How excessive inequality bit the rich North

Employment & Income,Inclusive Economy02 May 2014Tom van der Lee

In one of the chapters in the book ‘Het crisisdiner’ (The Crisis Dinner, published in Dutch, February 2014), Oxfam Novib director Tom van der Lee writes about the impact of inequality in the United States and Europe on the current economic downturn. He argues that eradicating inequality is the only way towards a stable economic recovery and job creation. Here you can read a shorter version of this chapter.

Many causes have been attributed to the credit crisis since 2008, including outrageous greed, super leveraged banks, over-the-top deregulation, mega-complicated mortgage products, ridiculous bonuses, toothless supervisors, an unfettered focus on growth, cheap loans. But there is one cause I would like to look at in more detail, namely excessive income inequality. And in particular in America in the period preceding the bursting of the housing bubble.

In the twenty years before the financial crisis people in the US failed to do the wise thing and safeguard basic social services, such as affordable health-care and access to education. Progressive taxation hardly existed. After all, tax cuts for the top echelons would allegedly trickle down and promote welfare for all. The result was a period of economic growth, but the incomes of poorer American households stagnated. A rapidly growing group of working poor even emerged. Now, poor households are just as status driven as other households. Despite stagnating salaries, they have tried to maintain their living standards and social status on par with those of richer individuals, neighbourhoods or cities. This behaviour, keeping up with the Joneses, could only happen because consumer credit was readily available. In a normally functioning economy this would not have been possible, because no one would lend for such purposes to anyone without a without good collateral or a sizeable regular salary.

Rather than taking immediate steps to combat growing income inequality, the credit sluice gates were opened wide. High inequality in other countries also contributed to the situation. Emerging countries, with China in the lead, circumvented the growing shortage in domestic demand by pumping up exports even more, taking advantage of low wages at home. The additional capital this generated was then invested in the US and above all in the housing bubble.

Inequality and economic growth

In his recently published essay, The Impact of Inequality on Growth, economist Jared Bernstein investigated the influence of income inequality on economic growth. In theory, Bernstein says, one can make several connections that explain why high income inequality has a negative influence on growth. Viewed from the supply side, the reasoning is that higher income inequality leads to higher inequality in opportunities and to a fall in average education levels, resulting in slower development of labour productivity, and thus of growth. Viewed from the demand side, a concentration of income at the top leads to less consumption, less investment and thus less growth, because people with top incomes are more inclined to save their extra dollars than people on middle or low incomes. There is also considerable evidence that a high concentration of wealth generates greater political influence for those advocating yet more tax cuts, fiscal exemptions for businesses and a reduction in public investments. This too results in slower development of labour productivity and growth.

For the US this is no exaggeration; IRS figures show that the effective tax burden for the 400 richest tax-payers fell from 26% in 1990 to 20% in 2009. Upward mobility also declined in the same period. A child born in the top 20% in the US has a 2 in 3 chance of staying at the top, whilst a child born in the bottom 20% only has a chance of 1 in 20 of reaching it. This results in the deplorable loss of a lot of human potential, and of new opportunities for increasing productivity. Despite these figures, the US continues to favour stimulating credit in its efforts to tackle the recession, in the hope of stemming the tide of rising unemployment. This is a very different approach to the severe debt reduction advocated by politicians in the richer euro countries in particular.

Rising inequality in Europe

Many European citizens have paid a high price for the crucial system error made when the euro was introduced. A lot of commentators had already pointed out, even before the Treaty of Maastricht was concluded, that the euro zone was too exclusively an economic union, whilst it should also have been a political union. Because the political dimension was very much absent, Europe also mismanaged inequality, both within and between countries.

Of course, income inequality has traditionally been lower than in the euro zone than in the US, because average family income is more modest and social safety nets and collective services are relatively better. Anyone who looks at the differences in Gini coefficients between the euro countries can see that income inequality was (and still is) highest in those hardest hit by the euro crisis, namely Greece, Portugal, Spain, Ireland and Italy. Research over the 2005-2010 period also reveals a negative connection, with a correlation of -0.69, between growth in inequality in the euro countries and growth in their economies. In other words, economic growth was relatively lowest in the countries where inequality increased.

