Why Income Inequality Causes Inflation

Unemployment and income inequality

While the current positive development on the labor market is regularly reported, the potential effect of changing unemployment rates on the distribution of income receives little attention. Especially those concerned about the unequal distribution of income should welcome the low unemployment rates, because they not only indicate that more people are doing paid work, but could also contribute to a more equal distribution of income in the next few years.

German labor market 2015: positive trend continues

The latest figures on the labor market situation in Germany make one sit up and take notice. A new high was reached in 2015 with an average of over 43 million people in employment. At the same time, the annual average unemployment rate fell to 6.4%.

The positive trend on the German labor market thus continued. Since 2003 - when 39.2 million people were employed in Germany - the number of people in employment has increased year after year and has now passed the 43 million mark for the first time, despite the financial and sovereign debt crises since 2008.

The average unemployment rate of all civilian labor force reached 6.4%, a new low since reunification. It has also shown positive development since 2005 - when it reached a record high of 11.7% on average.

The good labor market data, in particular the relatively low unemployment, could make a contribution to reducing inequality within Germany in the future.

Unemployment and Inequality: Theory

The higher the unemployment rate in a country, the more people cover their livelihood with benefits from the social security systems. These earnings are low compared to the incomes that unemployed people would receive if they were working. It is therefore to be expected that the inequality of income after taxes, contributions and state transfers will be higher the more people are unemployed.

Whether there is a positive correlation between unemployment and income inequality after taxes, contributions and state transfers depends on how high the burden on workers is from income taxes and social security contributions and how extensive the transfers financed by the unemployed are. As is so often the case, this question can only be answered empirically.

GINI coefficient: Inequality in Germany has persisted since 2006

Inequality is often measured using the GINI coefficient. The GINI coefficient is a statistical measure between 0 and 1 that can be used to represent and compare income inequality within countries. The GINI assumes the value 0 if everyone receives an equal amount of income and is 1 if one person combines the entire income and the other people do not receive any income.

Depending on their level of income, individuals receive more or less monetary transfers than they leave to the state in the form of income taxes and social security contributions. The GINI coefficient after taxes and transfers takes into account the redistribution brought about by the state. As a measure of the degree of income inequality in a society, it is therefore preferable to the GINI coefficient before taxes and transfers.

While the GINI coefficient for Germany fell slightly from 2007 to 2012, the GINI coefficient and thus the measured income inequality rose in 2013 and 2014. The favorable development of the labor market in recent years could have contributed to the fact that the GINI coefficient has not increased more strongly since 2006 and that the GINI data for 2015 not yet published will be similar to those from 2014.

Unemployment and Inequality: Empirical Research

Empirical studies on the relationship between the unemployment rate and inequality are available for various countries. There is empirical evidence that a lower unemployment rate reduces income inequality: for example in the USA, England, Sweden, Brazil and the Philippines.

There is also evidence for Germany that lower unemployment rates lead to lower inequality. Researchers at DIW and IMK point to this connection. While an earlier version of another paper found a strong positive effect of the unemployment rate on income inequality, the effect found in the final version is only small, but still goes in the same direction.

Keeping other factors constant also seems to apply to Germany: the lower the unemployment, the lower the income inequality. Obviously, the unemployment rate is not the only factor that can influence the development of income inequality. The empirical literature also discusses the effects of inflation, the distribution of market income, technological changes, the design of the tax system, monetary policy and the average household size on income inequality.

Low unemployment rate as a catching effect

The current high level of immigration to Germany will also affect income inequality. If people move to receive no or only low wages, the average income falls and the GINI coefficient rises.

It remains to be seen whether factors that increase income inequality will prevail over the next few years or factors that decrease inequality. Regardless of this, anyone who is concerned about the degree of inequality within Germany should welcome the good labor market situation over and above the direct positive effects of additional employment.

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