Can centre-left parties halt growing inequality?

Gavyn Davies On Gordon Brown's Budget conundrum

GORDON Brown's second Budget in March will confront the critical question which faces centre-left parties in all democracies today: to what extent should governments attempt to dampen or reverse the increase in economic inequality which is being driven by the fundamental forces of our time?

To start with some familiar propositions. The dominant forces for economic change in the world today - increasing global competition, along with profound technological advance in the developed economies - are displacing unskilled workers in the West.

There is some debate on whether these forces will continue to operate unabated in the next decade. Some economists, like Paul Krugman, believe that technical change will soon start to displace skilled workers instead of unskilled workers, but there is no evidence that this is happening yet. And since the process of globalisation is probably accelerating, it would take an extraordinary shift in the direction of technical change to alter the overall result.

These two forces, taken together, will considerably increase potential GDP. However, there will be short-term costs as workers and companies adjust to this new world. And if we are not alert to the dangers, there will be one huge long-term cost as well - a further meaningful increase in inequality in our societies.

This will occur because, as we have seen, the two revolutionary forces are inexorably increasing the wages of skilled workers relative to the unskilled. Since poverty is a relative concept, a "no intervention" strategy would mean accepting more poverty in our societies, although overall our economies would become much richer.

So far, we have seen two distinct models for coping with these changes in the Western democracies. In continental Europe, governments have in effect suppressed market forces, and have prevented the drop in relative wages for the unskilled from taking effect. As a result, inequality has not increased and measures of poverty have been broadly stable. But unskilled workers have been priced out of jobs, so unemployment has risen sharply.

By contrast, for much of the past two decades, market forces have been allowed to work unchecked in the American and British economies. Since unskilled workers have not been priced out of jobs, unemployment has hardly risen.

The total number of jobs, proportionate to the size of the economies concerned, has risen four times more rapidly in America than in continental Europe. But measures of inequality have risen very sharply. And, including labour force drop-outs, and incarceration rates, some studies suggest that the rate of non-employment in the United States was just as high as it was in Europe in the early 1990s.

Hence the search for a third way. From a technical economic point of view, such a third way could be designed relatively easily. Indeed, many economists have already done so. By common consent, it would have five main features:

l First, we would expand in-work welfare benefits, like the Earned Income Tax Credit in the US, to increase the incentive for unskilled workers to accept jobs.

l Second, we would offer a minimum guaranteed income level, regardless of employment circumstances, and we would probably implement this through some form of negative income tax.

l Third, we would introduce a new marginal wage subsidy, paid to employers who increased their total employment of low- wage workers. This might be somewhat like the New Jobs Tax Credit in the US in the late 1970s.

l Fourth, we would continue to tighten the eligibility rules for benefit claimants, and we would police the system even more actively. There would have to be time limitations on all forms of income support, other than the minimum support levels offered under the negative income tax. This would probably mean that lone-parent and disability benefits would have to be curtailed.

l Fifth, and ultimately most important, we would need to stem the production of unskilled workers by vastly improving our education and training systems. And remember that 80 per cent of those who will be in the labour force in 10 years' time are already there. So enhanced measures for life-long learning are essential.

Given that all of this is so obvious, why has it not been done? Because, hidden beneath these fine-sounding words, a huge political problem lies buried.

This programme of welfare reform would not save money - in fact, it would be extremely expensive in its early years. Furthermore, it would almost certainly involve a frontal assault on the increases in living standards that middle Britain and middle America have come to expect.

Look at the problem this way. If we do nothing, but simply allow market forces to run their course, then the real incomes of skilled workers will rise at least 1-1.5 per cent per annum faster than those of unskilled workers.

Over a decade, the improvement in the relative position of skilled workers is most unlikely to be less than 10 per cent. Extremely rough calculations (which need a lot more rigorous work) suggest that on the "no intervention" strategy, the Government could reduce the marginal rate of income tax by at least 1 percentage point - say from 20 per cent to 19 per cent - over this period.

In other words, we would see more of the same - poverty would grow, and middle or upper-income groups would take virtually all of the gains from economic growth.

What would the Government have to do to stop this further widening in income differentials? Again, very rough calculations suggest that it would have to increase tax receipts from the middle groups by about 9 per cent to achieve the required redistribution to hold relative incomes equal. This could be done by raising the marginal rate of income tax from 20 per cent to 22 per cent, instead of cutting it to 19 per cent.

All of these figures would need to be increased still further if the Government wished to implement a large increase in spending on education and lifelong learning, as well as holding relative incomes constant.

This clearly sounds drastic, and perhaps it is totally infeasible from a political perspective. But, of course, we could think of ways of increasing the tax burden which would be much less inflammatory than raising the marginal rate of income tax.

And even with this programme the middle-income groups would still enjoy large gains in their living standards - the Government would only be taking the cream off the top of these gains.

It is far from clear that this reform programme is the best way of getting the centre-left re-elected. In fact, it would probably be better from an electoral point of view simply to allow market forces to take effect, and to use this trend to consolidate already strong gains of the new Democrat and Labour Parties with middle income groups.

After all, turnout in low-income groups is quite low, and in Britain they generally vote disproportionately in places where Labour already has a lock on the likely result.

But as Mr Brown prepares his Budget, many are wondering what exactly is the point of the centre-left, unless it is willing to start tackling these intractable problems? And would new Labour really deserve to be re-elected if it sat back and did nothing as inequality in our society continued to mount?