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Income inequality increased in Sweden during the 1980s and 1990s, as did the returns to higher education. The main conclusion of this study is that increased income inequality between high‐ and low‐skilled workers is demand driven and is due to the presence of capital–skill complementarity in production. Increased investments in new, more efficient capital equipment, along with a slowdown in the growth rate of skilled labor, have raised the ratio of effective capital inputs per skilled worker, which, in turn, has increased the relative demand (and market return) for skilled labor through the capital–skill complementarity mechanism.