Rising inequality reduces growth

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It is pretty much accepted in economics that some inequality in income is not only fair, but also adds to economic growth.  A doctor, who studies for 5 years, and goes without income during that time, perhaps also ending up with a huge student-loan debt, should earn more than people who haven't done what she did.  How much more is a matter for debate.  The economists' answer is that the market will decide--if the benefits doctors gain aren't enough, fewer people will study to be doctors and a doctor shortage will develop.  (Of course, medical associations constrain the supply of doctors by setting high standards for entry into the profession, allegedly for safety reasons.  However, ambulance paramedics who study basically what doctors study, but for 4 years instead of 5 or 6, earn less than half what doctors earn.  Medical, law, and other professional associations are effectively trade unions/monopolies, and their power is always written into the law.)

So most economists agree that some degree of inequality is necessary for growth.  But how much inequality?  And, critically, if some inequality is good for growth, would more inequality be better?  Well, it turns out that rising inequality decreases growth:

Income inequality has widened in most OECD member countries during the past two or three decades. These trends are well documented (see references). According to a traditional measure of inequality, the Gini coefficient, income inequality rose by 10% from the mid-1980s to the late 2000s, while the ratio of top income decile to bottom income decile reached its highest level in 30 years.

Within countries, indicators of inequality, such as the Gini coefficient, say little about who has benefited or lost from these trends. A closer look at the situation of households provides a more complete picture and shows that in many OECD countries, gains in disposable incomes have fallen short of increases in GDP. This has been particularly the case for poorer households: in nearly all OECD countries for which data are available, GDP growth was substantially higher than households’ income growth in the lowest quintile.

Some countries have seen widening disparities in the lower half of income distribution, taking place even when overall inequality has been narrowing–this pattern is particularly striking in Spain. In other countries, such as Australia, the United Kingdom and the US, between 20% and 50% of total income gains generated have accrued to the top 1% of households, pointing to rising inequalities also within the upper half of income distribution.

A certain degree of income and wealth inequality is a characteristic of market economies, which are based on trust, property rights, enterprise and the rule of law. The notion that one can enjoy the benefits from one’s own efforts has always been a powerful incentive to invest in human capital, new ideas and new products, as well as to undertake risky commercial ventures. But beyond a certain point, and not least during an economic crisis, growing income inequalities can undermine the foundations of market economies. They can eventually lead to inequalities of opportunity. This smothers social mobility, and weakens incentives to invest in knowledge. The result is a misallocation of skills, and even waste through more unemployment, ultimately undermining efficiency and growth potential.

To explore the question further, our study estimated a relationship for GDP per capita in which a change in income inequality was added to standard growth drivers such as physical and human capital. The idea was to test whether the change in income inequality over time has had a significant impact on GDP per capita on average across OECD countries, and if this influence differs according to whether inequality is measured in the lower or upper part of the distribution. The results show that the impact is invariably negative and statistically significant: a 1% increase in inequality lowers GDP by 0.6% to 1.1%. So, in OECD countries at least, higher levels of inequality can reduce GDP per capita. Moreover, the magnitude of the effect is similar, regardless of whether the rise in inequality takes place mainly in the upper or lower half of the distribution.

[Read more here]

As in medicine, where one pill may help you return to health, but 10 will make you sick, in economies, modest inequality is good for growth, while extreme inequality is bad.  If inequality has risen 10%, the implication is that growth has been 6 to 11 percentage points lower than it would have been.  It's bad enough that whereas once the tide of economic good fortune lifted all the boats, now it only lifts the superyachts, but it's a real problem when too many superyachts mean there is no tide at all.

Here are some of several previous pieces I've written on this:

Inequality reduces growth.

The rich get richer

The Failure of American capitalism

The new American aristocracy

Karl Marx was right.