Measures and Mismeasures

29 Jul 2018

One of the major topics of public debate in Germany in recent years has focused on the growing gap between rich and poor. LMU economist Andreas Peichl, who studies inequality, discusses how the distribution of income and wealth is changing.

If you were asked to rate your own economic status on the basis of your income, where would you land on the spectrum between poor and rich? Peichl: With the gross income of a W3 professor in Bavaria – in my case that amounts to 6683.49 euros per month – one certainly belongs to the top 10% in Germany, but it doesn’t put one in the top 1%.

And in terms of assets? Assets are a completely different category, and I’m not in the top 1% bracket by that measure either. Nevertheless, there is a close connection between income and assets. The average civil servant belongs to a section of the population that possesses a relatively large stock of assets – or at least has the potential to acquire much wealth in the course of a lifetime.

Is the difference between the top and the bottom ends of the distribution growing? How has the extent of inequality in Germany changed in recent years? First of all, generally speaking, the extent of income inequality is less than that of inequality in wealth. That is true of virtually every country in the world. The range of income inequality in Germany changed very little during the 1950s and 1960s. The gap then widened at a variable rate from the mid-1970s until the mid-2000s. And since 2005 the size of the gap has remained essentially stable for those who are employed. For the population as a whole, the level of income inequality has in fact contracted, because we have had a boom in employment since 2005. The unemployment rate is falling, so more people are now earning money.

But in a quick poll on a busy street, most people would probably agree with the statement that the rich are getting richer while the poor are getting poorer. How do you explain that? Public perceptions of the level of income inequality in Germany indeed differ very starkly from what is actually the case. I believe that the media are largely responsible for this. Anyone who tunes into a TV program like “The Geissens” on RTL, in which millionaires mindlessly squander money, will inevitably get the impression that there are enormous amounts of wealth knocking around. Social media are also a major contributor to this notion. If you log onto Facebook or Instagram, what you see are people on their holidays, eating in smart restaurants or wearing something they have just bought in a fashion shop. What you do not see is average everyday life.

So far we have talked about income, what about asset wealth? As I said, the level of inequality with regard to assets is far larger. The relative level of inequality is usually indicated by the Gini coefficient: The higher its value, the greater the level of inequality. The maximum value of 1.0 would mean that a single individual owns everything. In Germany, the Gini coefficient based on gross income is on the order of 0.45, but the asset-based value is just under 0.8. In international terms that is relatively high. In Japan, the equivalent figure is close to 0.6, for France and the UK around 0.7. The corresponding figures for the US and Russia are just under 0.9 and over 0.9, respectively. Of course, one must always be careful about what are counted as assets.

Is that difficult to work out? Particularly with respect to international comparisons, Germans do have some entitlements that citizens in other countries don’t have, or at least not in the same form. Take our pension system, for instance, or education, for in principle education is free here. We have a very well-functioning, jointly financed healthcare system in which standardized contributions pay for virtually all services. Much of our infrastructure is also subsidized in ways that make it hard to decide how this category can be dealt with in the context of asset wealth.

Where do the data that economists use to measure the distribution of income in Germany come from? In the case of incomes, we have had access to all income tax returns since 2001 ­– in anonymized form and classified into groups. This means that we cannot determine what the richest man in Germany earns, but we are given a mean figure for the top ten.

Persons with particularly high incomes are reputed to be particularly creative in their use of tax loopholes. How reliable are these data? Tax avoidance is indeed a problem. But conclusions about income levels can still be drawn from tax data. For instance, up until 2013, with the aid of what is known as the Goldfinger method, it was possible to set up business companies abroad, which were technically loss-making enterprises. And taxpayers could use these losses to reduce their personal income tax rate in Germany. In other words, data relating to tax avoidance strategies sometimes provide indirect information about real incomes.

And how does one go about assessing the personal assets held by Germans? In relation to assets, data are much harder to come by, because we no longer have a wealth tax. So there are no official statistics on the distribution of wealth. The best one can do is to consult information based on surveys, such as those carried out by the Socio-Economic Panel (SOEP). But if I were suddenly to ask how large your income was in the last calendar year, you could only give me a rough estimate at best. Furthermore, surveys are especially problematic at the upper end of the distribution, where readiness to share information on this topic is not exactly high. On the other hand, income tax forms do contain information on capital assets, interest or dividends, income from the letting and leasing of real estate. And this allows one to deduce the value of the assets that yield such income. In addition, there are certain statistical procedures one can work with, which enable one to get some idea of how wealth is distributed at the top end of the distribution.

Inequality is often perceived as a social problem. Can you as an economist define a threshold above which it would pose a risk to social cohesion? There is no such thing as an optimal level of inequality – or equality, for that matter. Perfect equality is not desirable because it would reduce the incentive to give of one’s best. Very high levels of inequality are also undesirable, because they do endanger social cohesion.

Is it not possible to define a half-ways satisfactory measure of the level at which inequality becomes socially destructive? The underlying reasons for existing inequality are the important factor. If I have acquired my wealth by working harder than others and getting more done, society is less likely to object than it is I have a higher level of income because I happen to be white or come from a wealthy family. It comes down to the relative contributions of personal effort on the one hand, and background variables that have no relationship to one’s own exertions, on the other. The English term ‘equality of opportunity’ essentially means that individuals who work equally hard should have the same chance to reach their goals. It’s a bit like the American dream – from dishwasher to millionaire thanks to one’s own dedication.

And where does Germany lie in relation to offering equality of opportunity? The chance of reaching the top by dint of one’s own efforts is highest in Scandinavia. Germany comes somewhere further down the ladder and, among developed countries the US is at the bottom. People from disadvantaged backgrounds in the US are least likely to make it to the top. One might say that the American dream has been realized – in Sweden.

