Currently there is a lively debate in Germany about why the economy has become more unequal over the last 20 years. But there is little discussion on the drivers of inequality. Why is Germany less unequal in income than the US? There is a reason for it which has received little noticed.
A major source of inequality in rich countries is the development of the top 1% of income earners. In Germany, the top 1% of income earners are CEOs in industrial firms, partners in law firms and in management consultancies, and some medical doctors. Why has the income of this group increased so much?
Where you work is decisive
Two new studies for the US and Germany find that the income earned does not depend so much on the education level you achieve, but the firm you work for (Song et al. 2015, Card et al. 2016). To increase your income, you have to work for a firm which is very productive and which pays high wages. If you stay with the same firm all of your life, you can only marginally increase your income. It is the wage inequality between firms rather than within firms which explains the evolution of inequality. It is the matching of very productive firms with very talented people which generates the inequality in income. The mobility of workers from one firm to another is important in generating inequality.
The competition for talent
But what influences the mobility of workers between firms? In a past paper, my co-author and I show that the mobility of CEOs depends on the trade environment that firms face (Marin and Verdier 2012). In Germany, trade liberalisation has increased the chances of finding a better paying job. New foreign firms enter the market and search for qualified managers. Managers familiar with the German market environment are scarce. Foreign firms compete with incumbent firms for these managers and drive up their pay. In a recent paper on German CEO pay, I find that this competition for managers has contributed to the 3.5-fold increase in CEO pay in Germany between 1977 and 2009 (Fabbri and Marin 2016).
Germany is an economy that is very open to international trade. The competition for managers by foreign firms is much stronger in Germany, and therefore CEO compensation is supposed to be larger in Germany than in the US. But this is not the case. CEO pay in the US increased six-fold during the same period (Frvdman and Saks 2010). Therefore, openness to trade cannot by itself provide the answer.
Offshoring of managerial tasks
In a new study, we find an answer to this puzzle (Marin et al. 2015). CEO pay increased by less in Germany than in the US because of German offshoring of managerial tasks to Eastern Europe, which started in the mid-1990s after the fall of communism. Managerial offshoring is rather large. In 57% of foreign direct investment to Eastern Europe, a local manager was hired rather than a German manager. On average, two-to-three managers per investment were offshored to Eastern Europe. Managerial offshoring to Eastern Europe reduced the demand for managers in Germany which led to a decline in managerial pay. According to our estimates, managerial offshoring has led to a decline in CEO pay in Germany of 18%. The results suggest that managers in Germany operate in a tight labour market. Their scarcity allows them to receive large rents which do not necessarily correspondent to their performance.
Declining skill premia
There is an additional reason why inequality in Germany is less pronounced than in the US – the offshoring of production to Eastern Europe by German firms since the beginning of the 1990s. German firms offshored the skill-intensive part of the value chain to Eastern Europe. Since they could not find the skilled workers in Germany (in particular engineers), they relocated production to Eastern Europe and employed skilled workers there which were plentiful and cheaply-available. This led to a decline in the demand for skilled workers in Germany which lowered their wages. According to my estimates, offshoring of skilled workers to Eastern Europe reduced the skill premium by 40% (Marin 2011). People with academic degrees belong to the higher income group of German society. The falling skill premium dampened the spread between skilled and unskilled workers in Germany. During the same period, US firms offshored production to Mexico. In contrast to Germany the relocation of US-value chains to Mexico were not skill-intensive but labour-intensive. The relocation of production to Mexico reduced the demand for unskilled workers in the US, which lowered their wages. This contributed to a stronger spread in income between skilled and unskilled workers in the US (Feenstra and Hanson 1996).
Why education is not a panacea
In rich countries a new imperative to meet the challenges of globalisation has emerged – education, education, education. The only way to compete with a rising China, so the argument goes, is the expansion of education in rich countries. But declining skill premia in Europe suggests that the supply of people with academic degrees exceeds their demand (Marin 2015). A further expansion of education will lead to a further decline in the skill premium. In Germany a person with an academic degree today earns roughly 60% more than a high school graduate. A sufficient spread in income between skilled and unskilled workers is desirable to maintain the incentives for education. Today anxiety about the future leads to a run to enrol in universities in Germany. But will a university degree still provide an insurance against unemployment when there is an oversupply of university graduates in the future?
It is worthwhile to look for new ways to deal with the spread in incomes between CEOs and workers. In Germany in 1977, a CEO in the manufacturing sector earned eight-times more than a skilled worker in the same sector; in 2007, a CEO earned 17-times more (Fabbri and Marin 2016). The rise in CEO pay in Germany is an expression of the scarcity of managers. To dampen the rise in the premium of CEOs, it is desirable to reduce their scarcity. Two approaches suggest themselves – diversify the boardroom with female CEOs, and with foreign CEOs. In Germany, CEOs are mainly German and male. The scarcity of managers and inequality can easily be alleviated if firms start to hire foreign and female managers.
Card, D, J Heining and P Kline (2013) “Work place heterogeneity and the rise of West German wage inequality”, Quarterly Journal of Economics, 128(3): 967 – 1015.
Fabbri, F and D Marin (2016) “What explains the rise of executive pay in Germany?” Scandinavian Journal of Economics, 118(2): 235-263.
Feenstra, R C and G H Hanson (1996) “Foreign investment, outsourcing and relative wages”, in R C Feenstra, G G Grossman and D A Irwin (eds), Political Economy of Trade Policy: Essays in Honor of Jagdish Bhagwati, The MIT Press, Cambridge: 89-127.
Frydman, C and R Saks (2010) “Executive compensation: A new view from a long-term perspective, 1936—2005”, Review of Financial Studies, 23(5): 2099-2138.
Marin, D (2014) “Globalisation and the rise of the robots”, VoxEU.org, 15 November.
Marin, D (2011) “The opening-up of Eastern Europe at 20: Jobs, skills, and ‘reverse Maquiladoras’ in Austria and Germany”, in M Jovanovic (ed), International Handbook on the Economics of Integration, vol II, Edward Elgar.
Marin, D and T Verdier (2012) “Globalization and the empowerment of talent”, Journal of International Economics, 86(2): 209-223.
Song, J, D J Price, F Guvenen, N Bloom and T von Wachter (2015) “Firming up inequality”, Mimeo.