The economic imperative

As the general election creeps into view, focusing Labour minds on how to draw together a wide-ranging policy review into a realistic programme for government, there is a growing debate on the merits of ‘predistribution’ in tackling inequality. Is it better to aim for reducing the dispersion of market incomes or rely mainly on ‘redistribution` through tax and benefits? While the last Labour government introduced the minimum wage, it relied largely on the latter, attempting to soften the impact of markets through a revamped tax credit scheme that boosted the incomes of the lowest paid.

Ed Miliband has signaled his intention to give more weight to predistribution. Others have their doubts. In a recent critique in the IPPR Journal, Juncture, the American academic Lane Kenworthy argued that securing a narrower gap in market incomes will be difficult. Instead we will need to continue to rely on redistribution. So is this right? Should the thrust of achieving greater equality come through a boost to redistribution or can we really reshape markets to produce fairer outcomes?

While achieving a more equal share of the cake before tax and benefits requires a diverse range of policies – ones that tackle, for example, the growing educational divide and Britain’s failing housing market – the most significant driver of rising inequality over the last three decades has been a process of ‘wage compression` . While the share of national output going to profits has been rising, the share going to wages has fallen from an average of around 59 per cent in the two post-war decades to a little over 53 per cent today, with most of this fall concentrated in the lower half of earnings. As a result, the proportion of the UK workforce that is low paid has almost doubled over the last 30 years and now stands at over a fifth. With a large majority of the 580,000 jobs created since 2010 also low paid, the nation’s army of low earners has continued to swell through the crisis.

These trends have had profound social and economic effects. They have capped opportunities, boosted in-work poverty and weakened the incentive to work. They have driven up the cost of income support while turning Britain into a leading low-paid economy.

Kenworthy argues that the long squeeze on wages is set to continue: economies like the UK and the US will continue to hemorrhage better-paid manufacturing jobs, union bargaining power will go on declining, and there is limited scope for raising the minimum wage. Because of this, he argues that while there may be some potential for predistribution, most of the strain will have to be borne by ‘good old fashioned public insurance’ through more generous tax credits.

So how significant is the problem of wage compression and what policy approach would be most effective in tackling it? In 2011/12 aggregate wages across the whole economy stood at £835bn. This is around £85bn less than if the wage share had held its 1979 level. The argument about predistribution is essentially about how much of this £85bn shortfall or ‘wage gap` could be restored without a loss of competitiveness or jobs.

A recent study has looked at the potential impact of four predistribution style measures on the wage-gap: a small increase in the minimum wage, a halving of the numbers below the living wage, an extension of collective bargaining and a significant reduction in unemployment.[i] It found that a modest boost of 40 pence to the minimum wage and policies that halved the numbers earning less than the living wage would raise the wage floor for around 3 million low paid workers. In combination these two measures would add around £4bn to the aggregate wage bill, closing about 4.5 per cent of the wage gap.

A more significant fall in the wage gap and increase in the wage share would require bolder and more controversial policies, notably through a shift in the balance of bargaining power in favour of the workforce. Because of the ‘wage premium` associated with collective bargaining, the deliberate erosion of labour’s strength since the 1980s has played a big role in wage depression. Indeed, a doubling of the proportion covered by such collective agreements – bringing Britain closer to the European average – would significantly boost wages. Achieving this would require bold measures – such as the reintroduction of wages councils on a sectoral basis to set minimum wages by industry – but it would add an estimated £13bn to the wage pool, and close 16 per cent of the wage gap.

The other most significant measure would be a boost to the level of employment. The average level of unemployment in the UK has been much higher over the last 30 years than in the immediate post-war era. Tight labour markets – with lower low levels of unemployment – are associated with higher wage growth so that a rise in employment would also boost wages, by around £4bn.[ii] Together, these four policies would close around a quarter of the wage gap, adding over £20bn to aggregate wages and boosting pay especially amongst middle and lower earners. Such changes would thus have a noticeable, if modest impact, reversing the 30-year long trend of a shrinking wage share. Going further would require a more active industrial strategy aimed at a long-term rebalancing of the economy towards sectors that can support higher-waged employment and reducing the number of ‘bad jobs`.