Some academics, particularly sociologists, have begun to speak of a ‘refeudalization of society’, not only in the US, but also in Germany. Would you regard further growth in inequality as a problem? I don’t believe we have a problem at the moment. But I do think that we will have a problem if we don’t react to current trends. Germany has experienced several wars in which huge accumulations of wealth have been drastically reduced. Fortunately, we have now enjoyed the fruits of a long period of peaceful times, and one can now see that assets have again accumulated over this timespan. We have a high concentration of wealth – one the highest in Europe – and this wealth will now be passed on to the next generation. Here we come back to equality of opportunity. People who inherit large fortunes without having contributed personally to their growth often found wealthy dynasties. This phenomenon can be observed in the US. Some of its dynasties go back a very long time, and one can also see where such a development can lead. The businessman Donald Trump and his family will save a lot on taxes thanks to the new tax laws advocated by President Donald Trump. That is a big problem in terms of social cohesion. But this is not yet the case in Germany.

And what can be done to ensure that it doesn’t happen here? One way is to facilitate asset generation. In Sweden this is done ‘automatically’ via the pension system. Every contributor is guaranteed a basic pension, but one must agree to invest a certain fraction of one’s income in an individual pension scheme. The State offers schemes via the capital market, but one can also invest in private funds. So many more people in Sweden are able to build up assets – also as a provision for retirement – because there are state-backed institutions that help them to do so. But the first step that needs to be taken to reduce inequality relates to education.

You want to reduce asset inequality via policy measures in the area of education? Exactly. All serious studies demonstrate that doing something for children under 3 in families with a low socioeconomic status yields the highest returns on investment. And this must be done to prevent the disadvantaged from falling behind at an early age.

There have been lots of legislative initiatives in the provision of childcare recently. Yes, but ... In Germany we have virtually no state-supported pre-school education programs. We have subsidized day-care schemes for pre-schoolers. And when one sees how many children must be looked after, it is no wonder that the caregivers can do no more. Other countries are more advanced. In Sweden, for example, these jobs are far better paid because they are done by specially trained personnel. In Germany, that is true only of private day-care centers, which are correspondingly expensive.

And how might such a program of pre-school education be financed? Germany spends a relatively large fraction of its tax take on education. But most of this money goes into higher education, because we don’t charge tuition fees. In relation to the issue of higher education, that is quite absurd. Over 70% of the children of academics go on to earn a degree, and most of them subsequently make good money. Only about 20% of university students come from non-academic backgrounds. In essence, the non-academic section of the population pays for the education of academics, many of whom will become highly paid professionals.

However, the debate over the introduction of tuition fees in universities seems to be over, at least for the moment. That’s true.

So you believe more resources should be provided for government-backed pension schemes and pre-school education. Who then should stump up the money? In the present economic situation, we have more than enough tax revenue. And instead of providing new sectional pensions like the Mütterrente – allegedly intended to reduce levels of poverty among the elderly, for which it is an unsuitable tool – it would be better to invest in pre-school education. And apart from that, one could increase the level of the tax take without raising rates by reducing the number of permissible deductions. In the German system, there are over 500 legal ways of reducing one’s taxable income, more than anywhere else. Here, the average reduction amounts to over 20% of the declared taxable income. The average for OECD countries is around 10%. So we have twice as many sorts of deductions. Reducing the permissible deduction by 10% across the board would bring in 10% more tax.

Would this not be a burden on average wage-earners? Hardly. These deductions are of most interest to people who can call on the services of clever tax advisors, who help them to exploit them.

A radical reduction in deductions in income-tax law – is that enough to combat inequality? No, the law on estate tax also needs to be reformed. It is unbelievably complex and in some respects even bizarre. Because there are so many ways to avoid paying any inheritance taxes, including double-taxation treaties. But the latter really pay off only for relatively wealthy people.

How would you go about providing direct assistance to people with small incomes? The big problem here is that the combination of taxes, social security contributions and transfers means that people with comparably low levels of income are essentially worse off if they work more. For single parents with two children, there is an income bracket between about 1700 and 2400 euros per month, where every additional euro in gross income reduces one’s net income. This is because the additional earnings are deducted – at more than face value – from transfers such as the housing allowance or unemployment benefit type II. That is totally nonsensical, but it isn’t a new problem. The ifo Institute carried out a study on it 30 years ago, and Hans-Werner Sinn, a former President of the Institute, pointed out the anomaly 20 years ago. We’re doing so again now, but the problem is still being ignored.

Why? My guess is that it’s because there are too many ministries involved. Each is responsible for regulations that are logical in themselves, but the interaction between these rules is not.

You argue that we will get into big trouble unless we do take steps to prevent further growth in inequality – and yet you say in effect that nothing is being done. So the problem is already with us? We are certainly moving in that direction, perhaps even knowingly, with our eyes wide open. Many of the measures I have mentioned are unpopular. When people hear talk about changes in inheritance taxes, they immediately think they will be deprived of things like Grandma’s silver cutlery service. And measures to stimulate the build-up of assets or improve early education will first bear fruit only in the medium term, when the next Chancellor or her successor is in office. We need to take a longer view. Current policies effectively favor older citizens at the expense of the next generation.

Prof. Dr. Andreas Peichl holds the Chair of Macroeconomics and Public Finance at LMU and heads the ifo Center for Macroeconomics and Surveys. Peichl (b. 1979) studied Economics at Marburg Univer­sity and the University of Cologne, where he obtained his doctorate. He then joined the Institute of Labor Economics (IZA) in Bonn. In 2013, he was appointed to lead a research group in International Distributional Analysis at the Center for European Economic Research (ZEW) in Mannheim and was appointed Professor of Empirical Public Finance at Mannheim University.

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