All governments keep a sensitive eye on what is happening to inequality of incomes and inequality of opportunity because they want to be seen to be fair and because sharing the nation’s incremental prosperity helps bind the community together.

But governments are also concerned about national productivity, because it is the key to prosperity and high real wages, and joblessness because it causes economic waste, poverty and unhappiness.

Thanks to Leahy

These four policy targets are not always reconcilable with each other.

Too much fiscal zeal in pursuit of egalitarian values can have disincentive effects on work and innovation. Excessive use of employment protection laws (EPL) – laws which restrict the rights of employers to set wages, dismiss employees, use casuals etc. – can deter employment of low-skill workers.

Increased employment of ‘fringe’ workers often requires some sacrifice of national productivity. And to pursue productivity without regard for its wider effects on quality of life and inequality is to lose sight of what society is all about.

To assess how governments have been responding to these policy trade-offs and challenges over the last 15 to 20 years, I have chosen four performance indicators – far from comprehensive (for example, because of inadequate data, quality of life indicators such as the living, working and natural environment are largely ignored in the evaluation) but all important predictors of community happiness and cohesion.

1.Income inequality – the share of GDP going to the to the 1/5 of the population who earn the least

2.Income mobility – the degree of upward income mobility over one’s lifetime or relative to one’s parents, as measured by longitudinal studies

3.Productivity – measured either by GDP per-hour-worked or multi-factor productivity (which are better indicators than GDP per worker as the latter ignores cross-country differences in rates of investment and in work/leisure preferences).

4.Employment – measured as a proportion of working age population.

Governments differ as to the relative policy weight they give to each of these goals and the methods they use to advance them (in particular the role played by EPL). Amongst developed countries, there seem to be four distinct ‘social models’.

The table below sums up how the models differ on scale and mix of redistribution (with relative number of stars implying no normative judgment) and the sorts of outcomes they have delivered (with most stars going to the best performers on the four societal criteria above).

What does the table tell us?

Model 1 is dominated by the USA. Its overall scale of fiscal redistribution is at the low end of the spectrum, with relatively ‘flat’ tax structures and low levels of income support and social investment. And it has relatively free labour markets, with little use made of EPL.

This model delivers very good economic outcomes but poor distribution outcomes, both in terms of income inequality and income mobility.

Model 2 has been embraced by countries like Britain, Canada, Ireland and NZ. Relative to model 1, income support benefits are more generous (although conditional) and there is a little more job protection. But the overall scale of redistribution, especially through EPL, is modest compared to models 3 and 4.

Model 2 can boast good economic outcomes but on income distribution and mobility it produces mediocre results – although with less inequality than model 1.

Model 3 is found among the larger continental European countries such as France and Germany and some of their neighbours. It redistributes on a large scale, making extensive use of EPL and unconditional income support.

This model delivers a more equal income distribution than models 1 and 2 but its performance on social mobility is only marginally better. Its productivity performance (properly measured) is about equal to that of the first two groups. But it performs poorly on employment – not as poorly as is often claimed by those who focus solely on official unemployment figures, but certainly well below par.

Model 4 is favoured by the Scandinavian countries and some of the smaller Europeans (such as the Netherlands and Austria). It involves high taxes and redistribution on an even larger scale than model 3 – but the income support provided, while generous, is more work-conditional and employment protection laws are less strict than model 3 – although stricter than in models 1 and 2 (or Australia).

Instead this model relies heavily on ‘active’ social programs to enhance the productivity and mobility of low income people throughout their life cycle. For example, in addition to spending much more on education, governments in Denmark, Norway, Sweden and the Netherlands invest about four times more (relative to GDP) on active labour market programs – job placement, training, employment incentives, integration of the disabled, direct job creation and start-up incentives – than the English-speaking countries.

The policy works. Model 4 delivers low and stable levels of income inequality, high and rising levels of income mobility and very good productivity and employment outcomes. The Scandinavians also rank high in international competitiveness league tables. Model 4 countries, in common with others, experience occasional economic fluctuations. For example, the Netherlands has just experienced four years of cyclically-induced productivity slow-down but it is now recovering and the long term productivity trend (over two decades) remains relatively strong.

The ‘best’ mix of instruments
The poor employment outcomes in much of continental Europe are partly due to rigid monetary policy but, one suspects, they are also due to excessive reliance on EPL. This suspicion is confirmed when one looks at Italy, Spain, Portugal, Turkey and Greece. These countries, which are not included in our analysis, have very restrictive job-protection laws and deliver poor employment outcomes (as well, they are not generous with fiscal redistribution so they also produce poor distribution outcomes!).

On the other hand, the success of model 4 suggests that high levels of redistribution (including considerable employment protection) are not per se incompatible with good economic and employment outcomes – provided the redistribution policy mix is liberally spiced with ‘active’ government intervention to help people get jobs and improve mobility and work incentives.

Lessons for Australia
Australia’s policy mix of the last decade – liberal economic reform with moderate employment protection regulation and conditional income support for working age Australians – has been fairly close to that of model 2. And it has delivered similar employment and productivity outcomes but with somewhat less income inequality.

Private incomes (before taxes and transfers) are more unequal in Australia than in most other comparable OECD countries (the poorest quintile has the lowest share of earnings of any OECD country). But because our redistributive system is particularly effective in reallocating private incomes to people in the lowest income quintile, the inequality of final incomes is lower here than in UK, NZ and USA and average by OECD standards.

With a record like this, Australia could have simply rested on its laurels. But reform is the name of the game. So we got the recent workplace and welfare reforms. These take us towards model 1 (indeed in terms of how we treat trade unions and how we reward welfare to work we now have harsher regimes than the Americans!).

But the cross-country evidence above suggests that moving from model 2 to model 1 produces little economic benefit and considerable distributional pain. On the other hand, even a partial move from model 2 to model 4 offers more equality of opportunity without any national economic cost.

Sweden, for example, has much less income inequality than Australia, as well as more generous sickness, parental and study leave arrangements, better education outcomes and, it appears, greater intra-generational social mobility. Yet over the last five years it has achieved much stronger productivity growth than Australia, as well as higher employment/population ratios (with fewer casual jobs), lower inflation and a substantial external account surplus (unlike our big deficits, despite booming commodity prices). Much the same can be said of the other Scandinavian countries.

Has Australia taken the wrong turn?