The one-sided emphasis Europe has placed on austerity measures has increased rather than reduced that high income inequality. Between 2007 and 2011 income inequality grew by 6.6% in Ireland, 6% in Spain, 2.5% in Greece and 1.5% in Italy. Germany and the Netherlands, by contrast, saw a slight drop in income inequality in that period, by 0.2% and 0.6% respectively.

As influential economists (Stiglitz, Krugman and Bernstein) point out that it cannot be a coincidence that the highest levels of income inequality in the US occurred just before the great depression of 1928 and the financial crisis of 2009, it can also be no coincidence that the countries with the highest income inequality were hit hardest by the euro crisis.

The eurozone’s north-south imbalance

In the poorer European countries too, a kind of keeping-up-with-the-Joneses effect emerged. The enormous capital transfer, in the form of investments, from northern euro countries to the southern countries prior to the crisis not only led to growth in employment in the south, but – as became clear later – also created excessively high expectations of future productivity growth. Anticipating this new growth, people spent and borrowed much more than was sustainable to try and bridge the gap with the higher levels of welfare in the north more quickly. The imbalance became painfully obvious when the financial crisis spread to the euro zone like a fire storm. A wiser incomes policy in these countries could have had a dampening effect, allowing domestic demand to develop more gradually. The fall in demand after the crisis broke would then have been smaller, because debts would not have reached such high levels.

What made the impact even more painful was that the excessive levels of income concentration in these countries contributed to extra income and profits being siphoned off to other countries via fiscal constructions (with the Netherlands in the lead role) rather than to achieve the expected productivity growth in southern European countries. In Europe too, the diabolical combination of high income inequality and fiscal piracy proved deadly: on both sides of the Atlantic Ocean, the richer countries felt the bite of excessive inequality.

Were only the southern European countries to blame for all of this? Not at all; the northern countries, which did achieve huge productivity growth, made the error of not converting higher returns into higher wages for employees, but allowed them to be siphoned off mainly as higher profits for investors. The stagnation of average incomes, which we have witnessed in the Netherlands and Germany (whose coalition government approved Germany’s first minimum wage) since the 1990s, boosted the momentum of capital flow to southern Europe. A much more balanced income development in northern and southern Europe is needed if we want to prevent a repeat of the euro crisis. Growth with a one-sided focus on raising corporate profits, rather than on increasing welfare for all, is by definition unstable.

That more balanced policy will not be achieved without further political harmonization in the euro zone. The promise of the European Economic Community was, and remains, that its free markets, the opportunity of working in any member state, and a euro with which you can pay almost everywhere in Europe, would bring us greater welfare and opportunities. But it is of course obvious that not everyone is benefiting. Companies move to countries where they can produce at the lowest cost: with the most attractive investment climate, skilled labour with relatively low wages, and the weakest social regulations. This leads member states to try and outdo each other in a race to the bottom, with favourable social and fiscal conditions for businesses. Conditions that are usually unfavourable to employees and the public coffers. Without further political integration, competitive policy-making between member states will continue, especially on fiscal policies, to the extent that the countdown to the next bursting bubble has begun. Unfortunately, many euro-sceptics do not realize that their pleas to re-nationalize European powers are putting the cart before the horse.

A Dutch reality check

And what about the Netherlands? The Dutch too have witnessed low, but rising, income inequality. As said before, from 1985 to 2010 the 10% highest incomes rose by 1% more than the 10% lowest incomes every year. Yet over this period the Gini coefficient stayed reasonably stable: net income inequality remained within a bandwidth of 0.28 and 0.31 Gini. However, anyone who then also takes a look at capital inequality will see a huge difference. According to the Dutch Central Bureau of Statistics, the Gini coefficient of private capital (including pension capital) was over 0.80 in 2011. That is higher than the UK and as high as in the US.

