A more equal society will not hinder growth

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 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. 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.

Now consider the second conclusion. Inequality might in fact promote growth because it reflects high incentives for innovation and entrepreneurship. It might mean higher savings and so higher investment, since richer people may well save a higher fraction of their income. John Maynard Keynes once used this as an argument for Victorian inequality.

In poor countries, inequality might also give a part of the population the resources to start a business or get an education. Yet 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.

Redistributive policies
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; the use of tax revenues to finance public investment, better education or universal health services. 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, 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.

The implication is perhaps surprising. Not only does inequality damage growth, but efforts to remedy it are, on the whole, not harmful. The findings suggest that trade-offs between redistribution and growth need not be a big worry.

These findings are also consistent with observation. Europeans are aware 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 the far more equal east Asian countries – 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 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 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, notably on taxation. Yet if even the staff of the IMF is analysing this once taboo topic, its hour has surely come. – (Copyright The Financial Times Limited 2014)