Battling Inequality Increasing Competition to Improve Wages

Income disparity can be decreased but only if competition is increased, writes the chief economist at Commerzbank.
The gap between rich and poor is widening at a slower pace. But when can it start to close?

Capitalism inevitably widens the gap between rich and poor. More and more people in Germany believe this is true and question the legitimacy of our liberal economic order. But alarmism is ill-advised – inequality is not an automatic conclusion in a market economy. Instead, after a period of rising income inequality, strong economic forces will sink income disparity as long as the government ensures sufficient competition.

This fluctuation in inequality goes hand-in-hand with the emergence and spread of technological progress, the most important source of prosperity. At first, it is a small number of companies and their well-trained employees that develop and deploy innovations. These innovators take great risks and make a lot of money when they are successful – causing income inequality to increase. High profits and wages attract competitors. More and more companies use the new technologies, and workers gradually acquire the knowledge and skills to work in these companies and make good money there. As a result, inequality sinks again. 

This pattern also applies to Germany. The industrial revolution led to rising inequality and it declined again in the ensuing decades. In the formative post-war years of the Federal Republic of Germany, with its high degree of social mobility, educational expansion and scarcity of workers, something emerged that sociologist Helmut Schelsky called a "leveled middle-class society." But income disparities have risen again since the beginning of the 1980s and the trend accelerated in the 1990s. This is can be attributed to the so-called second industrial revolution or the advance of information technology.

Lawmakers should not reflexively react to the unbroken trend of rising inequality by raising taxes.

Well-educated employees can work with new technologies to increase their productivity and wages more than workers with little education. Since the early 1980s, about half of the increase in wage inequality in Germany is attributable to technical progress, which favors the well-educated.

The trend towards more inequality has yet to sustain a break, even though the rate of income disparity has slowed since 2010. The unusually strong economy means that less-educated workers were only able to make up part of the previous losses, though this is unlikely to be permanent. Besides, the process of digitalizing the economy is only beginning. Additionally, the more than 1 million refugees – many poorly educated – have increased competition for low-qualification jobs.

Lawmakers should not reflexively react to the unbroken trend of rising inequality by raising taxes. In a globalized world, this could cause venture capital and the highly qualified workforce to leave Germany, curbing innovative power and reducing the size of the pie.

A distribution policy for the 21st century must ensure that pioneering companies and their higher-income employees do not isolate themselves. Instead, they need exposure to strong competition, so that the benefits of technological progress are distributed throughout the entire economy. In order to achieve this, the government needs to keep the markets open to new companies, including those from abroad. It is in Germany's own interest to continue welcoming foreign direct investments. In addition, the government must provide for high-quality education.

This is the only way that new companies can find qualified employees to help them carve away some of the high profits from the pioneering companies. This enables more companies to pay even higher wages, thus reducing inequality.

But education is in a sorry state. In Germany, all children and adolescents must receive a good education – not just those whose parents can afford to live in a wealthy neighborhood or pay for private school. Only with a competition-oriented distribution policy will inequality begin to consistently decline again in a few years and the market economy retain its legitimacy.