Income inequality in Hong Kong has risen over the last three decades, as it has in the US, the UK and many other advanced economies. The question is, why? Understanding the causes and implications of this is important because it can show us what needs to be done to reduce inequality and alleviate poverty in our society.

 

Income inequality can be studied from three different perspectives.

 

First is the normative perspective. Many thinkers believe that the distribution of income should not be too unequal in a just society. The branch of economics that studies this subject is known as welfare economics and it approaches the issue in several different ways. The basic unit of analysis is the household, which is considered to be the appropriate recipient of public policy benefits aimed to reduce economic inequality. One approach is to study the distribution of household income net of transfers, taxes and other compulsory contributions. Another is to look at equivalence scales for comparing households of different sizes and with different combinations of individuals (like children versus adults). A third consideration is the shadow income of members who are not working in the labor market but contribute to domestic household work, such as taking care of young children. The normative perspective will not be considered in this essay. Moreover, government experts have already studied these issues carefully.

 

Inequality Gap Doubles

 

One simple measure of income inequality is the ratio of high income to low income households – the share of income of the top 90th percentile compared to that of the bottom 10th percentile. This ratio increased in Hong Kong from 7.6 to 9.3 in the period 1981-1996; and then more substantially from 9.3 to 15.4 over the period 1996-2011 (see Table 1).

 

In other words, household income inequality measured as the gap between high and low income families doubled, from 7.6 to 15.4 times, over the past 30 years.

 

While these figures appear to be substantial, they are gross income figures that have yet to be adjusted. Changes in household income distribution reflect a combination of many factors including changes in the composition and size of households, taxes and transfers. Until these have been taken into account, the figures tell us very little about the distribution of household welfare. A study by the Census and Statistics Department, Thematic Report: Household Income Distribution in Hong Kong (2007), is a good step towards this direction. It shows that inequality as measured by the Gini Coefficient did not change very much between 1996 and 2006 after making a variety of necessary adjustments to gross reported income. This result reflects some obvious attempt by government to reduce economic inequality through a variety of policy measures.

 

Second is the revenue perspective. Tax revenue data from North America and Europe have shown that household or individual income inequality has increased over the past three decades as the top 1% or top 0.1% of the population has gained a rising share of income. This is the kind of inequality that Occupy Wall Streeters are talking about. Income at this level is dominated primarily by non-human capital income and sometimes by tax treatments of income, so it concerns not only the economic aspects of inequality, but also social policy and politics. In this article we will be concerned primarily with the economic aspects of income inequality. This is an important subject, but it is not the concern of this essay and will not be discussed here.

 

The third perspective for looking at income inequality is that of positive economics, which states that income inequality stems primarily from the unequal human capital or productive capabilities of different workers. This perspective reflects the fact that the higher educated, high earners have become more skilled. Technology has favored them, industrial transformation has favored them and globalization has favored them. Inequality is worsened by increasing the numbers of low skilled immigrants and off-shoring or out-sourcing low end production, while it is reduced by increasing the supply of skilled workers through investment in schooling and training.

 

This perspective argues that income inequality is economic in nature, as the widening gap between the 90th and 10th percentiles is due to the increasing inequality of human capital or productive capabilities. This concept of inequality applies to the rest of the 99% of the population, who are not in the top 1% that the occupy Wall Street movement is concerned about. The appropriate unit of analysis is the working individual and the appropriate measure of productive capabilities is the hourly wage rate rather than monthly income, although the two are highly correlated.

 

The distribution of hourly wage rates was not available to me at the time of writing so instead I shall examine the distribution of individual employment income to see how inequality in the productive capabilities of the working population has changed over time. Figures in Table 1 show that the inequality gap between the 90th and 10th percentiles increased slightly from 5.3 to 6.5 in 1981-1996. It subsequently increased substantially from 6.5 to 10.3 in 1996-2011.

 

Expand Education to Meet Demand for Skilled Manpower

 

That means over 30 years, the inequality gap also doubled from 5.3 to 10.3. This growth in inequality is about the same as that reflected in household incomes. Since individual employment income reflects labor productivity the question is, why did labor productivity become more unequally distributed from 1996?

