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The persistent pay gap between Easterners and Westerners in Germany: A quarter‐century after reunification

2021; Elsevier BV; Volume: 100; Issue: 3 Linguagem: Inglês

10.1111/pirs.12594

1435-5957

Heather Dickey, Alessa M. Widmaier,

Labor market dynamics and wage inequality

A quarter of a century after Germany's reunification, Eastern Germans still earn substantially less than Western Germans. This paper revisits the German wage differential and isolates the effect of differing returns to human capital endowments, the possibility of a location effect, and human capital depreciation on the regional wage gap. While the endowment effect, location effect, and human capital depreciation jointly account for the wage differential between Easterners and Westerners living in the West, the same does not hold true for individuals settled in the East, where part of the wage gap remains unexplained. Un cuarto de siglo después de la reunificación de Alemania, los alemanes del Este siguen ganando bastante menos que los del Oeste. Este artículo revisa el diferencial salarial alemán y aísla el efecto de los diferentes rendimientos de las dotaciones de capital humano, la posibilidad de un efecto de localización y la depreciación del capital humano en la brecha salarial regional. Mientras que el efecto de la dotación, el efecto de la localización y la depreciación del capital humano explican conjuntamente el diferencial salarial entre los orientales y los occidentales que viven en el Oeste, no ocurre lo mismo con los individuos asentados en el Este, donde parte de la brecha salarial sigue sin poderse explicar. ドイツ再統一から四半世紀が経った今でも、東独出身者の所得は西独出身者よりかなり少ない。本稿では、ドイツの賃金格差を再検討し、地域の賃金格差に対する、人的資本の賦存への異なるリターン、立地効果の可能性、人的資本の減価償却の影響を特定する。ドイツ西部に住む東独出身者と西独出身者の賃金格差には、授かり効果、立地効果、人的資本の減価がともに寄与しているが、これは賃金格差の理由が部分的に依然不明な東部に定住した人には当てはまらない。 With the reunification of East and West Germany in 1990, the challenging process of economic, political, and institutional integration of two seemingly incompatible systems began. Previously occupied by the communist regime of the Soviet Union, the former territory of the German Democratic Republic (GDR or 'East') underwent rapid assimilation to Western capitalism and liberalism in the years that followed. Numerous aspects of the transition process occurred immediately, such as freedom of movement and the privatization of the Eastern economy that were implemented directly after the fall of the Berlin Wall in 1989, with monetary union following in July 1990. Other longer-term redistributive measures, which are still active today, were put into place to allow the East to catch up with the level of capital and technology available in the West. However, other aspects of convergence lagged behind the general move 'West-ward'. A prime example of differences that did not disappear so seamlessly is the wage gap between Easterners and Westerners, which still persists almost 30 years after reunification. While Easterners' relative earnings increased dramatically in 1990, from one-quarter to one-half of Westerners' wages, the adjustment rate slowed down during the 1990s. By 2016, the relative wage was approximately three-quarters. Classical economic theory would predict that convergence between wages in East and West Germany would occur over time. In classical economic equilibrium models, labour and capital respond to inter-regional disparities in economic opportunities, through undertaking regional migration, and thus act to reduce these disparities. The adoption of Western labour market (especially wage-setting) institutions should also be expected to reduce wage differentials between the two regions over time. However, despite the large number of East-to-West migrants and collectively bargained wages set to reach parity with West German levels in 1994, the persistence of a relatively large wage differential between East and West Germany points to the reality that transition processes in labour markets may be much slower than assumed by economic theory. This paper aims to isolate and quantify potential sources of the German regional wage differential. Most of the existing research on the East–West wage gap addresses the well-documented geographical difference in wages, and possible explanations for this are explored in the empirical literature. However, comparatively little attention has been paid to the substantial earnings gap between Easterners and Westerners, independent of their location after reunification. We seek to contribute to the existing empirical literature in the following ways. First, the paper investigates three potential determinants of the Easterner-Westerner wage differential: differences in human capital endowments; location effects; and human capital depreciation. To the authors' knowledge, no other empirical study has decomposed the Easterner-Westerner wage gap into its three most probable sources. Second, most of the existing literature (e.g., Burda & Schmidt, 1997; Franz & Steiner, 2000; Orlowski & Riphahn, 2009; Smolny & Kirbach, 2011) focuses on either regional wage differentials (i.e., East compared to West) or the wage gaps by origin (i.e., Easterners compared to Westerners). For a more in-depth exploration of the regional wage gap, this paper utilizes the Blinder–Oaxaca decomposition for the Eastern and Western German labour markets separately. The empirical analysis estimates four distinct wage equations: for Easterners settled in the East and in the West, and for Westerners settled in the East and in the West. Comparing wage equations by origin provides information about the importance of productive endowment differentials. Comparing by region can provide further insights into the effect of location. In addition, conducting this analysis for cross-sectional data over time can shed light on the potential influence of human capital depreciation. Third, most existing studies analyse the East–West German wage gap at the average level. However, it may be the case