are then three sources of inequality: employment versus unemployment, skilled versus unskilled wages,
and the distribution of capital. In fact, the Gini index for personal incomes can be expressed as a function
of the labour share, the relative wage, the unemployment benefit, and the proportion of the population in
each category. A smaller labour share, a higher relative wage, and a lower unemployment benefit, all
increase income inequality. This decomposition implies that the effect of labour market institutions on
inequality is ambiguous. For example, both higher union power and unemployment benefits increase the
unemployment rate, which tends to raise the Gini coefficient, but reduce the relative wage and increase
the labour share, both of which tend to lower inequality.
We test these propositions in a panel of OECD countries for the period 1970-96. We find that
the labour share remains a fundamental aspect of overall inequality patterns, with an effect roughly as
important as that of relative wages. Our results also show that that stronger unions and a more generous
unemployment benefit tend to reduce income inequality. The effect of labour market institutions tends to
be large, and explains a substantial fraction of the variation across countries. The other variable that
emerges from our analysis as having a large impact is the capital-labour ratio. High capital-labour ratios
tend to increase the labour share, and hence reduce income inequality. In fact, this appears to have been a
major force dampening the increase of income inequality in the US over the last few decades.
The paper adds to the recent revival of interest in the factors shaping the distributions income
across countries (Bourguignon and Morrisson, 1990, 1998; Li, Squire, and Zou, 1998; Barro, 2000;
Alderson and Nielsen, 2002; Breen and Garaa Penalosa, 2004). For decades empirical work on cross-
country differences in the distribution of income consisted of tests of the Kuznets hypothesis taking the
form of regressions of inequality on the level of GDP and its square. Only recently have variables other
than the level of income been considered, such as the level of human capital, the degree of
democratisation, or the extent of financial development. Although this approach is helpful in
understanding the underlying causes of inequality, it leaves little room for policy recommendations as in
most cases the particular mechanism through which these variables impact inequality is not understood.
By focussing on the basic determinants of the distribution of income we want to understand whether
labour market institutions play a role because they affect the unemployment rate, the distribution of
wages, or the way in which capital and labour are rewarded.
The paper is also related to the literature on the evolution of inequality in industrial economies
over the past three decades. Two features have dominated this literature. One has been the increase in
income inequality in a number of countries; the other the sharp rise in the relative wages in the UK and
the US (Atkinson, 1997, 2003; Gottschalk and Smeeding, 1997; Bound and Johnson, 1992; Juhn, Murphy,
and Brooks, 1993). Our paper emphasises two aspects. First, that although wage inequality is a crucial
aspect of the income distribution, the distribution of wealth still plays a substantial role as captured by the
negative impact of the labour share in our regressions for the Gini coefficient. Second, our analysis
highlights the differences between an increase in the relative wage and in wage inequality. Understanding
the evolution of inequality requires knowing the proportions of agents receiving each salary and not only
the relative salaries, and looking at the labour share is a (crude) way of capturing both.