Cross-country Differences in Inequality and Growth Trends: The Role of Human Capital and Labor Market Policies

The model described here provides a central role for policies and institutions that compress the wage structure. For example, unions and progressive income taxes reduce (after-tax) wages at the higher end of the wage distribution while artificially boosting them at the lower end. As a result, they reduce the marginal benefit of investment (the higher wages in the future) relative to the cost of investment (the current forgone earnings), and hinder investment. Similarly, minimum wage laws impose an upper bound on the amount of on-the-job human capital investment, by effectively preventing firms from creating jobs that offer low initial wages (below the legal minimum) but higher training opportunities. Therefore, individuals in an economy with a compressed wage structure will not increase their investments as much as in an economy with an undistorted labor market. As a result, the model predicts that countries with more redistributive institutions (i) will not experience a large increase in inequality in the early phases of SBTC, but (ii) will also not be able to accumulate the requisite human capital, and therefore experience the growth surge that happens several decades after the onset of SBTC. At least, casual observation suggests that this prediction fits the differences between the U.S. and U.K. on one hand, and France and Germany on the other. Notice also that both growth and inequality are endogenous in this model and are determined by the interaction of SBTC with the institutions of each country. This paper investigates these predictions more systematically by explicitly introducing the variation in these policies both across countries and over time into the model above.