Inequality Hurts Growth, But How?
By Greg Ip..
- Students study math at the Ridings Federation Winterbourne International Academy in South Gloucestershire, England, in February.
- MATT CARDY/GETTY IMAGES
A major new study by the Organization for Economic Cooperation and Development raises the tantalizing prospect that no such tradeoff is necessary: Growing inequality may actually hurt growth.
If so, then policies that close the income gap may actually help rather than hurt the broader economy.
It’s an intriguing finding, but one with a caveat. The study is better at showing that inequality hurts growth than at explaining why. That means policy makers who want to use taxes and social spending to close the income gap cannot assume they’ll help the economy in the process.
In theory, inequality has an ambiguous relationship with overall economic prosperity. The allure of getting rich is an important spur to innovation, educational attainment and hard work. So some inequality is necessary for economic growth. But under some circumstances, it may do the opposite: It can leave the poor incapable of investing in their own skills and health, encourage them to borrow too much, which brings on financial crises, and lead to social unrest and support for laws and regulations that undermine capitalism.
In trying to figure out which effects predominate, economists have come up with conflicting answers. In 2000, Robert Barro of Harvard University found that more inequality led to lower growth in poor countries, but higher growth in rich countries.
The OECD disagrees. It sifts through 30 years of data from its predominantly rich member countries and finds that when the “Gini coefficient,” a popular measure of inequality (a Gini of 0 means everyone has exactly the same income; a Gini of 1 means one person gets all the income) goes up, growth declines.
Is that because inequality hurts growth, or vice versa? The OECD uses a statistical test to conclude it’s the former. Refining the relationship, the study finds that higher inequality has a significant impact on relative educational attainment among different income classes. As inequality goes up, the poorest 40% of the population get fewer skills and lower quality education. For example, numeracy among lower-income families declines as inequality increases; no such relationship exists for middle- and upper-income families.
Then they estimate how much more education the poor may have had if inequality had not increased, and plug that into a growth model that includes components such as human capital. From this, they conclude cumulative economic growth was 4.7 percentage points lower for the average OECD country between 1990 and 2010 (that’s about $2,500 for the average American).
The question is, why? Here’s where it gets complicated. It’s no surprise that poor people have less time and money to spend on college, tutoring and the like. But why should this depend on how much richer everyone else is? Is it really inequality holding the poor back, or poverty, which is a different problem in need of different remedies?
The OECD’s tests indicate that inequality has an impact on the human capital of the poor independent of poverty. Put another way, if the rich were less rich, the poor would be better off.
The study, however, doesn’t explain why. In interviews, OECD researchers suggest the cost of education is driven by things like teacher salaries, which in turn are linked to overall economic growth. If the incomes of the poor lag the overall economy, education will be increasingly out of reach. In the U.S., for example, upper-income families’ demand for college tuition and homes in neighborhoods with good schools might put both out of reach of the poor.
But this is just a hypothesis.
The study notes it would be interesting to explore “whether the link between inequality and educational attainment varies with countries’ institutional characteristics or policy settings,” but “preliminary attempts to explore these issues proved inconclusive.”
So what should policy makers do? Raise taxes on the rich to dampen the cost of tuition and thereby make it more accessible to the poor? This seems an awfully blunt instrument.
In fact, there are two different policy challenges: how to help the poor, and how to finance that help.
There are good and bad ways to do both. Passive support such as unemployment and welfare benefits do less to raise education and incomes than direct training assistance, work subsidies and child care.
The education system might directly tackle inequality by sending the best teachers to the toughest schools, as Korea does.
As for paying for this: The OECD prefers raising taxes on the rich and multinational companies, for example by limiting tax breaks or the ability of companies to shift their taxable activities to low-tax jurisdictions. Their research finds that such redistribution need not hurt economic growth. But nor is it a given that this is the only approach. If the key to reversing inequality is raising the resources the poor have for education, this can also be done through sales, property or payroll taxes, much as is already done in the U.S. and in many European countries.
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