Question

How might these policy changes affect the wage gap between low-skill and high-skill workers in the United States?

  Subsidies paid to businesses to introduce robots into the production process.

Answer 1

Policymakers in many OECD countries are increasingly concerned about high and rising inequality. Much of the evidence (as far back as Adam Smith’s The Wealth of Nations) points to the importance of skills in tackling wage inequality. Yet a recent strand of the research argues that (cognitive) skills explain little of the cross-country differences in wage inequality. Does this challenge the received wisdom on the relationship between skills and wage inequality? No, because this recent research fails to account for the fact that the price of skill (and thus wage inequality) is determined to a large extent by the match of skill supply and demand.

Pros

• Skills matter for wages at the individual level: skilled workers have, on average, higher wages than unskilled workers.
• Differences in skills can explain a significant share of the wage gap between certain socio-economic groups.
• Changes in the demand for skills, driven by technological change, globalization, population aging, and organizational changes, have increased the return to skill and, thereby, wage inequality.
• Wage inequality tends to be lower in countries that are better at meeting the demand for skills.

Cons

• Differences in skills and in their distribution account for only a small fraction of differences in wage inequality between countries.
• Differences in the prices of skills (or how skills are rewarded) account for a much larger proportion of cross-country differences in wage inequality.
• The prices of skills are determined, at least in part, by labor market institutions, which have an important impact on the distribution of wages.
• A large portion of cross-country differences in wage inequality remains unexplained by skills or skill prices.

Cross-country difference in wage inequality are primarily driven by differences in returns to skill

Studies that find that skills cannot explain cross-country differences in wage inequality tend to conclude that differences in how skills are rewarded are far more important to use the terminology introduced above, the “skills price” effect is much larger than the “skills endowment” effect. For example, an early study based on data from the 1990s found that higher skills prices in the US than in other countries could account for 18–55% of the difference in wage inequality between them, a finding confirmed by another study using the same data that placed the estimate at around 36%. More recent calculations using PIAAC 2012 data provide estimates in the same ballpark, ranging from about 33% to 57%. These results are not surprising in light of the large variation across countries in the return to skill.

The return to skill is determined (at least in part) by labor market institutions

Most of these studies go on to claim that differences in the return to skill must be driven by differences across countries in labor market institutions, in particular, wage-setting mechanisms that influence how skills are rewarded. For example, higher minimum wages will compress the wage distribution and therefore reduce the return to skill. Similar effects might be expected in countries where the wages of a large portion of workers are set through collective bargaining.

Limitations and gaps

Most of the economics literature (as well as the wider literature on inequality) focuses on only a single driver of wage inequality, which tends to be either labor market institutions or the demand for and supply of skills. Few studies have analyzed both drivers simultaneously and on a comparative basis (although this has not stopped some researchers from making sweeping claims about the relative importance of one factor compared with the other). One study that compared the role of skills with that of labor market institutions concluded that skills are at least as important as labor market institutions in explaining international differences in wage inequality. However, more comparative analyses are needed before any definite conclusions can be reached.

A second limitation of the literature is the narrow focus of international surveys of adult skills on cognitive skills, though the surveys have greatly advanced understanding of the determinants of skills and their importance for labor market outcomes. Cognitive skills are only one part of the wide array of skills and attributes that are believed to be of value in the labor market. In particular, there is a set of wider, non-cognitive skills that are also important in the modern workplace, such as perseverance, self-control, openness to experience, the capacity to work collaboratively or as part of a team, and communication skills. International skills surveys have not yet directly assessed this wider set of skills. Adequately accounting for these skills could further elucidate the link between skills and wage inequality.

Finally, while skills and how they are rewarded may jointly explain a substantial portion of international differences in wage inequality, an important share of these differences remains unexplained. For example, one study found that the distribution of skills could, on average, explain 3–13% of the differences in wage inequality between the US and other countries, while skills prices could explain 28–55%. However, the same study found that the unexplained (or residual) part was as high as 26–64%. Similarly, another study found that the greater variance in skills in the US could account for just 7% of higher wage inequality compared with other countries, while higher skills prices could account for nearly 25%. The same study found that most of the differences in wage inequality across countries occurred among workers who were identical in terms of skills and other measured characteristics.

These findings raise the question of what other factors are being captured by this residual. One possibility is that there are differences across countries in unobserved skills and how they are rewarded, which may be related to the non-cognitive skills reference above. Another possible explanation is that the sorting of individuals across firms may result in very different returns over time for two seemingly similar individuals if, for reasons beyond the individuals’ control, the firms grow at very different rates. There is indeed mounting evidence that firm-specific premiums are an important source of wage inequality.

Summary and policy advice

While some research finds that skills are unable to explain cross-country differences in wage inequality, other research has clearly demonstrated that skills matter for individual wages and that wage inequality depends on how well the supply of skills keeps up with the demand. In addition, there are some methodological concerns with the research that claims that skills cannot explain international differences in wage inequality.

On balance, therefore, policymakers concerned with tackling high or rising wage inequality need a comprehensive strategy that includes both a skills component and measures aimed at making labor market institutions more inclusive. Skills policies should focus not only on increasing the average level of skills of the workforce, but also on reducing inequalities in the way skills are distributed among the population and keeping the supply of skills aligned and responsive to labor market needs. The balance between skills policies and reform of labor market institutions will, of course, differ from country to country.