Growth Under the Haves, the Have-Nots, and the Have-Yachts

Ever since the financial crisis and recession hit in 2007, there has been an increased interest in inequality and it’s effects on economic growth. Most of these arguments have been founded on questions of morality, but also some on pragmatism. Emmanuel Saez at the University of California-Berkeley found that 95% of income gains in the two first two years of the recovery after the Great Recession have gone to the top 1% of income-earners in the United States, leaving the rest of society lagging. More globally, 85 of the richest families in the world control 1 trillion ($1.6 trillion), roughly the same as the bottom 3.5 billion people.

Joseph Stiglitz, Nobel Laureate and one of the leading opponents of global income inequality

The issue of inequality and its effects on growth have been debated for a while. One of the earliest hypotheses was put forward by Simon Kuznets back in the 1950s and 1960s, known as the Kuznets curve. This curve basically showed that, empirically, economic development results first in increasing inequality, reaches a peak, and then reduces inequality. The growth in countries like South Korea and Taiwan has largely debunked this hypothesis. An argument put forward by some academics and leaders is that inequality provides incentives for entrepreneurship due to the fact that they have so much to gain. In poor countries, Robert Barro has written that inequality can lead to growth by letting a few individuals get a good education and invest in businesses. Others, in particular Nobel laureate Joseph Stiglitz, have argued that global inequality distorts economic growth through political economic power that promotes rent-seeking and weak corporate governance over strengthening human capital and ideas of fairness.

Through this quagmire, the IMF recently waded into this global argument with a new paper written by Jonathan Ostry, Andrew Berg, and Charalambos Tsangarides about both the effects of inequality on growth and redistribution’s inequality on growth. In particular, they make a distinction between what they call “market inequality”, which is inequality before taxes and transfers, and “net inequality”, or inequality after taxes and transfers. One of the main conclusions from the study is that more unequal societies tend to redistribute more. This is mostly skewed from industrial states, especially in Europe, that have large amounts of redistribution, cutting down their net inequality.

Lower inequality leads to less sustained growth

The bulk of this study focuses on the findings that the higher the net inequality, the lower the real growth rate on GDP. It also finds no statistical significance on redistribution affecting GDP growth. An example given is that an increase in inequality from the level of the United States (ranked 37) to the level of Gabon (ranked 42) would shave 0.5% off of GDP. The last part of the study looked at the duration of the growth spells. Again, the results show that higher rates of inequality are correlated with a higher risk that the spell of growth will end. Turning to redistribution, if there is already a large amount of redistribution in society, such as in some of the developed countries, further redistribution hurts growth. However, for the lower 75% of countries in the world, redistribution has no discernible effect on the duration of growth.

There are a few caveats that need to be addressed with this study, though relatively minor ones. As with any statistical study, these are only correlations, and correlation should not be confused with causation. Data on redistribution is also light, with this study using a proxy of direct taxes and subsidies. Amazingly, they don’t include government provisions, such as health and education. Both of these factors have been proven in various studies to have positive impacts on growth, including studies from the World Health Organization showing adult survival rates improving GDP growth to studies by Eric Hanushek and Ludger Woessmann showing how years of schooling is correlated with higher GDP growth. As these factors are a little more difficult to quantify, it’s understandable that they were not included in the redistribution factors. However, the results of these studies, along with others, show a general trend that countries could improve education and health spending along with other measures to reduce inequality while having economic growth at the same time.

Inequality in the developing world
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