April 22, 2014 6:24 pm
A more equal society will not hinder growth
Inequality damages the economy and efforts to remedy it are, on the whole, not harmful
©Ingram Pinn
Inequality is a hot topic right now. The reaction to Thomas Piketty’s Capital in the Twenty-First Century shows the rising tide of anxiety. But Mr Piketty devoted almost no attention to why inequality matters or whether the cost of reducing it might outweigh any likely benefits. This lacuna needs to be filled.
Much discussion of the book has focused on the political aspects of inequality. But the economic aspects also merit attention. To my surprise, the staff of the International Monetary Fund, the most staid of institutions, addressed these questions in February in a note entitled Redistribution, Inequality and Growth. It came to clear conclusions: societies that start off more unequal tend to redistribute more; lower net inequality (post- interventions) drives faster and more durable growth; and redistribution is generally benign in its impact on growth, with negative effects only when taken to extremes.
The obvious explanation for the first conclusion would be that, at least in universal suffrage democracies, the bigger the market-generated inequality, the greater the political pressure for redistribution, since votes are distributed more equally than money. Those with money might respond by seeking to disenfranchise the poor, either directly or indirectly. They might also seek to attract support from those lower down the income scale by emphasising social and cultural concerns. Moreover, the wealthy always exercise political influence. That redistribution usually wins out is not astonishing, but is noteworthy.
Now consider the second conclusion. Inequality might in fact promote growth because it reflects high incentives for innovation and entrepreneurship. It might also mean higher savings and so higher investment, since richer people may well save a higher fraction of their income than poorer ones. Indeed, John Maynard Keynes himself once used this as an argument for Victorian inequality. In poor countries, inequality might also give a part of the population the resources with which to start a business or get an education. Yet, on the other side of the argument, inequality might deprive the poor of the ability to stay healthy, acquire skills or look after and educate their children. It might generate instability, as politics polarises between low-tax conservatism and redistributive populism. It might also thwart the forging of consensus on how to respond to adverse shocks.
On the third conclusion, it is easy to see why redistributive policies might hurt growth. The economic costs of taxes rise disproportionately, as they reach very high levels. At the same time, some redistributive policies might impose very modest or even negative costs: the elimination of arbitrary tax loopholes favouring the rich is an example; the use of tax revenues to finance public investment, better education or universal health services is another. Such measures might promote greater equality and higher growth.
In theory, then, the connections between inequality, redistribution and growth could go in different directions. The answers need to be found in careful analysis of the evidence, however imperfect the latter is sure to be. The results of the IMF’s study are strikingly clear.
Over the past half century, notes the IMF study, market (that is, pre-intervention) inequality has been rising in high-income countries and falling in developing countries. This is in line with what one would expect in an era of globalisation. Moreover, as one would also expect, the difference between market and post-intervention inequality in high-income economies is smaller than elsewhere, because they have far more redistributive states.
The analysis relies on cross-country data on growth, inequality and redistribution. It looks at the impact of both inequality and redistribution on growth in real incomes per head over five years and at the duration of the growth spells. On the five-year growth periods, the clear finding is that inequality reduces growth. The direct impact of redistribution is negligibly negative. But the indirect effect, via reduced inequality, is beneficial to growth. Again, higher inequality reduces the likelihood that a spell of growth will last. Finally, the study finds that increasing already very high levels of redistribution will harm growth. Yet, below the policy extreme, further redistribution does not harm growth.
These findings are also consistent with casual observation. Europeans are aware that the economies of the highly redistributive Scandinavian countries have outperformed the less redistributive countries in the south.
Moreover, these high-tax countries are also not suffering fiscal crises. Again, anybody who understands a little about development knows that the far more equal east Asian countries – notably, Japan and South Korea – vastly outperformed the far less equal countries of Latin America after the second world war. The Asians invested far more successfully in education and, in this and other ways, brought the population inside their dynamic modern economies.
This analysis cannot, of course, end the political debate on these huge topics. Instead, it opens it up, in a rather optimistic direction.
It is not only possible, but valuable, to marry open and dynamic market economies to the sense of shared purpose and achievement brought by tolerable degrees of inequality. Moreover, less inequality is likely to make economies work better by increasing the ability of the entire population to participate, on more equal terms. An important condition for this, in turn, is that politics not be unduly beholden to wealth.
Managing such a combination of market dynamism with effective redistribution is one of the defining political challenges of our era. It will take purposive action by states and greater co-operation among them, notably on taxation. Yet if even the staff of the IMF is analysing this once largely taboo topic, its hour has surely come.
Copyright The Financial Times Limited 2014.
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