External employment practices and income inequality: A cross-country comparison

Markus Weissphal, Paderborn University

Recent work has suggested that a large part of rising inequality in income may be attributed to the employment strategies and practices of large firms. Cobb (2016) and Davis and Cobb (2010) corroborate that firms have dismantled their internal labor markets and adopted an employment strategy based on externalizing employment practices such as outsourcing or contract labor. Autor, Dorn, Katz, Patterson and Van Reenen (2017) argue that large, industry-leading “superstar firms” are also pursuing externalizing employment strategies. These usually result in significant wage penalties for employees (e.g. Goldschmidt & Schmieder, 2017). However, it is still unclear if and to what extent the growing use of external employment practices can explain the rising income inequality in richer societies.

This paper contributes two important points to that debate based on new pooled cross-section time-series data at country level for 27 OECD countries in the period from 1990 to 2015.

First, we show that the empirical links ascertained by Davis and Cobb (2010) do not hold for all countries. In that paper, employment concentration, defined as the employment share in the economy of the ten largest companies, measures the importance of internal labor markets. Large firms have traditionally implemented internal labor markets with long-term employment contracts and generous pay structures, which have reduced aggregate income inequality. Cobb (2016) argues that this effect disappears with the rise of external employment practices, which allow for more pay variation especially across firms. This argument implies that employment concentration (the proxy for internal rather than external labor markets) should be negatively associated with inequality at country level. Davis and Cobb (2010) found such a pattern in a cross-section of countries and in a longer time series for the United States. However, the pattern is not general. In our data, we also find countries with a strongly positive correlation, most remarkably the United States (correlation of 0.94 from 1990 to 2015) and Germany (0.89).

Secondly, we suggest a new empirical model that reconciles the divergent correlations. Autor et al. (2017) identify a relationship between the rise of “superstar firms” (larger firms that capture exceptionally high market shares and profits) and the fall of the labor income share. We include the labor income share as a measure for market concentration and argue that it may moderate negatively the relationship between employment concentration and income inequality. The cross-section time-series regressions (including a number of control variables and estimated in various ways) support the idea. Employment concentration will be linked negatively to income inequality with a higher labor share and positively with a lower labor share.