Income Inequality and Economic Growth

The relationship between inequality and economic growth is complex. Yet, an evergrowing income inequality risks harming future growth by creating support for bad policies. A column by Fabrizio Zilibotti.

Fabrizio Zilibotti
«The reason why it is difficult to identify a clear relationship between inequality and growth is that inequality has many different sources. »

Is income inequality bad for economic growth? Or is it necessary to keep incentives right in a society that rewards effort and merit? The boom of income inequality over the four last decades has revitalized this politically charged question. Yet, economists can offer no straightforward answer. Politicians, on the contrary, know it even too well. Conservatives and liberals have no doubt that government interventions that redistribute income among citizens reduce market efficiency and growth. Socialists, instead, claim that an unequal distribution is a drag on progress and future growth.

The debate in economic research stretches back to the work of Simon Kuznets in the 1950s. He argued that the relationship between economic development and income inequality is hump-shaped. At low levels of development, economic growth increases inequality. However, as economies grow richer, further growth brings about a decline in inequality. Historians (for instance, Williamson in 1985) have documented evidence that income inequality indeed first grew and then declined in XIXth Century Britain. Does Kuznets’ theory apply to the contemporary world? If one plots for each of today’s countries an index of income inequality (e.g., the Gini index) versus an indicator of economic development (e.g., the GDP per capita), one can see some evidence of a Kuznets-like relationship. However, this is tenuous and plagued by several confounding factors.

Kuznets described a statistical relationship between inequality and development. But what do we know about the causal effect of inequality on economic growth? One can take a comparative perspective. Latin America is traditionally a continent with a very unequal income distribution. In contrast, inequality has always been lower in East Asia. Back in the 1960s, South Korea and other fast-growing East Asian countries (e.g., Taiwan, Malaysia, etc.) were poorer than most Latin American nations. Yet, by now, many have caught up and surpassed them. Arguably, a more equal distribution of income was key for the success of the Asian countries, for instance, because it led to less political turbulence. Since Latin America and Asia differ in several other dimensions, an even more informative comparison is that with the Philippines. The Philippines and South Korea were very similar countries in the 1960s in GDP per capita, population, urbanization, and school enrollment. If anything the Philippines was a more industrialized economy. However, the income distribution was much more unequal in the Philippines than in South Korea. Today, the GDP pc of South Korea is five times larger than that of the Philippines. This suggests again that inequality may harm growth.

The United States – ahead in inovation

Consider, next, China and Russia, the two large economies that made the transition from a socialist planning system to market economies. China was a low-inequality country when it first embarked its ongoing path of stellar growth. There, fast economic growth was accompanied by a massive increase in income inequality. Russia, on the contrary, became very quickly an unequal country soon after the fall of the Soviet Union. Initially, it experience a period of economic stagnation during the 1990s, although it was partially reversed in the following decade, when Russia experienced higher growth and some reduction in income inequality.

The picture of the recent experience of industrialized economies is more blurred. Since the early 1980’s, inequality has boomed in the United States, one the richest economies worldwide, more than anywhere else in the rich world. It is controversial whether the growing inequality has favored or slowed down economic growth. Either way, the US has been consistently the most innovative economy worldwide. It has also proven more resilient than Europe in recovering from the ashes of the Great Recession. Does it mean that, contrary to Kuznets hypothesis, inequality is good for economic performance in rich countries? Even this claim would be very problematic. Within Europe, it is countries like Sweden and Norway characterized by strong welfare state institutions that have been doing especially well.

The reason why it is difficult to identify a clear relationship between inequality and growth is that inequality has many different sources. Part of the inequality stems from differences in human capital and talent – which some countries are better at valorizing. In the US, an important share of high income proceeds from innovation and new successful start-up firms. For instance, 11 of the 50 richest individuals in the US listed by Forbes are successful inventors. In a recent study titled «Innovation and top income inequality,» Aghion, Akcigit, Bergeaud, Blundell and Hemous document that there is a strong geographic correlation between the income share that accrues to the richest 1% and innovation as measured by the citation-weighted number of patents. While innovation is not the only source of increasing inequality in the US, that study shows that about 17% of the overall increase in inequality can be attributed to inventors and innovators. That American institutions are especially well-suited to promote research and innovation is witnessed by the superior organization of the top US Universities (such as Harvard, MIT, Stanford or Yale) relative to the European counterparts. These institutions attract and promote the very best world-class talent. Since research and innovation are the engine of economic growth, this type of top income inequality promotes high growth.

Europe – ahead in equal opportunities

Yet, growth is not only driven by superstars. Europe does better than the US at equalizing opportunities. Public education based on general funding is a powerful engine of equalization that is also conducive to higher growth. If talent can be found in all ranks of society, an open access to education opportunities is important to promote the most gifted people to the positions of leadership. In the US (and even more so in many developing countries) large part of the population cannot afford good schools. In spite of the popular notion of the American Dream, recent studies have found that intergenerational mobility is lower in the US than in Europe. Moreover, social mobility appears to have declined over time. This a major social waste. In summary, the US is good in taking the cream to the surface out of a socially selected group. In contrast, Europe is better at offering broad-based opportunities. There is no simple relation between inequality and growth.

What we know is that extreme inequality may harm social cohesion. In a seminal paper written in 1994 Persson and Tabellini argue that, in democracies with an unequal income distribution, people may demand policies that depress investments and innovation. While until recently the growing inequality has not triggered major social conflicts, lately many industrialized countries have experienced a growing political polarization – the Donald Trump phenomenon being an example. The forms of protest are diverse, and not all of them demand more government-mandated redistribution. For instance, in the US there is growing pressure to reduce free trade, while in Europe there are movements against labor and capital mobility. While other factors may also be important, it is difficult not to think that the growing inequality is eventually taking its toll on moderation and political stability.

In conclusion, the relationship between inequality and economic growth is complex. Yet, an evergrowing income inequality risks harming future growth by breaking social cohesion and creating support for bad policies. This is especially true if many people feel excluded from the opportunity to ascend and succeed.