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The rise in income inequality over the last 20 years is a widely discussed problem in Germany at the moment. But there is little discussion on the drivers of this inequality, and why Germany is more equal in income than the US. There is one reason for this which is widely overlooked.

A major source of inequality in rich countries is the rising pay of the top 1% of income earners. In Germany the top 1% of income earners are CEOs in industrial firms, partners in law firms and in management consultancies, and some medical doctors. Why has the income of this group increased so much?

Where you work is decisive

A worker’s income does not depend so much on their education level, but on the firm they work for, as shown by two new studies on the US and Germany (, ).  To increase your income you have to work for a firm which is very productive and which pays high wages. If you work for the same firm all your life, you can only marginally increase your income.

Wage inequality between firms, rather than within firms, explains the evolution of inequality. Matching very productive firms with very talented people generates inequality in income, meaning that the ability of workers to move between firms is important in generating inequality.

The competition for talent

But what influences the mobility of workers between firms? If we look at CEOs, it depends on the trade environment that firms face, as I showed in a paper with Thierry Verdier ().

In Germany, trade liberalisation has increased the chances of finding a better paying job. New foreign firms enter the market and search for qualified managers, but managers familiar with the German market environment are scarce, and foreign firms compete with incumbent firms for these managers, driving up their pay. This competition for managers contributed to a 3.5 fold increase in CEO pay in Germany between 1977 and 2009 ().

Germany is an economy very open to international trade. The competition for managers from foreign firms is much stronger in Germany than in the US, and therefore CEO compensation should be larger in Germany. But this is not the case. CEO pay in the US is 6 times higher now than it was in the 1970s (). This means that there must be other factors at work beyond openness to trade.

Offshoring of managerial tasks

In a new study we find an answer to this puzzle (). CEO pay increased by less in Germany than in the US because of the offshoring of managerial tasks to eastern Europe, which started in the mid 1990s after the fall of communism.

Managerial offshoring is widespread. In 57 percent of foreign direct investment projects in eastern Europe a local manager was hired rather than a German manager. On average 2 to 3 managers per investment were offshored to eastern Europe.

Managerial offshoring to eastern Europe reduced the demand for managers in Germany, leading to a decline in managerial pay. According to our estimates, managerial offshoring has led to a decline in CEO pay in Germany by 18 percent compared to what it would without offshoring. The results suggest that managers in Germany operate in a tight labour market. Their scarcity allows them to receive high incomes which do not necessarily correspond to their performance.

Declining skill premium

There is an additional reason why inequality in Germany is less pronounced than in the US: the offshoring of production to eastern Europe by German firms since the beginning of the 1990s.

As German firms could not find skilled workers in Germany (in particular engineers) they relocated production to eastern Europe where there were many skilled workers who were cheaply available.

This led to a decline in the demand for skilled workers in Germany, lowering their wages. Offshoring of skilled workers to eastern Europe reduced the skill premium by 40 percent according to my estimates ().

Workers with university degrees generally enjoy higher incomes in Germany, but the falling skill premium dampened the spread between skilled and unskilled workers during this period.

While US firms offshored production to Mexico in the 1990s, the relocation of US-value chains to Mexico were not skill-intensive but labour-intensive. The relocation of production to Mexico reduced the demand for unskilled workers in the US, lowering their wages. This contributed to a larger income gap between skilled and unskilled workers in the US ().

Why education is not a panacea

In rich countries, the response to the challenges of globalisation has been education, education, education. The only way to compete with a rising China, so the argument goes, is to expand education in rich countries.

But the declining skill premium in Europe suggests that the supply of people with university degrees . A further expansion of education will lead to a further decline in the skill premium. In Germany a university graduate earns about 60 percent more than a high school graduate, and a sufficient spread in income between skilled and unskilled workers is desirable to maintain the incentives for education.

In Germany, anxiety about the future is leading more young people to enroll in universities. But will a university degree still provide an insurance against unemployment when there is an oversupply of university graduates in the future?

We must find new ways to deal with the differences in income between CEOs and the rest of the population. In Germany a CEO in the manufacturing sector earned 8 times more than a skilled worker in the same sector in 1977, but in 2007 the CEO earned 17 times more ().

The rise in CEO pay in Germany is due to of the scarcity of trained managers. So to reduce the gap between CEO and worker pay, we must find more CEOs. This can be done by diversifying the boardroom with more women and foreign CEOs. In Germany CEOs are mainly German and male. If firms start to hire foreign and female managers, we can reduce both the scarcity of managers and inequality in one fell swoop.