Policymakers in many OECD countries are increasingly concerned about high and rising inequality. Much of the evidence (as far back as Adam Smith’s The Wealth of Nations) points to the importance of skills in tackling wage inequality. Yet a recent strand of the research argues that (cognitive) skills explain little of the cross-country differences in wage inequality. Does this challenge the received wisdom on the relationship between skills and wage inequality? No, because this recent research fails to account for the fact that the price of skill (and thus wage inequality) is determined to a large extent by the match of skill supply and demand.

While cross-country differences in skills and their distribution explain only a small part of international differences in wage inequality, it is wrong to conclude that skills do not matter for wage inequality. Differences in wage inequality across countries are driven primarily by differences in the return to skills, which is determined in part by labor market institutions, but also by how well the supply of skills meets the demand. A comprehensive policy package to tackle wage inequality should include a focus on skills, reforms of labor market institutions that influence how skills are rewarded, and alignment of skill supply and demand.

A large and growing body of evidence has helped policymakers better understand the causes of both high and rising wage inequality. Two key sets of explanations have emerged. For the first set, which focuses on labor market institutions, there is general agreement that changes in minimum wages, unionization, and employment protection legislation, or differences in them across countries, can explain a substantial portion of the increase or cross-country variation in wage inequality. For the second set of explanations, which focuses on the role of skills, there are two competing strands of research. One strand, with many supporters, finds that changes in the demand for and supply of skills have caused rising wage inequality within countries over time. Yet another strand has found that skills explain little of the differences in wage inequality across countries. For policymakers, these findings may send mixed messages about the importance of skills in tackling wage inequality. The objective of this paper is to provide clarity on this issue.

Skills explain very little of the international differences in wage inequality The idea that skills and worker training enter into the determination of individual wage rates dates to at least Adam Smith. The notion received fresh impetus from the development of human capital theory in the 1960s, which provided a strong theoretical and quantitative foundation for the relationship between skills and wages. Since then, estimates of the return to education, virtually all positive (and frequently large), have flourished in the economics literature, and increases in the return to skill have featured prominently in explanations for the rise in inequality in a large number of developed countries in recent decades [1]. While most of the literature has used proxies (like occupation or educational attainment) for measuring skills, recent studies have begun to use more direct measures of (primarily cognitive) skills and have replicated many of the well-established findings in this literature. Against this backdrop, a small but growing literature has found that differences across countries in the distribution of (cognitive) skills appear to explain very little of the differences in wage inequality across countries. Taken on their own, these studies may leave the impression that skills do not matter for wage inequality. The standard approach in this research is to use decomposition methods to analyze three components of international differences in wage inequality: one due to skills (sometimes referred to as an “endowment” or “composition” effect), one due to how skills are rewarded (or skills “prices”), and one that remains unexplained (or a “residual”). The first group of studies, which appeared in the early 2000s, was based on the International Adult Literacy Survey, carried out between 1994 and 1998. One of the studies found that the distribution of test scores could explain, on average, only 3–13% of the higher wage inequality observed in the US [2]. Another found that skills inequality could account for only about 7% of cross-country differences in wage inequality [3]. More recently, a number of studies have exploited data from the OECD’s Programme for the International Assessment of Adult Competencies (PIAAC) for similar purposes and obtained essentially similar results: differences in the distribution of skills across countries can explain little, if any, of the differences across countries in wage inequality [4], [5], [6]. In a way, such conclusions are not surprising. Even a cursory look at the aggregate cross-country data suggests that there is little correlation between skill inequality and wage inequality (Figure 1). While there are countries with both high skill inequality and high wage inequality (such as Canada, Germany, Italy, and the US), and others with both low skill inequality and low wage inequality (Scandinavian countries), there are also countries with high skill inequality but low wage inequality (such as France) and some with low skill inequality and high wage inequality (such as Japan and Korea). The second important observation to take away from Figure 1 is that the variation across countries in skills inequality is fairly low: the ratio of numeracy scores at the 90th percentile to those at the 10th percentile ranges from 1.4 in Slovakia to 1.8 in the US. There is much more variation across countries in wage inequality: the ratio of wages at the 90th percentile to those at the 10th percentile ranges from 2.2 in Sweden to 5.8 in South Korea. Does the fact that differences across countries in the distribution of skills explain very little of differences in wage inequality mean that countries with high wage inequality should not be concerned about skills? The very simple answer is no. There are at least two important reasons why countries should invest in skills if they are worried about wage inequality. The first is that there is a strong relationship between an individual’s skills and wages. So within countries, a wide skills gap between the highest skilled workers and the least skilled ones necessarily implies wider wage dispersion. The second reason why countries with high wage inequality should be concerned about skills is that the skills premium (and therefore wage inequality) will increase if the demand for skills is high while the supply of skill fails to keep up with demand. Even at a cross-country level, there is evidence that countries that are better at meeting the demand for skills tend to have lower wage inequality. In what follows, each of these arguments is explored in turn.

