significance. What is less satisfying is the unemployment equation, where the tax wedge continues to have
a negative impact, while the capital-labour ratio has positive coefficient.22
Figure 2 — Predictive ability of the model estimated in table 6 — Gini index on income inequality
Gini index
canada
year
actual---predict
The predictive ability of the model is good, as can be seen from figure 2 that compares the actual
and the predicted dynamics of the Gini index. This is rather impressive if one considers the block
recursive nature of the model, noting that in addition to its own prediction error, the prediction for the
Gini index accumulates the prediction errors from the other three endogenous variables. In particular our
model captures the trend reversal in income inequality observed in most European countries at the end of
the 1970s (notably the Netherlands, France and United Kingdom), which seems to be largely explained by
the contemporaneous decline in the labour share.
3.5. Counterfactual exercises
We have performed a number of counterfactual exercises to assess the relative importance of the various
labour market variables. To illustrate the process, consider figure 3. Using the estimated coefficients in
table 6, we have obtained the predicted values for labour share, wage differential and unemployment rate
for all the country/year observations available in the sample (and even outside the estimation sample, as
22 The former sign reverts to positive when the sample is restricted to 6 countries for which we have more consistent
observations (89 observations), while the latter becomes insignificant if year fixed effects are neglected.
22