Labour market institutions and income inequality : evidence from a panel of European countries

Abstract

Over the past few decades, income inequality has risen in a majority of advanced countries, leading to a broad debate on the causes of this trend. Empirical studies have relatively overlooked the role labour market institutions have in explaining these developments, and the few studies which have assessed this relationship reported conflicting results. This study looks at the relationship between income inequality and labour market institutions in developed countries. Moreover, to shed light on the conflicting findings within the literature, this dissertation specifically aims to assess whether the hypothesised relationship is nonlinear. In this light, the first empirical model estimated uses annual data on income inequality and labour market institutions and their squared values, in a panel of 26 European countries for the period 2005 to 2018, where labour market institutions consist of trade union density, wage-setting coordination, the Kaitz index, employment protection legislation (EPL), unemployment benefit replacement rates and the tax wedge. Subsequently, other potential commonly identified correlates of income inequality, consisting of other macro-economic variables and population characteristics are incorporated within the empirical model. The empirical findings indicate that trade unions, captured through the union density rate and the degree of wage-bargaining coordination explanatory variables, have a sizeable role in explaining variations in income inequality across countries and over time, for the selected sample. Whereas union density has a consistently statistically-significant inverted U-shaped relationship with income inequality, wage-setting coordination has a robustly statisticallysignificant U-shaped relationship with the distribution of household income. These quadratic relationships are present in the extended model, both robustness tests and after the inclusion of institutional interaction terms, underscoring the persistence of the hypothesised non-linear relationship of unions with income inequality. Furthermore, when adopting a wider perspective by looking at the entire institutional set-up, through the introduction of institutional interaction terms, minimum wages, unemployment benefits and the tax wedge also have a role in explaining income inequality patterns.