Wage inequality, skill inequality, and employment: evidence and policy lessons from PIAAC
The variation in wage inequality across developed countries has puzzled economists for many years, and different theoretical explanations and empirical evidence have been presented on this issue. Some economists argue that these differences can be explained by supply and demand factors, whereas others emphasize the influence of wage-setting institutions on the wage structure. Consistent with the first theory, the variations in wage inequality across different countries can be explained by variations in skill inequalities. Countries that have more compressed (dispersed) wage structures simultaneously have more compressed (dispersed) skill structures as well (Nickell and Bell 1995;1 Leuven et al. 2004). According to neoclassical theory, supply and demand factors, skill-biased technical change (SBTC), and globalization are responsible for the increase in wage inequality in the past decades (Katz and Murphy 1992; Juhn et al. 1993; Katz and Autor 1999; Goldin and Katz 2008; Acemoglu and Autor 2012) and market forces play a more significant role in explaining cross-national differences in wage inequality and return to skill than institutional factors (Gottschalk and Joyce 1998). Since the Anglo-Saxon countries had simultaneously higher wage and skill inequalities compared to continental and Nordic Europe, this was taken as proof of the theory. The reasoning behind this theory is that higher wage inequality is a consequence of higher return to skills. A high skill premium goes along with increased motivation to invest in skill formation (Heckman et al. 1998; Welch 1999) and, consequently, greater supply of highly skilled labor. This explanation, however, fails to explain the high educational attainment in Nordic countries, which exhibit among the lowest rates of wage inequality when compared to other developed countries. Alternative explanation for variation in wage dispersion is based on the variation in wage-setting institutions. Economists who are in favor of this hypothesis stress the importance of decreasing real minimum wages and union membership in order to explain the widening wage gap (Freeman 1991; Freeman and Katz 1994; Blau and Kahn 1996; Bach et al. 2007; Machin 2016). A similar conclusion comes from Dew-Becker and Gordon (2005, 2008), who, in addition to these explanations, identify peer-group behavior as responsible for increasing wage dispersion at the top of the distribution in the USA. Card and DiNardo (2002) reach similar conclusions and also criticize the skill-biased technical change argument as being unable to account for gender and racial wage inequalities and differences in return to education.
Variation in wage inequality in the bottom half of the wage distribution is also often linked to variation in employment in the low-skill sector. According to neoclassical theory, differences in wage dispersion are often credited as an important explanation for differences in unemployment rates. Whereas dispersed wage structure can contribute to employment creation, wage compression in the bottom half of the wage distribution (usually assumed by labor market institutions) can cause unemployment in the low-skill sector (Siebert 1997; Heckman and Jacobs 2010). Due to the skill-biased technical change, relative demand for low-skilled workers in developed countries exhibited a decline; their relative marginal productivity deteriorated (relative marginal productivity of skilled workers rose). However, wage compression and excessively high wages (higher than marginal productivity) at the low end of the wage distribution cut low-skilled workers out of employment. Consequently, countries should allow for higher wage dispersion in the bottom half of the wage distribution and lower wages for the low skilled (institutional reform) which should push their employment levels up. This is in line with a trade-off between efficiency and equality (Okun 1975), according to which it is impossible to achieve high employment and low inequality at the same time. In order to achieve high employment, countries must accept high wage dispersion. By comparing the distribution of wages and employment in Germany and the USA, Siebert (1997) concludes that the relevant policy recommendation to increase employment in Germany at the low end is to allow for dispersed wage structure (higher wage inequality).
High and increasing wage inequality as well as high unemployment in some OECD countries shifted the focus of policymakers to differences in wage dispersion. This paper discusses theoretical and empirical backgrounds of wage compression hypothesis. The wage compression hypothesis is based on the perfect market model and its rigid assumptions. However, many of these assumptions are flawed—as the empirical analysis of this paper shows. Cross-country differences in wage dispersion cannot be explained by cross-country differences in skill dispersion; educational attainment does not seem to be higher in countries where return to schooling is high, and there is wage dispersion within skill levels, which is in stark contrast with marginal productivity theory. These arguments are in contrast with theoretical foundations of the wage compression hypothesis. Finally, unemployment/e-pops/average hours worked are not correlated with compressed wages. Thus, this paper shows that the wage compression hypothesis is not supported by empirical evidence and therefore challenges the theoretical assumptions it is derived from. The results of this study (although descriptive) have some important consequences for policy-making. Recommended policies for eliminating wage compression, and allowing for higher wage dispersion, are the deregulation of labor market institutions (collective bargaining, unemployment benefits, unions, minimum wages, etc.) and a reduction of public welfare policies. However, since wage compression is not correlated with labor market performance in the low-skilled sector (contrary to the theory), these policy recommendations need to be revised. Moreover, higher wage dispersion is related to major social and health problems, as well as the higher share of low-paid jobs. This study shows that countries that have good labor market performance in the low-skill sector have good labor market performance in general and this is likely due to macroeconomic policies. Consequently, the role of expansionary macroeconomic policies in fostering employment needs to be revisited.
The analysis presented in this paper extends the existing literature by examining these issues. This paper shares the most similarities with the work of Freeman and Schettkat (2001) and Devroye and Freeman (2001). Freeman and Schettkat (2001) examine the wage compression hypothesis based on differences between the USA and Germany in relation to employment. They find that skill compression can only partly explain wage compression. However, the wage compression hypothesis cannot explain the US-German difference in employment. Devroye and Freeman (2001) study the relationship between the distribution of earnings and the distribution of skills and find that skill inequality explains only 7% of wage inequality. Within-skill-group inequality plays a larger role than inequality between skill groups; this contradicts the theory. In contrast to the first two studies that were based on the international literacy survey in the 1990s (International Adult Literacy Survey—IALS), in this paper, a more recent data set is used, with a larger number of countries and larger sample sizes. It is important to check whether the results based on the IALS survey can be confirmed by using the Program for International Assessment of Adult Competencies (PIAAC).
This paper is organized as follows. In Section 2, the data set and data adjustments are presented in more detail. This section is followed by the empirical analysis in Sections 3 and 4. Firstly, international differences in skill levels, wage inequality, and the relationship between skill inequality and wage inequality are examined. In Section 5, the dispersion of wages within skill levels is investigated. Section 6 analyzes the wage compression hypothesis and its effect on employment. Finally, Section 7 concludes.