Distortions, structural transformation and the Europe-US income gap

Abstract

This paper uses a model of structural transformation with sectoral distortions to study the convergence of income between Western Europe and the United States (US). It shows that in addition to income effects and growth differentials in sectoral total factor productivities (TFP), sectoral distortions are important for understanding the reallocation of resources across sectors. Allowing for a growing wedge between the marginal revenue product of labor relative to capital can explain the rapid decline in the manufacturing share of hours for the US that started in the 1980s. The distortions are also important for explaining the paths of sectoral hours for many European countries. However, the distortions lead to a misallocation of resources across sectors, which helps explain why the rapid Europe-US income convergence that started in the 1950s stopped in the early 1980s.