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Direct Government Intervention to Lower Inequality Won’t Work
By Taeyoon Sung

Income inequality, and the policies to resolve it, have become one of the most important issues in economics. There have been numerous academic and policy debates on the subject around the world, especially as a growing number of people have begun to address increasing income inequality as a critical policy concern. Of course, there are some who argue it is necessary to eliminate inequality altogether and that everyone should be economically equal; but most agree that it is excessive inequality that should be avoided, and that inequality cannot be completely eliminated. I believe that excessive inequality creates various socio-economic problems.

 

Inequality and the issues that stem from it — such as corruption — may not only hinder socio-political stability, but may also trigger extreme behavior from people that could even endanger the community if inequality is so severe that it threatens their livelihoods.

 

Economists sometimes take this perspective further and directly link inequality and economic growth, arguing that a more egalitarian society can, in fact, grow faster. In this context, East Asia and Latin America are often compared, with observers noting that relatively equal East Asia has experienced higher economic growth than Latin American countries with severe inequality. But we cannot definitively conclude that inequality and low economic growth are causally related, even when there exists a correlation between the two variables and we address inequality as a social problem. It is not possible to conclude that lowering inequality will directly bring about economic prosperity.

 

Comparing East Asian and Latin American economies, it is worth noting that investment in education and human capital accumulation has been one of the major driving forces behind low inequality and high economic growth in the former. Production-factor markets in East Asia have experienced a relatively high return from investments in education that were able to accumulate human capital significantly, and the resulting economic growth from this may have alleviated income inequality. Relatively low government corruption in East Asia also contributed to less income inequality and high economic growth.

 

Thus, we can argue that income inequality may impede economic growth when it hinders educational opportunity and endangers an individual’s chance to accumulate human capital. From a theoretical point of view, neoclassical economic growth stories that emphasize savings and capital accumulation point out the importance of human capital accumulation in addition to physical capital accumulation; also, the endogenous economic growth theory stressing technological innovation presents human capital accumulation as one of the most critical factors in driving economic growth and innovation. As a result, severe income inequality that obstructs education and human capital accumulation can be detrimental to economic growth, but lowering income inequality directly may not always result in economic prosperity.

 

Therefore, it would be more effective policy-making to find the channels through which income inequality negatively affects economic growth and focus on these channels rather than approach income inequality in general. In this context, it would be more important to prevent income inequality from adversely affecting education and human capital accumulation, as well as corruption when it invades property rights.

 

The South Korean Case

 

Such a perspective offers a particularly significant insight into recent South Korean policy. The administration of President Moon Jae-in, who came into office in 2017, has been pursuing what it calls “income-driven growth.” This is a type of wage-led growth that is based on the post-Keynesian idea of promoting economic growth by resolving income inequality and increasing the wages of lower-income earners. At its core, the Moon administration’s policy led to a 16.4 percent increase in the minimum wage in 2018 and a 10.9 percent increase in 2019. The policy objective has been to achieve economic growth by increasing the wages of low-income earners, which will strengthen their purchasing power. In reality, though, the policy has led to very different results from what was intended. Employment and the labor market have deteriorated to their worst levels on record, with the exception of the Asian financial crisis of 1997-98 and the global financial crisis of 2008.

 

For example, year-on-year growth in average employment was approximately 100,000 people in 2018, which is around a third the level of roughly 300,000 people in 2017. The bottom 20 percent income tier — which is likely to be subject to the minimum wage — has been hit the worst, with the share of unemployed households in that tier increasing from 43.6 percent in the fourth quarter of 2017 to 55.7 percent in the fourth quarter of 2018. The monthly average income of the bottom 20 percent of households is reported to be 1.236 million won (about US$1,100) in the fourth quarter of 2018. That number is not the result of a slower increase, but rather the fact that the absolute income level has decreased by 17.7 percent compared to 2017. This was the most significant decrease since records have been kept. We should also note that their income has fallen significantly, despite the fact that the income transfer to this bottom 20 percent increased by almost 11 percent due to growing government expenditures including public pensions. Contrary to the government’s intention to improve the economy by raising the minimum wage, the jobs for those who are impacted by the minimum wage have disappeared, leading to a significant decrease in labor income and total income. The consequence has been a 36.8 percent decrease in year-on-year labor income for the bottom 20 percent income tier in the fourth quarter of 2018.