 

Table 2 shows the annual percentage increase in real individual employment income by decile groups. The first group is the bottom 10 per cent and the last group is the top 10pc. Real income from 1981 to 1996 rose at an annual rate of 4-5% for almost every group except the lowest and the two highest deciles. The lowest group, which is the poorest, experienced an annual increase of 5.69% and the two highest groups, the richest ones, of 5.68% and 7.16%.

 

Hong Kong during this period was experiencing a high economic growth rate due to China’s opening, rapid industrial restructuring, a weak US Dollar, a low interest rate environment, and a buoyant global economy. The labor market was very tight with high levels of wage and price inflation. The benefits of greater productivity due to the relocation and expansion of export oriented manufacturing across the border was widely spread throughout all levels of society.

 

The figures are quite different for the period 1996-2011. The three lowest decile groups experienced close to no increase in real income over 15 years, while the three highest groups saw real incomes rise at an annual rate of over 2%. The four groups in the middle had real income increases of between 0.7 and 1.5% per annum.

 

In 1998 the Asian Financial Crisis was causing deflation in Hong Kong and the negative effects lasted until 2003. Industrial restructuring due to the relocation of manufacturing across the border was coming to an end and Hong Kong had become a service economy. A stronger US Dollar, a high interest rate, and a slowing global economy dampened real wage increases across the entire spectrum of income distribution. Higher skilled workers fared better than lower skilled ones in general. This is a common pattern found in all economies largely because technological progress rewards skilled over less skilled workers.

 

The path breaking studies by Professors Kevin Murphy, Claudia Goldin and Lawrence Katz have documented the distribution of real wage rates in the US and shown that technological progress in the workplace is biased towards skilled workers and increases the demand for them over less skilled workers. This in turn has led to a higher wage premium for college educated workers over high school workers. In the US the growth of college educated manpower since the 1980s has lagged behind growth in the demand for skilled workers. As a consequence, the wages of skilled workers have grown faster than less skilled workers.

 

Their studies also found that in the US the distribution of real wage rates narrowed between 1910 and 1950 then remained stable before diverging in the 1980s. The main reason for the narrowing of real wages was the offsetting effects of rapid increases in education. The supply of skilled workers grew such that their wage rates increased at a slower rate than those of less skilled workers. Another interesting finding was that Canada did not experience divergence in the real wage rates between skilled and less skilled workers in the 1980s, unlike the US. Murphy, Goldin and Katz showed that this was entirely due to a rapid increase in the supply of skilled workers through the expansion of education, which kept pace with the growing demand for these workers.

 

In the US, their studies showed that although globalization, the off-shoring and out-sourcing of production, and immigration had some effect on increasing wage inequality on the margins, by far the largest effect was the failure of the education system in supplying skilled workers when the economy needed them from the 1980s onward. In the words of Professor Jan Tinbergen, the first Nobel laureate in economics: “Inequality is the outcome of a race between education and technology. When technology advances ahead of educational change, inequality generally rises. By the same token, when increases in educational attainment speed up, economic inequality often declines.” 

 

Recent Lows in Tertiary Expansion

 

So what happened to the education provision in Hong Kong from 1981 to 2011? Did it help to provide the required number of skilled workers? Table 3 shows the net annual average percentage increases in population (aged 15 and over) by schooling attainment. There was rapid growth in the number of people with tertiary education at both the non-degree and degree levels between 1981 and 1996. Degree holders increased at a net annual rate of 5.4%, 6.3% and 12.5% in the periods 1981-86, 1986-91, and 1991-96. This probably reflected the conversion of the two polytechnics and colleges of education into degree institutions. This effect is mirrored in the decline of tertiary non-degree holders in 1991-96.