Individuals with higher skills have higher wages The first (and simplest) argument for why policymakers who are concerned about wage inequality should focus on skills is the strong association between an individual’s skills and wages. Figure 2, based on the latest round of the adult literacy surveys (PIAAC), shows that workers who can understand a broad range of complex mathematical information (scoring at levels 4 or 5 on the numeracy tests) have wages that are, on average, 60% higher than adults who lack the basic numeracy skills required for performing many everyday tasks (scoring at level 1 or below). In some countries, like England/Northern Ireland and the US, the wages of high-skilled workers are twice as high as those of low-skilled workers. More formal estimates of the return to skill, which control for a range of other characteristics that might affect wages, find, on average, that an increase of one standard deviation in numeracy skills is associated with an 18% increase in wages among prime-age workers—ranging from 12—15% in the Scandinavian countries to as much 28% in the US [7]. These studies find that skills proficiency plays an independent role as a determinant of wages, over and above the role played by formal education. With a considerable wage premium attached to skills, it is not surprising that skills explain a significant portion of the wage gap between certain socio-economic groups—which is a second piece of evidence supporting the link between skills and wage inequality. Across the 22 OECD countries that participated in PIAAC, wages are 18% higher for men than for women; 36% higher for older workers (aged 50–56) than for younger ones (aged 16–29); 20% higher for workers with at least one parent with a higher education than for those whose parents have only a lower secondary education; and 15% higher for workers who are native-born than for those who are foreign-born. Recent analysis shows that differences in skills can account, on average, for 83% of the wage gap between workers with different levels of parental education and 72% of the wage gap between native- and foreign-born workers. By contrast, skills explain a much smaller (but still substantial) part of the wage gap between men and women (23%)—suggesting that factors others than skills are responsible for the bulk of gender wage disparities. Finally, younger workers would earn even less relative to older workers if they had equivalent numeracy skills; however, younger workers tend to have higher numeracy skills than workers in previous generations [8].

Cross-country difference in wage inequality are primarily driven by differences in returns to skill Studies that find that skills cannot explain cross-country differences in wage inequality tend to conclude that differences in how skills are rewarded are far more important—to use the terminology introduced above, the “skills price” effect is much larger than the “skills endowment” effect. For example, an early study based on data from the 1990s found that higher skills prices in the US than in other countries could account for 18–55% of the difference in wage inequality between them [2], a finding confirmed by another study using the same data that placed the estimate at around 36% [3]. More recent calculations using PIAAC 2012 data provide estimates in the same ballpark, ranging from about 33% [5] to 57% [6]. These results are not surprising in light of the large variation across countries in the return to skill documented in Figure 2.

The return to skill is determined (at least in part) by labor market institutions Most of these studies go on to claim that differences in the return to skill must be driven by differences across countries in labor market institutions, in particular, wage-setting mechanisms that influence how skills are rewarded. For example, higher minimum wages will compress the wage distribution and therefore reduce the return to skill. Similar effects might be expected in countries where the wages of a large portion of workers are set through collective bargaining. Indeed, there is substantial evidence to show that labor market institutions are significant both in determining wage inequality over time within countries and in explaining different levels of inequality across countries. For example, several studies have concluded that the decline in the real value of the minimum wage has been responsible for part of the rise in inequality in both Mexico and the US and that falling industry-based minimum wages contributed to rising inequality in the UK in the late 1980s and early 1990s. The decline in the share of workers who are members of trade unions is another factor that has been associated with rising wage inequality, particularly in English-speaking countries and Japan. Finally, labor market regulatory reforms aimed at increasing flexibility (in particular the relaxation of employment protection legislation for fixed-term and temporary agency work contracts) are also asserted to have contributed to the rise in inequality in OECD countries through the expansion of non-standard employment that they have encouraged [8]. Some estimates from a comparative study indicate that, over the period 1973–1998, changes in labor market institutions could account for a 23% fall in male wage inequality in France (where the minimum wage was increased and employment protection legislation became stricter) and for an 11% increase in male wage inequality in the UK and the US (where union power weakened and minimum wages were reduced [9].