Determinants of Wealth Inequality

2014

Wall Street

The factors of wealth inequality

Many factors are thought to affect wealth inequality, but their precise impact and relative importance are not well understood. Over longer periods, the level and distribution of wealth in a country will depend on the growth rate of the economy, demographic trends, savings behavior, inheritance arrangements, general macroeconomic trends (such as globalization) and government policies affecting, for example, taxation and pension provision. In the short run, the stock of household assets is relatively fixed, so changes in the distribution of household wealth tend to be driven by changes in asset prices, which can affect wealth inequality because the composition of household portfolios varies by wealth level. Cross-country comparisons are also sensitive to exchange rate movements in the short run.

Wealth inequality and asset prices

The composition of household portfolios tends to vary by wealth level in a systematic way. For middle wealth groups, equity in the family home is often the dominant feature. At lower wealth levels, savings accounts are more prominent – and debts are also more evident – while equity in private businesses and listed companies is heavily concentrated higher up the distribution. As a consequence, stock market appreciation tends to favor wealthier individuals and to cause the share of top wealth groups to increase. This leads to the expectation that wealth inequality will fall when financial assets are declining as a fraction of the household portfolio – as happened during the early years of this century; and to rise when the share of financial assets is increasing – as happened after the financial crisis.

The impact of house price rises is more difficult to assess. The middle class are expected to benefit disproportionately, since owner-occupied housing is more prominent in their portfolio; this has an ambiguous effect on overall inequality, since the top and bottom wealth shares both tend to fall. Furthermore, second homes and investment property form a significant part of the portfolios of wealthier individuals, and appreciate in line with owner-occupied housing. So the impact of house price rises on wealth inequality is not easy to identify and measure. One study for the United Kingdom concluded that rising house prices tend to reduce the share of the top wealth percentile. Another study based on data for the United States echoes this result by showing that the ratio of equity prices to house prices has a powerful positive effect on the wealth share of the top percentile.

Some commentators have claimed that rising equity prices are a consequence – as well as a cause – of rising inequality. It is suggested that rising income inequality in the United States from the 1970s onwards raised the disposable income of the top groups, who typically save a higher proportion of their income. As captured in Figure 3, this led to an increase in funds seeking investment opportunities, driving down interest rates and raising stock prices, which in turn created further capital gains for the top income groups, propelling income inequality to even higher levels. In addition, the fall in interest rates encouraged the housing bubble that developed in the United States in the early 2000s and fuelled the unsustainable growth of debt, which triggered the financial crisis of 2007-08. If this account is even partially true, it raises concerns about the implications of the widespread rise in wealth inequality since 2008, and about the implications for equity markets once low interest rates are no longer regarded as a priority by central banks.

Wealth inequality and wealth growth

Trends in wealth inequality across countries are also likely to depend on the rate at which household wealth is growing. Fast growing economies are usually associated with successful entrepreneurs and the rapid emergence of young businesses owned by a family or a small group of shareholders. The new wealth created when these businesses are established – and later valued and listed – is highly concentrated, leading to an increase in overall wealth inequality. In the longer run, ownership of the new assets is dissipated via broader shareholdings and intergenerational transfers. However, the initial increase in inequality can persist for many years. Effects like these can be seen today in the more rapidly growing transition countries and emerging markets, and help account for the high levels of wealth inequality in emerging markets evident in Table 1.

Social and demographic impact on wealth inequality

In the longer run, wealth inequality will be affected by demographic trends, of which the most important are rising longevity and ageing societies. As the length of retirement is extended, savings for lifecycle purposes will become a more important component of personal wealth. Lifecycle saving is far from equal, and rising income inequality will magnify the differences; but on balance, greater lifecycle saving and pension wealth is expected to reduce wealth inequality. Furthermore, the reduction may well be sufficient to offset any increase in inequality associated with ageing populations, due to the fact that older individuals tend to be wealthier than average.

Other social and demographic factors will also have an impact in the longer term. The spread of popular assets – especially owner-occupied houses, cars and other consumer durables – is seen as a major reason for the secular decline in wealth inequality during the 20th century. Starting from a world in which the working class formed a large fraction of the population and lived in rented accommodation, used public transport and had few possessions, it was inevitable that wealth inequality would decline. Smaller household sizes and more equal treatment of females are also likely to affect trends in wealth inequality, although the precise impact is difficult to assess.

Inheritance and wealth inequality

Property rights and inheritance customs are core subjects in understanding the level of wealth inequality and its transmission over time. In traditional rural societies, wealth inequality is almost synonymous with unequal landholding perpetuated through inheritance. This is true in the Indian subcontinent, parts of Africa, and perhaps most famously in the large latifundia of Latin America, where conditions have historically been semi-feudal. In these circumstances birth dictates opportunity to a large extent. In contrast, the settler societies of Argentina, Australia, Canada and the United States handed out land freely, creating a remarkably equal initial distribution of wealth. Similar impacts occur when land is redistributed on an egalitarian basis through land reforms like those in South Korea and Japan after World War II. In other countries, complex patterns of property rights may mean that the nominal owner of a piece of land may not have the right to work it, or to sell it. Yet other examples exist of countries where land has been redistributed and the more equal distribution frozen through a prohibition on sale – China is the leading current example, but Ethiopia has a similar setup. These complexities pose great challenges to understanding and analyzing wealth inequality.