 

After 1996, the net annual rates of increase of degree holders were much lower the previous 15 years, as the figures in the table show. They were 4.1%, 4.1% and 3.1% in the periods 1996-2001, 2001-06, and 2006-11, respectively. At the same time, the net annual rates of increase of tertiary non-degree holders in the periods 1996-2001, 2001-06, and 2006-11 were -4.9%, 15.2% and 4.3%, respectively. The cumulative effect of the increase in tertiary non-degree holders was the same as in 1981-1996 and would have been much worse had self-funded Associate Degrees not been introduced. The Associate Degree was Mr. C H Tung’s policy initiative, which was developed into a policy proposal by Mr. Antony Leung, who was then Chairman of the Education Commission.

 

Taken together, these figures reflect a slowdown in the scale of investment in tertiary education in 1996-2011compared with 1981-96. The slowdown might be partly justifiable in view of the slower economic growth during the Asian Financial Crisis, but it is hard to defend post-2003. Both degrees and non-degrees are now growing at the lowest net rate in 30 years. These figures reflect the economic explanation for rising income inequality, which has been seen in most advanced economies: there are not enough skilled workers to keep up with technological progress.

 

To arrest this trend it is absolutely necessary to increase the supply of skilled manpower. This can be achieved in four different ways: (1) attract foreign workers; (2) introduce tertiary education vouchers to provide partial public funding for students studying in self-funded tertiary institutions or even going abroad (with the requirement they return to Hong Kong to work for a period of time upon graduation); (3) move more aggressively to provide better sites, capital funding, and attract operators to expand self-funded tertiary education; and (4) target growth in subjects within the UGC supported sector that cannot be provided through self-funded institutions. These measures will not bring immediate improvements in income inequality, but they will have the right longer term effect.

 

From a politician’s perspective, any individual who has not experienced an increase in real income over the past 15 years is a frustrated and angry constituent. In Hong Kong this would include working individuals in the bottom three decile groups of the income distribution range, folks whose monthly employment income is lower than $8000. Although it is difficult to define who is “poor”, the rising “poverty” at the bottom fuels many populist demands that government adopt more aggressive interventionist policy measures to assist these people.

 

Education as Fundamental Solution for Inequality

 

Poverty assistance typically has been approached in two ways. The first is to adopt policies that enhance the incomes of the poor. The second is to subsidize expenditures that are basic necessities. Many politicians and advocacy groups support income enhancing policies that include minimum wages, regulations limiting work hours, unemployment insurance, workers’ compensation, employment standards, income supplements, and other labor market policies. But the long term effectiveness of these policies in alleviating poverty has always been in doubt. They may achieve some short run redistributive effects, but over time they only make it more costly for business to create better jobs.

 

Many politicians also support subsidizing expenditures which include rates, utility charges, tuition fees, transportation costs, and so on. These subsidies often benefit everyone – rich and poor alike – and are costly to target specifically at the poor. The advantage is that they are cheap and efficient to administer and provide immediate benefits, but like the labor market policies they fail to address the root cause of income inequality: to enhance the productive capabilities of those with low productivity.

 

It is worth pointing out that by imposing harsher constraints on power companies, bus companies, rail companies, tunnel companies, and so forth in raising their fees and charges may be good politics, but this is even worse than providing direct subsidies because of the enormous inefficiency and political cost. Still, their overall effects are probably less costly than labor market policies that increase inefficiency for all companies and not just the few.

 

On both normative grounds and to reduce political divisiveness, there is a strong case to be made for arresting growing income inequality and alleviating poverty. But what is sorely missing in policy discussions is the crucial positive analysis to tackle the deep causes of this rising inequality that is best described as a race between technology and education. Investing in education is not only essential for reducing income inequality, it is also crucial for promoting economic growth. The US is the richest nation in the world today because of the enormous investments it made in education a century ago that allowed it to overtake Europe. The US today is at risk of losing that advantage; and so is Hong Kong.

 

References:

 

Claudia Goldin and Lawrence F Katz. The Race Between Education and Technology, Harvard University Press, 2008

 

Lawrence F Katz and Kevin M Murphy. “Changes in Relative Wages, 1963-1987:

Supply and Demand Factors,” Quarterly Journal of Economics, February 1992.

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