The trend reversal in income inequality and returns to education: How bad is this good news for Latin America?

Augusto de la Torre, Julián Messina 07 March 2013

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Latin America witnessed unprecedented economic and social achievements during the last decade. In particular, the year 2003 appears as an important inflexion point for the region’s economic history, a point that we have highlighted in several World Bank publications1. Specifically, moderate poverty (less than US$4 purchasing power parity per capita, which leveled around 45% of total population during the 1990s and until 2003, steadily falls to less than 30% by 2011, allowing more than 70 million Latin Americans to leave poverty in less than a decade. From 2003 on, in addition, the region starts a visible process of economic convergence, with a GDP per capita growth of around 3% per year, significantly above that of advanced economies. But the development that stands out the most is the reduction in income inequality – an aspect widely documented by López-Calva & Lustig (2009) and Gasparini, Cruces & Tornarolli (2011) – which, even though starting from extremely high levels, is particularly surprising considering that income inequality has been on the rise elsewhere2.

In this column we would like to highlight some intriguing aspects of the relationship between certain changes in the labour market, on one hand, and the drop in income inequality in Latin America, on the other. We start by noting that the dominant factor contributing to the reduction of households’ total income inequality was the reduction of inequality in labour-related income (Figure 1). In effect, the disparity in labour earnings measured through the Gini index increased modestly (if we consider the simple average of national Ginis for LAC) or remained stable (for the weighted average) during the 1990s and first years of the 2000s, and started declining from 2003 onwards. As we can observe from Figure 1, this trajectory is very similar to that of total household-income inequality.

What’s behind the decline in inequality of labour earnings?

Therefore, in order to understand what lies behind the contraction in household-income inequality, we need to understand what lies behind the decline in the inequality of labour earnings. A natural explanation is the return to skills. Aedo & Walker (2012) documented in detail the evolution of the returns to different education levels for a significant number of countries in the region, and showed that such returns follow, in broad terms, a trajectory consistent with the evolution of the Gini for labour-related income, increasing in the period previous to 2002-03 and descending thereafter. The implication is that the most promising explanation of the post-2003 drop in income disparity in Latin America is the reduction of the skill premium, measured indirectly through the returns to education.

Figure 1a. Household-income inequality and individual-earnings inequality (differences from country means)

Figure 1b. Gini of labour earnings and total household income Gini for LAC-15

The search for the drivers of the decline in income inequality thus turns into a search for the forces behind the generalised contraction in the skill premium in the region. Even though research on this question is at a very early stage, potential explanations have started to flourish and are worth exploring in some detail. Naturally, demand as well as supply factors must be examined.

Figure 2a. Wage dispersion within groups by education

Figure 2b. Labour-income inequality and characteristics of the labour force in Latin America

Supply factors

One hypothesis that emphasises supply factors is the degradation of tertiary education, that is, the possibility that the notable expansion of coverage in post-primary education was accompanied by an increasing dispersion in the quality of education centres, pushing downwards the average quality of post-primary education, especially at the tertiary level. Indeed, some of this may have been happening, as evidenced by the increase in the dispersion of wages among workers with tertiary education (Panel A, Figure 2). Other important changes in supply factors appear to be less relevant to understand the recent decline in the wage premium. For example, both female labour force participation and the average years of schooling of the labour force (or the share of workers with post-primary education) increase steadily – i.e., along upward trajectories with relatively constant slopes – over the last two decades, without the inflection point observed in wage inequality and the returns to skills (Panel B, Figure 2). In fact, in our current work (Fernandez-Sierra & Messina 2013, in progress) we apply the classic Oaxaca decomposition to different income-distribution quartiles, following the methodology proposed by Firpo, Fortin & Lemieux (2009), and find that changes in the composition of the labour force during the 2000s contributed to increase, not to diminish, the inequality of labour earnings in the biggest Latin American economies.

It is thus difficult to explain the post-2003 reversal of the trend in wage inequality and the skill premium in most Latin American economies without turning to demand factors. A virtually unavoidable inference is, therefore, that since roughly 2003 the demand for skilled workers in Latin America has been growing at a rhythm significantly below that of the supply of skilled workers. But, why? A possible, and arguably worrisome, reason may be the recent boom in commodity prices, in what would seem to be a revival of the so-called Dutch disease.