In advanced industrial societies unequal landownership is not a core social issue, but inheritance remains an important route to wealth ownership for some people. Furthermore, inherited wealth tends to be quite unequal since middle and lower income families cannot afford to bequeath much, so children of the wealthy benefit disproportionately. In certain situations, the impact may be equalizing. For example, it may assist the spread of new wealth amassed in the first generation fortunes of successful entrepreneurs. Overall, however, it is likely that inheritance tends to raise the level of wealth inequality and to ensure that wealth inequality persists over time, especially in slower growth economies.

Taxation and government policy

Governments can have large impacts on wealth inequality, in a range of ways, some of which tend to be overlooked. High inflation restricts people’s ability to build wealth through saving, and sudden unexpected bouts of inflation can erode or even wipe out the savings of broad groups. A lack of secure property rights can have a similar chilling effect on entrepreneurship or accumulation of real assets. As well as reducing growth rates, such factors can help to generate high wealth inequality. But higher wealth concentration can also result from more benign influences. For example, strong social security programs — good public pensions, free higher education or generous student loans, unemployment and health insurance — can greatly reduce the need for personal financial assets. Public housing programs can do the same for real assets. This is one explanation for the high level of wealth inequality we identify in Denmark, Norway and Sweden: the top groups continue to accumulate for business and investment purposes, while the middle and lower classes have no pressing need for personal saving.

Governments can also reduce wealth inequality, of course. The sheer size of the public sector has an impact. More economic activity undertaken by the public sector leaves fewer opportunities for private entrepreneurship and investment. Progressive income or estate taxes, and taxes on wealth or capital income, reduce rates of return and hamper asset growth. High levels of taxation on large estates appear to be one of the reasons why wealth inequality declined during the 20th century, as wealthier individuals transferred ownership of core assets during their lifetime. Nowadays, family trusts and similar arrangements are frequently used to mitigate estate tax liability, so the impact is now much weaker.

Similarly, while progressive income and capital taxes are likely to lower wealth inequality, flatter tax structures will lead to rising inequality, as some commentators have suggested has happened in recent decades. More positively, tax shelters for retirement saving give the middle class more incentive to accumulate assets. This will tend to reduce the top wealth shares over time, although the shares of bottom wealth holders may fall as well.

Summary and conclusions

Many factors contribute to the level and trend of wealth inequality, and their interactions are highly complex. In the short term, asset prices have a strong effect, with the relative fortunes of the wealthy rising and falling with the stock market. It is likely that the abrupt switch from decreasing inequality up to 2007 to increasing inequality in the years after 2007 is linked to the change in the relative importance of financial assets in household wealth, which followed the same pattern. In contrast, house price increases tend to favor the middle class, prompting a reduction in top wealth shares. Interestingly, rising inequality in recent years may have contributed to asset price increases by providing the top income groups with more funds to invest, and caused wealth inequality to rise further, by giving those lower down more reason to borrow.

Over longer periods, wealth inequality is influenced by economic growth, demographics, savings behavior, landholding, inheritance and government policy. Fast economic growth, for example, is expected to lead to the rapid rise of new businesses, raising inequality. This may account in part for the high level of wealth inequality evident in emerging market economies. Patterns of landholding and the transmission of land from generation to generation is an important consideration in developing countries, while inheritance more generally will tend to support higher levels of inequality, especially in slower growth economies.

Governments can influence the level and distribution of wealth in many ways. Higher levels of taxation – on income, capital, property or inheritance – are all expected to reduce inequality in the longer run, although the repercussions on personal incentives are widely debated. Encouraging wealth creation through tax advantages given to retirement savings programs is less controversial and will tend to reduce inequality. Welfare state policies, including public pensions, help to reduce income inequality; somewhat perversely, however, they reduce the need for lower and middle income families to save, lowering their wealth and tending to raise wealth inequality.

Given the complex sources for wealth inequality it is difficult to predict future changes. However, in China, India and some other emerging market countries, slower growth may bring a deceleration in the rise of wealth inequality, and time will allow recent new fortunes to spread among a wider group of owners. Wealth inequality may also fall as the share of financial assets in aggregate total wealth stabilizes or declines. In mature economies, policies to address wealth inequality are receiving increased attention and can hopefully be designed to avoid unwanted effects on growth or economic security. Among emerging markets, policy makers would be advised to study countries, such as Singapore, which have tried to ensure that wealth gains are broadly shared, and which have succeeded in keeping wealth inequality in check.

2013


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