that the wage gap between Easterners and Westerners varies significantly along the wage distribution. If the relationship between the regressors and the dependent variable evolves across the conditional wage distribution, this will be ignored by the standard OLS methodology (Dickey, 2007). We use the quantile regression methodology to identify the regional wage differentials at the 10th, 25th, 50th, 75th, and 90th percentiles and attribute these gaps to the potential sources stated above. Finally, the most recent studies (Blien, Möller, thi Hong Van, & Drunow, 2016; Kluge & Weber, 2018; Smolny & Kirbach, 2011) addressing the Easterner-Westerner wage differential were conducted using data up to 2008 and 2010 respectively, and most of the empirical literature employed data from the 1990s or early 2000s. This paper uses data from the SOEP for 2016. In light of the persistently large wage differential between East and West Germans a quarter of a century after reunification, it is timely to re-examine the sources of this particular regional wage differential and attempt to identify why regional convergence in wages has not fully taken place as predicted by standard economic theory. Identifying the causes of this persistent wage gap may also shed light on appropriate policy responses to mitigate this gap; in particular, whether "people-based" or "place-based" policies would be more effective in addressing the wage disadvantage experienced by East Germans relative to their Western counterparts. The paper is organized as follows. Section 2 briefly outlines the theoretical and empirical literature that addresses the Easterner–Westerner wage differential in Germany. Section 3 discusses the data and methodology used, and the results of the empirical analysis are discussed in section 4. Section 5 provides a discussion of potential policy implications, and lastly, section 6 concludes. How much an individual earns for their labour is influenced by both the quantity and quality of various productive characteristics, most notably education, labour market experience, and training. The "quantity" of human capital an individual is endowed with is directly related to their exposure time (expressed in years) to each of these components of human capital, whereas the "quality" of an additional endowment unit is assessed in its ability to increase productivity (Hanushek, Ruhose, & Woessmann, 2015). This section will describe three mechanisms that may induce, at least part of, the wage gap between Easterners and Westerners. The endowment effect is associated with the quantity of human capital endowments, while the location effect and human capital depreciation are more directly related to the quality of productive characteristics. 11 The role played by other factors (such as systematically diverging industry and employment preferences or discrimination) in contributing to the wage gap will not be addressed in this paper. The endowment effect describes the wage premium that an individual with larger amounts of human capital receives compared to an individual with less favourable endowments. If individuals are assumed to be rational, human capital accumulation can be regarded as an investment decision, where individuals weigh up the costs and benefits associated with attaining a particular amount of human capital. For example, the costs of attaining a university degree will include the direct costs of attending university, as well as the opportunity cost of the foregone earnings while not working and the foregone return to work experience. The future benefits of this investment in higher education is the wage premium (over high school graduates) accrued over the working life of the individual. This investment decision applies not only to formal education but to other forms of human capital as well, for example, on-the-job training. In essence, individuals will only make the effort to acquire human capital if it will increase their future earnings by more than the cost of acquiring the human capital, where the minimum necessary wage premium will vary across individuals. Hence employers are not willing to pay higher real wages to some employees unless they are more productive than others. Two hypotheses are in line with the rational decision-making assumption of economic agents. The human capital model (e.g., Schultz, 1961) suggests that the acquisition of education and training itself makes individuals more productive because it involves the transmission of knowledge and skills relevant to the labour market. Conversely, the signalling hypothesis (Spence, 1973) argues that those individuals who choose to undertake a degree are, on average, more productive than those who do not, but that college does not in itself increase productivity. If the cost of undergoing further education is higher for less productive individuals (because they have to invest more effort to achieve the same outcome as more productive individuals), then having a college degree can inform employers about the otherwise unobserved productivity of potential employees. While these models differ fundamentally on how human capital affects productivity, they both lead to the outcome that individuals with higher amounts of human capital are, on average, more productive and therefore it is natural to expect them to occupy a more advanced position in the labour market. The "justified" (Blinder, 1974) pay differential resulting from systematic differences in human capital between groups is commonly referred to as the endowment effect. In our analysis of the wage gap between Easterners and Westerners in Germany, part of this persistent gap may be explained by Easterners having less favourable human capital endowments compared to Westerners. The location effect describes the pay differential between geographically separated groups that is the direct result of differences in regional economic conditions. Here, the main focus lies on differences in returns to productive endowments that are induced by regional