So just how feasible is such a package? There is no reason why the first two measures – lifting the minimum wage and reducing the proportion below the living wage – could not be implemented. The increase in the minimum wage would merely restore its real level to that of 2008 with minimal effect on jobs. A phased move on the living wage could be achieved without significant job losses or increased costs to firms.[iii]  And the second two, changing the balance of bargaining power in favour of the workforce and the pursuit of lower unemployment, are more difficult but ought to be key elements of a progressive alternative.

These measures would have the important impact of taking some of the pressure off redistributive tax and benefit measures. Indeed, it is arguable that any attempt to achieve extra redistribution through existing mechanisms would face its own set of constraints.

The existing benefit system in the UK does provide a substantial boost to the incomes of those working for low wages, while reducing the inequality of market incomes.[iv] Labour from 1997 embraced a strategy of labour market freedom buttressed by ‘stealth redistribution`, with a much strengthened system of social protection for those in work. While this helped reduce poverty and raise living standards at the bottom, by 2010 the policy had clearly run out of steam.

Gradually, Britain’s system of income support has come to play a greatly extended

role, way beyond its original aims. The need to compensate for the failure to provide decent livelihoods and work for a rising proportion of the workforce has led to a steady rise in the total benefits bill from an average of 8.5 per cent of GDP in the 1970s to an average of 12 per cent over the last 25 years.  The aggregate cost of social security is also set to rise over the next few years, despite a number of cuts in benefit levels.

A further constraint is that the cost of social security spending is increasingly born by those whose earnings are not much higher than those in receipt of credits, one of the likely explanations for the apparent hardening of public attitudes towards benefits in recent years. The British tax system shifted from being progressive to regressive during the 1980s, and the burden of welfare spending now falls more heavily on middle than top income groups.

Redistribution from the middle to the bottom is hardly a progressive strategy. Without reforms that tackle the explosion of tax avoidance and create a more progressive tax system, any further hike in the level of wage subsidies would do little to secure redistribution from the top, while risking the further erosion of support for the welfare state.

By subsiding low-paying employers, the tax credit system may encourage lower pay, thus entrenching the problem it is trying to solve. Indeed, it is likely that the removal of measures from the 1980s to maintain pay levels may have encouraged British employers to take us down an economic ‘low road` of low pay and productivity.

Others, such as the Harvard political theorist, Roberto Unger, have a more fundamental critique of the emphasis on redistribution. Writing in Juncture, he argued that it has diverted attention away from more important goals towards “after-the-fact redistribution and regulation rather than any reshaping of either production or politics. By the terms of that bargain, any attempt to alter fundamentally the productive and political arrangements was abandoned.”

So, while reversing wage depression will face a number of hurdles, there are also limits to the potential of traditional redistribution to reduce inequality. And there is also an increasingly powerful political case for tackling low pay at source, with declining living standards set to be a central issue in the 2015 election.

Ed Miliband has been making the running on improving the wage floor. But with relatively few firms signing up to the living wage, and a justifiable reluctance to make the living wage statutory, Miliband has now pledged to give a tax break lasting a year to firms which pay the living wage. He has also asked Alan Buckle – deputy chairman of KPMG – to work with businesses on the detailed implementation of this scheme and on how to encourage greater use of the living wage. The ‘make work pay’ contracts will aim to raise wages and keep the benefit bill down by a switch from topping up wages via tax-credits to improving them at source with employer subsidies, though with the advantage that the tax break will be limited to a year. Once introduced by firms the presumption is that the policy would stay when the tax break is removed leading to a permanent rise in the wage floor.

But there is a further critical argument in favour of predistribution, and that is one of restoring economic sanity. According to economic orthodoxy, the shift from wages to profits over the last 30 years – not just in the UK but in the US and to a lesser extent in other rich nations – should have improved economic health. Instead, it has created a number of highly damaging distortions, fracturing demand, promoting debt-fuelled consumption and raising economic risk. While profits have been booming, the share of GDP going to private investment in the UK has been in steady decline. Because labour is cheap, firms have less incentive to become more productive, helping to turn the UK into today’s low value-added and low-skilled economy.

The evidence is overwhelming: an excessive imbalance between wages and profits breeds fragility and weakens growth. According to the International Labour Organisation, nearly all large economies – including the UK and the US – are ‘wage-led’ not ‘profit-led`. That is, they experience slower growth when an excessive share of output is colonised by profits.

