How Economic Inequality Kills Growth

January 9, 2015

We all know deep down that economic inequality is damaging to society. However, talking about inequality, and arguing against the policies that perpetuate it, can be hard going. Aside from those who will argue that a certain level of inequality is necessary to stimulate hard work and innovation, many people harbour the sense that inequality is in some way natural – and devilishly hard to root out.

However, the evidence is mounting that inequality is actually harmful to economic growth. As the rich get richer, relative to everyone else, society becomes poorer than it would have been, had their ascent not been allowed. At least, that’s the message from a recent report from the Organization for Economic Cooperation and Development, which should be food for thought amongst policy makers across the world.

The OECD, by the way, is often characterized as a capitalist club. It was set up in 1961 specifically to promote economic growth within a market system, as a Cold War tool, producing research and guiding the media to promote business friendly sentiments across Europe and North America.

It still remains a club that is limited to richer nations and is dedicated to enriching corporations. In the 1990s, it was the OECD which was tasked with designing the notorious “Multilateral Agreement on Investment” – a tool which would have swept away many national obstructions to corporate operations across the world. The MAI provoked a groundswell of opposition from anti-globalization campaigners, and was abandoned even before the Battle for Seattle. If enacted, the MAI would have provided corporations with unprecedented insulation from national laws (described on Wikipedia as “discriminatory investment conditions causing loss of profit.”).

This heritage means that the new research on inequality is surprising, and encouraging.

The report itself (entitled “Trends in Income Inequality and its Impact on Economic Growth” and written by Federico Cingano) argues that many developed nations of lost out on economic growth due to the effects of rising inequality.

Cingano zeroes in on the rising wealth of the top 10 percent of people in developed nations, which has ballooned in the last 30 years. As he notes “Today, the richest 10 per cent of the population in the OECD area earn 9.5 times the income of the poorest 10 per cent; in the 1980s this ratio stood at 7:1 and has been rising continuously ever since.”

The amount of lost growth is substantial. For example, between 1990 and 2010 Britain, Finland and Norway all lost out around 9 percent of economic growth due to inequality. Mexico has missed out on 11 percent, while New Zealand has lost an astonishing 16 percent of economic growth over the same time period.

The effects of inequality are clear. As the report finds, “lowering inequality by 1 Gini [coefficient, a metric used to calculate inequality] point would translate in an increase in cumulative growth of 0.8 percentage points in the following 5 years.”

Cingano argues that growth has been stymied by those in the lowest 10 percent of incomes missing out on educational opportunities. This section of society has seen its skills stagnate due to poor education and what Cingano terms “to a lower amount of effort (e.g. hours) while studying” – resulting in poorer literacy and numeracy. What this means is that the “human capital” of societies across the developed world has been slipping, due to missed educational opportunities and life choices that simply never opened up.

There are, of course, other factors. The report also highlights inadequate transfers for childcare and lifelong learning, as well as high quality housing. Cingano might have added that trade liberalization has ambiguous consequences for the poor (with well-trained, well-paid manufacturing jobs migrating), despite benefiting the rich.

However, in his literature review, Cingano makes the interesting observation that there is no discernable correlation between the level of redistribution (i.e transfers funded by taxation) and economic growth. We often hear that high taxation kills growth, but this is a canard. Cingano finds instead that “inequality in disposable incomes is bad for growth, and that redistribution is, at worst, neutral to growth.”

We should never be shouted down by those who maintain that taxation is a burden on the economy. In fact, an activist government is vital to guiding economic growth.

What can be done to redress the inequalities that the OECD now deplores? Cingano suggests some easily achievable measures. We should institute higher marginal rates, be cracking down on tax avoidance “as top earners now have a greater capacity to pay taxes than before”, tax deductions for the rich should be abolished and we should reassess the role of taxes on property and wealth.

This should be coupled with active policies to provide opportunity for the bottom 10 percent, including “policies to promote and increase access to public services” (meaning health and education). Free childcare should be offered, and much more on the job and vocational training is required.

The problem is that suggesting many of these measures is politically hard to imagine, in Britain at least. Higher taxes on the rich would provoke asinine accusations of “class warfare”, while higher expenditure on public services goes well beyond the obsession with austerity that limits the political imagination of the political class.

On the other hand, the OECD report is a symptom of a broader shift within policymaking circles across the world. There is a growing scepticism about “growth” – or at least the tools used to attain it. Trickle down theory and the dynamic powers of free markets are being abandoned and interventionism is being dusted off.

As Cingano concludes, “focusing exclusively on growth and assuming that its benefits will automatically trickle down to the different segments of the population may undermine growth in the long run inasmuch as inequality actually increases.”

This call to abandon decades of neoliberal policy may be a bitter pill for some to take, but the tide has shifted towards policies which redress inequality.

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