Traditionally capital inequality has always been higher than income inequality. But now the difference has become very large. According to Quote, the top 500 incomes owned 6% of national capital in 1997, a figure that had risen to 10% in 2011. In this light, we should bear in mind that about 30% of Dutch people do not have private capital, and that 10% have negative capital. Poverty in the Netherlands has also grown and, according to the CBS, affected 7.6% of Dutch people in 2013. This picture is confirmed by what we have seen elsewhere: a strong rise in debts at the bottom end and a considerable growth in property at the top end.

In retrospect, it is difficult to explain why there was hardly any political debate when the Netherlands decided to abolish the law on capital gains tax in 2001, or to considerably relax inheritance tax in 2010. The influence of the highest levels of income and capital concentration in the Netherlands is apparently so great that private capital is hardly taxed anymore. Of course, the argument is still bandied around that capital tax no longer makes much sense, because it would only lead to capital flight abroad. The hypocrisy of that argument is revealed when we take a look at the role the Netherlands plays as the biggest airport for global transit capital flights.

In 2010 a total of 10,200 billion euros passed in and out of the Netherlands. This is over 10% of the entire global economy. We are making it very easy for multinational corporations to move money to tax havens that have zero tariff corporation taxes. No wonder that 8,500 multinational corporations have mailbox companies in the Netherlands. This is why our country is host to 12,000 trust offices that facilitate the channelling of royalty, interest and dividend payments between subsidiaries, allowing multinationals to reduce their profits artificially in countries with high tax rates and increase them (to dizzying heights) in countries with low or zero tariffs. While we’re on the subject, why is there no political debate in the Netherlands on the fact that we maintain a zero tariff for both royalty payments and for dividend payments abroad?

What does this all mean? While the real tax level for Dutch citizens is about 39.5%, we make it legally possible for multinationals like Google, Nike or Starbucks to only pay a mere 2% in taxes. The Netherlands can justifiably be called a ‘tax transit haven’.

The Netherlands is therefore not only culpable in making developing countries lose between 660 and 870 billion euros in tax income every year, it is also helping to erode the tax basis in developed countries. This is true, for starters, of southern European countries: over half of Italian, Greek, Spanish and Portuguese multinational corporations had and still have a mailbox company in the Netherlands.

The Dutch were therefore actively helping to increase the capital flow from northern to southern Europe prior to the euro crisis, have been making it fiscally attractive for Southern multinationals to siphon off their profits for many years, and then, after the crisis, added insult to injury by helping them in their successful efforts at evading the necessary tax increases imposed by the Greek, Portuguese and Spanish governments. Meanwhile, these countries have had to cut back hard on social services, the civil service and pensions, and raise the tax on labour and consumption (VAT), increasing inequalities even further. It is extraordinarily sad to witness our financial and political elite laying the blame for the crisis with the southern countries themselves. As if, like Pilate, the Netherlands could be washing the blood off its hands.

Momentum for fighting inequality

It is glaringly obvious that from both a moral angle and that of a sustainable economy with a stable financial sector, we owe it to ourselves and future generations to intervene. Most urgently, we need to reduce tax on labour and raise tax on capital, raw materials and environmental exploitation. Dealing with extreme inequality and fiscal piracy should get top priority. In a world where the 85 richest people own more than the 2.5 billion poorest people, this speaks for itself.

Fortunately, this seems to have entered into the awareness of the ‘most powerful’ people in the world. It comes as no surprise that a pope calling himself Francis is taking the lead in this. What does come as a surprise though, is that at the World Economic Forum in Davos (the annual brainstorm summit of the international elite) inequality has been notably placed at the top of the agenda. And that the leader of the world’s biggest economy, Barack Obama, is now saying that ‘’inequality is the defining issue of our time’.’

The big question is whether this will also become one of the main priorities of the new European Commission and the new European parliament in a couple of months time.

The book ‘Het Crisisdiner‘ (Dutch) has been published by Prometheus, Amsterdam. ISBN: 9789035141551


Resource material for this article:

In addition to World Bank, Eurodad and CBS statistics:

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