Is income inequality always a bad thing?

Published December 19, 2016 by lagmen
The have-nots.

Income inequality is on the rise. Many economists and analysts take it as given that inequality does economic harm. But for something that has become conventional wisdom, there is surprisingly little evidence to make a definitive case that income inequality is bad for the economy.

First, the facts: Income inequality has worsened significantly in both the US and UK since the 1980s. In macroeconomic terms, this was hardly a period of great stagnation. But could it have been even better if incomes were distributed more equally?

For their part, researchers from the IMF believe that income inequality is bad for the economy, and published a series of papers to prove it. Most rely on data from poor countries, while others use smaller samples of richer countries to identify a correlation between inequality and growth. But these regressions don’t include factors that could have caused the increase in inequality; the exclusion of these factors makes it hard to establish causality between inequality and growth. There just isn’t any conclusive evidence on what inequality means for long-term growth. But there are several theories why it’s bad for the economy.

Reduced spending power

Poorer people spend more of their income, so if they get less of the pie that implies lower consumption and a weaker economy. (Put another way, the savings rate rises, since richer people save more of their incomes.) This argument takes a static view of the economy—savings are what provide the foundation for long-term economic growth, not spending. Also, it is at odds with the fact that the recent deterioration in income equality accompanied a fall in the savings rate.

Lower social mobility

A more compelling argument is that inequality undermines meritocracy, so the most talented don’t rise to the top. Instead, the children of the elite remain in positions of power, and the economy grows less innovative and productive as a result. Inequality may also discourage people from putting in effort to climbing the ladder, undermining work and effort.

This may all be true, but it is hard to prove with data. As income inequality rose in the last few decades, statistics also showed the odds of moving up the economic class ladder stayed the same.

Political instability

Up until recently, people who worried about inequality argued it would concentrate power to the hands of the elites. But if a large enough share of the population feels left behind by economic forces, they will vote in anti-establishment, populist policies that could harm growth—not just for the elites, but for everyone. That may explain, to some extent, the Trump and Brexit victories; although the economic implications of those votes remain murky, there are plausible scenarios in which the poor are hurt hardest by rising inflation, lower growth, and protectionist policies.

It is hard to know if the resentment of voters choosing to rebuke the status quo is related to rising inequality, stagnating incomes, or some combination of the two (among other non-economic factors). Some economists have developed a theoretical model that suggests people feel a natural aversion to inequality.

What to do about it

Assuming that inequality is a problem, how to address it? Progressives argue for more redistribution from rich to poor. But how this money is delivered and spent is crucial. Some share of the discontent isn’t purely economic, but social in nature. More money alone may not address those grievances, or promote labor mobility and greater community connections.

A new book by Stanford historian Walter Scheidel (pdf) comes to a rather striking conclusion about the most successful ways to reduce inequality: “war, revolution, state failure and pestilence acted as the main equalizers of income and wealth both in the distant and the more recent past,” he writes. “We must ask whether fiscal policies that seek to curtail inequality are likely to succeed in the absence of these destructive forces, and what this suggests for the future of global inequality.”

Less destructively, economist Tyler Cowen (pdf, p. 248) believes that business-friendly policies like reducing licensing regulations, promoting charter schools, and relaxing zoning rules would remove friction and boost income-generating opportunities for everyone, especially the poor. But these take a more classically liberal, free-market approach. If a by-product of rising inequality is support for protectionist politics, there is little chance that these sorts of policies will see the light of day.

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