaggerated; if globalization has limited the power to redistribute, then this limit is largely political in origin; and

  • Equity is not just a matter of rich and poor but has many dimensions.

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