differences in factor availability and technological progress. If the quality of human capital stock is assessed in its ability to increase productivity, investment in these productive characteristics may not be of the same value in different locations. Since K, L, and β are strictly positive numbers, must be increasing in the capital-per-labour-unit ratio . Thus, the greater the relative capital abundancy that prevails in an economy, the more will MPL increase when the effectiveness of labour improves (given α > 0). The amount by which human capital investment increases an individual's productivity directly depends on the relative factor availability in the economy. Consequently, a region with larger availability of physical capital per unit of labour will exhibit higher returns to human capital investments. Technological progress enhances returns to human capital investments in a similar fashion. In a dynamic economy, the effectiveness of labour increases at a fast pace, allowing human capital investment to intensify labour productivity proportionally more than in an economy with slower technological advancements. Deriving this phenomenon using models of technological diffusion, Nelson and Phelps (1966, p. 75) conclude that "the rate of return to education is greater the more technologically progressive is the economy." Other regional economic conditions may also affect wage levels, either directly or indirectly (i.e., through alteration of returns to human capital stocks). These factors include, but are not limited to, the cost of living, unemployment levels, population density, the presence of collective bargaining and negotiated wages, industry concentration, and the share of firms belonging to high-paying sectors (Sapsford & Tzannatos, 1993). In the context of the East–West wage gap in Germany, it is possible that homogeneous human capital characteristics are rewarded differently in the two regions due to location effects. This would particularly be the case if the East exhibits less favourable economic conditions and most individuals in the East and West remained in their respective region of origin. However, arbitrage in the form of regional factor migration and redistributive efforts is expected to equalize economic conditions in the two German regions in the long run. Thus, classical economic theory would argue that the Easterner–Westerner wage gap that is due to location effects should approach zero in the future as differences in regional economic conditions diminish. In 1990 the political and economic system previously only prevalent in the West was applied to the whole of reunified Germany. "East German workers 'arrived' in a completely new environment, albeit neither voluntarily nor as the result of a physical move" (Burda & Schmidt, 1997, p. 4). The situation in Germany in the early 1990s was therefore comparable to a "mass-migration" of Eastern workers into the capitalist system. Here, the assimilation and migration literature can be drawn upon to help explain a further source of the East–West German wage gap. The assimilation hypothesis, originating in the seminal work of Chiswick (1978), seeks to explain the well-documented wage differentials observed between foreign-born and native-born individuals. This theory centres on the argument that human capital acquired in a foreign country may be less productivity-enhancing than natively-acquired endowments. This may be a result of the knowledge and skills obtained through education, training and experience being, to some extent, country-specific. Relevant to this study is the possibility that education and experience obtained in a centrally-planned economy may not be as advantageous in a capitalist system as education and experience acquired in a free market economy. In addition to human capital being country-specific, and therefore not perfectly transferable from home to host country, migrants may also face another source of disadvantage post-migration. Migrants' productivity relative to natives may be lower due to their lack of familiarity with customs, regulations, working practices, and job opportunities in the host country, and this may directly translate into a relative wage penalty for migrants. Thus, human capital acquired abroad by immigrants does not enhance wages by the same margin as natively-sourced endowments for two reasons: (i) it enhances productivity to a lesser extent; and (ii) foreign human capital invokes additional search costs and risks for employers. However, the assimilation hypothesis also predicts a process of catch-up where the initial wage disadvantage due to "temporary adjustment problems" (Lang, 2000) will disappear over time as migrants gain work experience, training, and education in the host country. As immigrants assimilate, it is predicted that their earnings will rise faster than those of native workers. The "knowledge gap" will narrow at a diminishing rate since the largest adjustments are made just after arrival. Consequently, the differences in returns explained by human capital depreciation will asymptotically approach zero in the long run (Laing, 2011). The application of the assimilation hypothesis to Germany would suggest that human capital acquired in the GDR would be of less value in the market economy of reunified Germany than human capital acquired in the West. Numerous empirical studies post-reunification support this by documenting the fall in returns to human capital experienced by Eastern Germans. For example, much of East Germans' individual human capital was rendered unproductive after reunification (Burda & Schmidt, 1997). Bird, Schwarze, and Wagner (1994) find that firm experience did not translate to the same amount of human capital under socialism as under capitalism, and the value of labour market experience accumulated in the former socialist economy of the GDR has depreciated in the transition process to a market economy, partially explained by new production processes and profound changes in the organization of