 

In the name of its “economic growth” policy, the government’s wage-setting policy has directly intervened in the labor market by setting the minimum wage substantially above market equilibrium in the hope of resolving income inequality. But in reality, the policy has adversely affected employment and the macroeconomic environment. The impact of the wage rises on jobs and the overall economy greatly varies from the country’s actual economic fundamentals, because the drastic increases in the minimum wage are out of step with current economic conditions and have resulted in an adverse shock to the economy.

 

Jobs and the Jobless

 

The average national income per capita in South Korea is roughly US$30,000, while the US is approximately US$60,000. Thus, the real burden of the hourly minimum wage on South Korea’s per capita GDP is 1.9 times greater than that of the federal minimum wage in the US. It is even 1.5 times above that of California, where the state minimum wage is one of the highest in the US. The ratio of South Korea’s minimum wage to its median wage is also one of the highest in the world, except for France. The sudden and drastic increase in the South Korean minimum wage also raised overall labor costs, so that companies that were previously holding off adding jobs are now even more reluctant to create new jobs. Meanwhile, companies that are mainly affected by the minimum wage have responded by eliminating jobs.

 

Consequently, income inequality has deteriorated further, because people have lost their jobs or cannot find jobs under the current policy. Those with stable jobs may have earned more as their wages grew, but people with lower incomes who also face relatively more insecure job opportunities have experienced severe income loss, because many can no longer find work. For example, the average number of working members per household in the bottom 20 percent income tier has decreased from 0.81 in the fourth quarter of 2017 to 0.64 in the same quarter of 2018. The relative income ratio of the top 20 percent income tier to the bottom 20 percent tier, which divides the disposable income of the top 20 percent by that of the bottom 20 percent, has worsened from 4.61 in the fourth quarter of 2017 to 5.47 in the same quarter of 2018. That increase in the income inequality index is the worst since statistics have been kept.

 

Moreover, real GDP growth in 2018 was at 2.7 percent, down from 3.1 percent in 2017. The overall labor cost increase from the drastic rise in the minimum wage acted as a negative shock to the economy, although it does not explain all the reasons for the decline in the GDP growth rate. In short, the government’s direct market intervention in the form of wage-driven or income-driven growth, particularly on the price factor involving lower income tiers through higher minimum wages, has appeared to fail in achieving the goal of resolving income inequality and promoting economic growth. Some argue it will take a bit longer for the policy to be fully effective, but in fact, all that we are likely to see is a dissolving of the negative impact of the initial shock, just as in all other shocks to the economy.

 

To be sure, income inequality is a critical issue in the economy, and it is essential to work toward resolving or alleviating the problem. However, this does not necessarily mean policies intended to deal with income inequality will result in economic growth. What we need to do instead is to ascertain clear channels between such critical problems and various other economic issues, including growth, and focus on how we can work around these channels, rather than directly intervene in income inequality or wages by using policies that stand against the market.

 

Even if income inequality may impede economic growth, we have to understand how exactly the issue poses a problem for growth and seek a reasonable solution for the specific problem. We also have to consider the possibility that direct government intervention to resolve income inequality may not succeed. The result may be completely different from what the government intends, especially when policy-makers fail to accurately reflect market mechanisms and current economic conditions. Another thing to remember is that the adverse effects of the government’s direct intervention involve a price: not only could the redistributive policy fail to achieve its intended goal, it could increase non-productive government expenditures, thus further aggravating the negative impact of unsustainable policies on the economy.

 

Back to Issue
    The Moon Jae-in administration’s policy to reduce inequality in South Korea have surely been well-intended. But the policy of ‘income-driven growth,’ with its reliance on large, government-mandated increases in the minimum wage, have been an unmitigated disaster. It is time to focus on making the private sector more competitive, not less.
    Published: Mar 27, 2019
    About the author

    Taeyoon Sung is Professor at the School of Economics at Yonsei University, and also serves as Dean of the Underwood International College at Yonsei University. He has published widely in various prestigious international journals on economics.

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