The wage/profit imbalance has, arguably, also prolonged the crisis. While living standards have been falling across rich nations, and wage-based consumption has slumped, corporate profitability has reached new heights. The result is a global economy awash with spare capital. American corporations are sitting on cash reserves of $1.45tn, the equivalent of a tenth of the American economy, and a sharp rise since 2010. We can add to this the trillions in private accounts owned by the world’s billionaires.[v]

In the UK, corporate cash piles and personal fortunes have also climbed to record levels. The world’s corporate and personal money mountain – sitting in banks and corporate treasuries – could have been used to launch a sustained recovery, renewing infrastructure and creating jobs. Instead most of it is lying idle – ‘dead money` according to Mark Carney, governor of the Bank of England.

The ‘distribution question` has long been a central issue of political economy. But even its discussion was dismissed as heresy by the market theorists who dominated economic thinking from the 1980s. “Of the tendencies that are harmful to sound economics, the most poisonous is to focus on questions of distribution”, wrote the Chicago economist, Robert E Lucas, Nobel prizewinner and one of the principal architects of the pro-market, self-regulating school, in 2003.[vi]

That view is no longer tenable. “I think our eyes have been averted from the capital/labor dimension of inequality”, declared another Nobel laureate Paul Krugman in 2011. ‘”It didn’t seem crucial back in the 1990s, and not enough people (me included!), have looked up to notice that things have changed.”

To correct this imbalance and the distortions it creates requires a new economic model that gradually returns the wage share closer to its post-war level with big firms devoting more of their profits to pay. There is now a growing consensus that economies built around poverty wages and huge corporate and private surpluses are unsustainable. In that sense creating a more equal distribution of the cake, before the advent of tax and benefits, is an economic necessity, and one that is being acknowledged even in the most unexpected of quarters.

“Going forward…labour will fight back to take its proper (normal) share of the national cake, squeezing profits on a secular basis” wrote the leading Société Générale financier, Albert Edwards in a note to his clients. Both Christine Lagarde, head of the IMF, and President Obama have signed up to the need to boost wage shares.

Yet despite the developing consensus, the imbalance is getting worse. Where there has been growth, most of the gains have accrued to the top one per cent, while the gap between wage and output growth across rich nations has risen through the crisis.[vii] It is this gap, one which first emerged during the 1980s, that is the primary explanation for falling wage shares and growing surpluses. Kenworthy argues that this 30-year old trend is more likely to be the ‘new normal` than a temporary aberration. The presumption here is that market activity cannot be shaped by government intervention and that we simply have to live with the outcomes, however shocking, ameliorating their social impact through redistribution as best we can.

On present trends, the next phase of wage growth is likely to be weak with the risk that the wage share continues to shrink. This would mean another hike in the level of inequality.  Even at this early stage of recovery the combination of stalled living standards and the growing mountain of idle money in the UK and the US may be quietly sowing the seeds of the next crisis. Although new jobs have been created in some higher paid sectors like business services during the crisis years, they have been outstripped by jobs towards the bottom end of the pay ladder while the number of jobs in middle-pay brackets has fallen, leaving an even more polarised pay structure. Partly as a result, consumer credit levels in Britain are rising at the fastest rate since 2008 [viii]; payday lenders and the ‘Wonga economy’ are becoming an issue of increasing political salience. The mega $920 million fine imposed by regulators on JP Morgan for reckless financial trading, along with new allegations of bank manipulation of the multi-trillion dollar foreign exchange market, are sure signs that little has changed. Another is the risk of another bubble in house prices and some company valuations.

As recovery gathers pace, global cash surpluses – heavily leveraged – are likely to find homes that raise economic risk and feed another round of destabilising financial deal-making. This year has seen a number of multi-billion pound deals financed by this cash mountain, from the £15bn Liberty Global bid for Virgin Media to the $24bn attempt on Dell, the PC maker.

The private equity giant, the Carlyle Group has $50bn of ‘dry powder` waiting to pounce as opportunities become available, while Blackstone has nearly $40bn. Such activity means huge windfall gains for the small number of ‘marriage brokers` masterminding the deals, but paid for by the upward transfer of existing not the creation of new wealth.

If this is the new norm, it is unsustainable. Sticking with the status quo and allowing the top to continue to reap most of the gains from growth will end in another crisis. A bit more redistribution through more generous income support will not provide the level of correction needed. What is needed is an economic alternative around a more proportionate sharing of the cake, with wage rises matching productivity growth, with capital reined in and the rich made to pay more. Far from easy to achieve, but increasingly an economic imperative.