work (Franz & Steiner, 2000). We investigate to what extent the depreciation of Easterners' human capital endowments can account for the wage gap between Easterners and their Western counterparts. Note, however, that the wage gap between these two groups should approach zero in the long run as Easterners assimilate to the requirements of the free market system and catch-up to Westerners in terms of wages. Given the uniqueness of the German case, the East–West (or Easterner-Westerner) wage differential has attracted a considerable amount of research, with much of this literature dating to the early years after reunification. This section briefly summarizes the main studies that investigate the earnings gap between East and West Germany. Early investigations into the effect of reunification on wages in the two countries tended to focus on what happened to wages and the returns to human capital endowments in the East during its transition process towards a capitalist economy. Bird et al. (1994) investigated the changes that took place in the structure of wages in the former GDR during its transition. Prior to reunification East Germany exhibited a much flatter wage structure compared to the West German labour market, although the free-labour market assumptions were not directly applicable to West Germany either since the West German labour market was heavily influenced by wage-setting regulations and national-level union-industry negotiations. The introduction of free-market bidding in the previously socialized labour market was expected to affect both the value of human capital attributes such as education and experience, and also the supply of and demand for these aspects of human capital. Bird et al. (1994) find that education retained its value after the transition to a capitalist economy, but the return to experience fell to half its earlier value. Older workers in East Germany, whose human capital largely consisted of work experience but little schooling, therefore suffered the largest decline in wages under the new system. Krueger and Pischke (1995) focused on both wage determination and inequality in East and West Germany. East German wages grew rapidly between 1989 and 1991, by 38.3%, along with an increase in earnings dispersion that occurred mostly at the upper tail of the distribution (earnings grew by over 50% between 1990 and 1991 for the top 10% of earners). Similar to Bird et al. (1994), Krueger and Pischke's results indicate that, while education was of equal quality and value in the GDR and the West, the returns to experience were much lower in East Germany, suggesting very low returns to seniority in that country. Krueger and Pischke (1995) conclude that workers' skills were not the main problem in East Germany; instead outdated technology, insufficient capital, and inefficient management contributed more to low wages and low productivity in the East. Burda and Schmidt (1997) employed an Oaxaca-style decomposition to investigate the East–West wage differential, which amounted to approximately 25% in 1996. Their analysis points to comparable endowments of education and training in both countries (if not more favourable in the East), but returns to age were depressed under socialism and continued to be so after reunification. Their decomposition analysis found that differing rates of return to endowments, and not measurable endowments themselves, were the cause of the observed wage differentials. In fact, if East Germans had received the same returns to their endowments as West Germans in 1990, their relative hourly earnings would have been almost 4% higher. They conclude by stating that the East–West variation of estimated returns is more appropriately interpreted as a measure of human capital depreciation, and not wage discrimination. Franz and Steiner (2000) revisited the East–West wage gap a decade after the two countries of Germany reunified. They describe the changes that took place in the distribution of hourly wages between 1990 and 1997 and analyse the economic factors determining these changes. Regarding wage developments, the first two years saw excessive increases in nominal wages, followed by a sharp decline in the growth rate of nominal wages between 1993 and 1995, and stabilization of wage growth in the following years. To account for structural factors that affect wages, Franz and Steiner (2000) control for firm size, industry and region in their analysis. They find that firm size differentials were relatively small under socialism (possibly explained by little job mobility in the former GDR), but increased substantially after reunification. Similarly, the effect of firm tenure (as a proxy for firm specific human capital) was also small, but tenure profiles became steeper after reunification. Franz and Steiner (2000) conclude that, since observable human capital endowments did not change dramatically in East Germany after reunification, the observed rise in wage inequality in the East was related to an increase in the returns to innate abilities that became more important in the more flexible East German labour market. More recently, Orlowski and Riphahn (2009) investigate whether the systematic differences in the returns to experience and tenure in the two regional labour markets have disappeared over time. They confirm the findings of earlier studies that the East exhibited flatter experience-wage profiles, which continued to exist into the mid-2000s. Their results suggest that the returns to tenure are small but similar in the East and West, whereas experience profiles still lag behind substantially in the East almost twenty years after reunification. This is particularly the case for medium and high-skilled workers who enjoy significantly higher returns to experience in the West. Orlowski and Riphahn (2009) conclude that the observed differences in returns to experience between Easterners and Westerners is unlikely to be caused by differences in the price of homogeneous experience, but instead is more