Is the financial market driving income distribution? – An analysis of the linkage between income and wealth in Europe

Ilja Kristian Kavonius and Veli-Matti Törmälehto in this ECB paper:

Globalisation has a major impact on the levels and distribution of wealth. The financial markets are highly integrated, and valuations of financial assets follow international patterns, which has contributed to large increases in financial wealth over the past 25 years. Nonetheless, this has not led to an equally large increase in property income because the rates of return have decreased during the same era. Moreover, changes in functional income distribution (capital/labour shares) have not been fully transmitted to the distribution of primary income between households because other institutional sectors – particularly the government sector – hold considerable amounts of financial assets. At least in the short term, the decrease in rates of return seems to contradict claims that, due to an increase in both financial and inherited wealth, we are entering an era of increasing income inequality.

In this article, the link between financial wealth and pre-tax household income distribution is scrutinised for three European countries using a conceptually fully consistent macro framework.

The analysis is performed for Finland, France and Spain. The analysis in this article is related to but different from the analysis performed by Thomas Piketty (2014) and estimates presented in the World Inequality Database (WID). Piketty argues that wealth is increasingly accumulating in wealthy households, and this wealth is playing an increasingly important role in the generation of income, which will lead to increased income dispersion. The structural changes in the labour shares indicate that, in terms of income generation, the role of both property and labour income is changing. In our framework, this process should entail a structural shift in the ratio between capital and labour income in the highest income deciles.

The stock of wealth has indeed increased much in recent decades. This increase is a result of increased investment in financial and non-financial assets, i.e., the investment of savings, as well as the price increase of actual assets. Nevertheless, returns were higher some decades ago, and if they were similar to levels 20 years ago, the capital/labour ratio would have moved structurally towards capital. This would also have strongly increased inequality, as capital income is typically concentrated in the highest income deciles. However, as the rates of return in these three countries practically halved from 1995 to 2019, the capital/labour ratio has actually remained relatively stable. 


It is also essential to note that if we analyse solely the distribution of gross national income, a different picture emerges. In terms of total economic development of all institutional sectors, property income plays a more pronounced role and has more volatility compared to pure household sector income. Relatively volatile property income implies more volatility in the functional income distribution (capital/labour shares), but clear structural changes are not evident. At the national level, the share of capital income is, for obvious reasons, larger than at the household level, but we argue that this does not automatically entail increasing (interpersonal) inequality. In particular, the countries analysed in this article are characterised by considerable equity ownership by general government and non-profit institutions serving households, whose returns are used for the public good. 



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