Wage compression and the decline in inequality in Latin America

This blog posts explores some questions behind an article written by Levy Yeyati and Pienknagura – Wage compression and the decline in inequality in Latin America: Good or bad?“. We summarise the authors claims behind the decline in Latin American income inequality, and explain whether the decline is good or bad for Latin America.

The authors claim that there are 3 possible factors behind the decline in Latin American income inequality: increasing access to education, a decline in the demand for skill-intensive industries or a worsening of the educational system. Before we analyse these effects, it is important to note that the compression of the educational premium only accounts for half of the decline in inequality, so other factors must also be involved.

On the first point, Yeyati and Pienknagura, point out that more children from the lower ends of the income distribution have access to education. These children are likely to receive lower wages in the future, than children from high-income families – perhaps because they have less funds to access further tuition, books or because they are encouraged by their family to go into low income jobs – which means that the returns to education will fall. This is more of a statistical phenomenon than the fact that actual returns fall, so shouldn’t be considered a bad thing, especially as more people will be better educated. If we control for socio-economic status then we shouldn’t see an effect on returns to education so the incentive to study will remain. However, it could be argued that the signalling effect of education (people with better ability get more education, because they find it easiest) is diminished, and as a result the higher ability students have to pursue longer educational careers in order to signal to employers their ability. If this longer educational career is only a signalling effect (i.e. there are negligible actual effects on human capital) then this might be considered as inefficient.

The second proposed explanation is that returns to education have fallen as a result of lower demand for high-skills by employers. This is likely to arise in Latin America due to an increase in commodity prices, an industry which is low-skill intensive. This would imply that the share of the labour force in skill intensive sectors should fall. However, this was not evidenced when Timmer and de Vries looked at 7 Latin American countries they saw that sectors with higher educational intensity grew more, relative to other sectors. It is likely that this explanation is inappropriate to explain the Latin American decline in educational premia.

The final proposed explanation is that educational quality may have fallen. This could arise through a number of channels, from worsening teachers, to a poorer curriculum, to the skills which firms require not being taught, to lower resources and funding being channelled into education. Unfortunately this is a difficult hypothesis to test, due to the many variables incorporated into educational quality. Results from PISA suggest that this hypothesis may hold some sway in explaining the declining educational premium.

I believe that the first and third arguments are most convincing, as the evidence refutes the second theory. I think it is more likely that the first argument accounts for the declining educational premium, and the third is less likely because the demand for high skilled workers has increased; so obviously firms don’t believe that educational quality have fallen that significantly, otherwise they would hire skilled workers from abroad. Although it may be the case that they have to spend a lot of time and resources training up their workforce themselves, this could act as a good test to see whether educational quality in Latin America is indeed falling or not.

This reduction in inequality may be perceived as good because from a normative perspective we generally consider more equal societies as fairer and better. However, this is arising due to the fall in educational premium which might result in fewer people undertaking higher education (due to lower incentives) which may affect the economies of Latin America down the line, when they suffer from a lack of highly skilled labour and human capital. Furthermore, if Yeyati and Pienknagura’s hypothesis that educational quality is falling is correct, then this is also a bad outcome for Latin America, as they may struggle to compete in high-skilled industries in the future.

More generally, from an economic perspective falling inequality may be a positive thing because in a Kaleckian demand sense we are likely to see an increase in aggregate demand, providing that inequality is falling as a result of those with the lowest incomes growing (ceteris paribus), and not that the highest incomes are falling (ceteris paribus). Furthermore, falling inequality may be associated with a fairer society, which ought to imply that there would be less political pressure for a change in government or in the political system. This could help to increase investor and consumer confidence, again boosting the economy.

Leave a Reply

Your email address will not be published. Required fields are marked *