likely to be a result of the type of experience earned in the East German labour market differing in character or quality compared to the experience earned in the West German labour market. Overall, the differences between the East and West wage structures are due to systematic regional differences (such as differences in firm characteristics and regional public policy) and not a result of individual differences between Easterners and Westerners. Smolny and Kirbach (2011) investigate whether the source of the persisting wage differences is related to the location or the people, and ask what East Germans would have earned if their working place would have been in West Germany instead of East Germany. They find that the factors that were important for income determination in West Germany are relevant in East Germany as well. Their estimates reveal that the returns to experience and education converged in the two Germanys over the period 1990–2008. If human capital depreciation was responsible for the significantly lower returns in the East after reunification, then the differences in returns between the East and West would be expected to narrow over time as Easterners adapted to the requirements of the competitive market system. Smolny and Kirbach's (2011) results, along with Burda and Schmidt (1997), therefore provide some evidence that human capital depreciation was an important component in explaining the East–West wage gap. However, Smolny and Kirbach (2011) also find evidence of a persistent wage gap once the two regions exhibited similar returns to productive endowments in 2008, and they interpret the remaining wage differential as the consequence of a negative location effect in the East. Despite significant redistribution at the federal level, the East may not have fully caught up with the West with respect to technological progress and capital accumulation. Their finding that Eastern migrants moving to the West experienced a wage gain of nearly 30% supports the hypothesis that differences in locational conditions, and not differences in human capital endowments, are primarily responsible. The authors further suggest that the remaining gap between Eastern migrants and Westerners might be the consequence of a negative selection effect in migration (i.e., Eastern migrants have less favourable endowments than Eastern stayers). Hypothetical wage gains for Easterners with average characteristics moving to the West could amount to 40%, resulting in even higher earnings than those received by Westerners. Lastly, two very recent studies have revisited the persistent wage gap between East and West Germany. First, Blien et al. (2016) argue that the substantial differences between labour market outcomes in Eastern and Western Germany must be understood in relation to the initial conditions of unification and transformation in eastern Germany. Their focus is primarily on the substantial institutional changes that followed unification; in particular, how the transformation of the East German economy and its industrial and ownership structure led to the divergence of innovation and productivity performances in the East and West, which then propagated to the labour market, influencing unemployment and wages in both regions. Their findings indicate that the regions of East Germany have problems developing an endogenous growth process because they lag behind in the frequency of innovations, and because many firms in the East lack autonomy and capacities in research and development due to their owners being located in the West. The authors conclude by suggesting that technology policies could be one solution to stimulate innovation behaviour and improve productivity development in the East as part of integrated regional policies to promote regional capacities. Second, Kluge and Weber (2018) use a large linked employer-employee dataset to decompose the German East–West wage gap into composition and wage-structure effects. Their analysis covers the period 1996–2010, and focuses on differences in worker, establishment, and regional characteristics (female employment share, union coverage, industrial structure, establishment size, labour productivity, urban agglomeration, and local price levels). Adopting recentred influence function (RIF) regressions, to estimate region-year-specific wage equations, and the Blinder-Oaxaca decomposition approach, they estimate that around 40% of the observed wage gap at the median level can be explained by differences in worker, establishment, and regional characteristics. Of particular importance among these structural factors are local price levels and differences in establishment size. The authors conclude by observing that these structural differences between the East and the West have been stable over time, with little evidence that they will diminish over time; thus, there is little expectation that Eastern wages will converge considerably toward West German levels in the years to come (Kluge & Weber, 2018). In summary, much of the existing empirical literature supports the argument that the endowment effect, if it exists at all, is only a minor factor in explaining the East–West (or Easterner–Westerner) wage gap. The remaining wage gap between the two regions has been interpreted as either human capital depreciation or as a location effect. The microdata for the empirical analysis comes from the German Socioeconomic Panel Study (GSOEP), which is a longitudinal survey of private households and persons started in the Federal Republic of Germany in 1984 and extended to the GDR in June 1990. For the purposes of this study, the GSOEP collects information regarding personal and human capital characteristics, and labour market outcomes. The most recent wave is 2016, constituting 29,178 individuals from 17,822 households. We focus on employed individuals with German citizenship aged 27 to 65 years of age, who have been living in present-day German territory both before and after reunification. 22 Since the role played