Dutch disease?

This hypothesis may be stated as follows. The extended boom in commodity prices induced, through the appreciation of the real exchange rate, a substantial reallocation of resources (including labour) from non-commodity tradeable sectors to non-tradeable sectors. Provided that the latter are relatively less intensive in skilled labor, this reallocation would reduce the skill premium and the returns to education, bringing down wage inequality.

In our last semiannual report (de la Torre, Messina & Pienknagura, 2012) we analyse the main components of the aforementioned chain of facts. The take off of commodity prices at the beginning of the decade is widely known (Panel A, Figure 3). It led to major gains in the terms of trade for the net commodity-exporting countries which, in turn, translated into an appreciation of the real effective exchange rate (Panel B, Figure 3). As a result, the share of employment in manufacturing tended to fall, while the share of employment in non-tradeable sectors, such as construction, tended to rise (Panels C and D, Figure 3). This is consistent with the finding in a recent paper by Gasparini et al. (2011) that during the 2000’s there was a negative association between the evolution of terms of trade and the education premium. Moreover, disaggregating their data we can observe that, with the exception of Peru, such a negative relationship is stronger in the net commodity-exporting countries; by contrast, the relationship vanishes or becomes positive in the case of net commodity importing countries (Figure 4).

Figure 3

Note: Panels C and D represent the partial correlation of each of the employment shares and the commodity trade balance after controlling for GDP per capita in US dollars and the population size of each country.

Sources: De la Torre, Messina and Pienknagura (2012).

Figure 4. Skill premium and terms of trade 1990-2010

Note: Commodity net exporters (importers) are defined as those countries that on average displayed a positive (negative) trade balance in commodities during the 2000s.

Source: Gasparini et al. (2011).

Conclusions

There is a lot of room for research to better understand the factors behind the spectacular decline in income inequality experienced by most countries in Latin America during the last decade. Undoubtedly, this is a luminous and welcome fact for a region historically scarred by excessive inequality. This positive news, however, seems to hide a dark side: the specialisation of the region’s economies in activities that are relatively low in skill intensity and that therefore tend to be of lower productivity.

Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Aedo, C and I Walker (2012), Skills for the 21st Century in Latin America and the Caribbean, The World Bank.

Autor, D H, Lawrence F Katz, and Melissa S Kearney (2008), “Trends in US Wage Inequality: Revising the Revisionists”, The Review of Economics and Statistics 90(2), 300-323.

Card, D, J Heining and P Kline (2012), “Workplace Heterogeneity and the Rise of West German Wage Inequality”, NBER Working Paper 18522.

De la Torre, A, J Messina and S Pienknagura (2012), “The Labor Market Story Behind Latin America´s Transformation”, Semiannual Report, Regional Chief Economist Office, Latin America and the Caribbean, The World Bank.

Gasparini, L, G Cruces and L Tornarolli (2011), "Recent Trends in Income Inequality in Latin America", Economia, Journal of LACEA.

Gasparini, L S Galiani, G Cruces and P Acosta (2011), “Educational Upgrading and Returns to Skills in Latin America Evidence from a Supply-Demand Framework, 1990-2010”, CEDLAS Working Paper.

Fernández-Sierra, M and J Messina (in progress), “Supply and Demand Factors and Wage Inequality in Latin America”.

Firpo, S, N Fortin and T Lemieux (2009), “Unconditional Quantile Regressions”, Econometrica, Econometric Society, 77(3), 953-973, 05.

López-Calva, L F and N Lustig (eds.) (2010), Declining Inequality in Latin America: A decade of progress?, Washington, DC, Brookings Institution Press.

World Bank (2011a), “On the edge of uncertainty: Poverty Reduction in Latin America and the Caribbean during the Great Recession and Beyond”, Poverty and Labor Brief, Washington, DC, The World Bank.

World Bank (2011b), “A Break with History: Fifteen Years of Inequality Reduction in Latin America”, Poverty and Labor Brief, Washington, DC, The World Bank.


1 See for example. World Bank (2011a, 2011b)

2 See, for example, Autor et al. (2011) for the case of the US, and Card, Heining and Kline (2012) for the German case.

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Topics:  Labour markets

Tags:  education, income inequality, Latin America