Question of the Week: Inequality Part II

How does inequality affect economic growth?

Question of the Week posts review important questions and controversies in global development by providing background information and links to a full spectrum of analysis and opinion. Following a recent post on global trends in income inequality, today’s post examines the effect of inequality on economic growth.

The relationship between inequality and economic growth is the subject of significant debate, with many scholars believing that inequality hinders growth.

Inequality might threaten economic growth for a number of reasons. For one thing, it may steer governments toward short-term policies meant to assuage popular discontent rather than ones that promote long-term prosperity. “Rising inequality can lead to instability and poor political choices, as governments facing populist demands opt to curry favor—for example, with inefficient subsidies on fuel or food—rather than promoting long-term sustainable growth,” argues Asian Development Bank chief economist Changyong Rhee. Egypt is a prime example of this phenomenon: the country’s balance sheet is weighed down by fuel subsidies. “The subsidies mostly benefit the well-off, encourage profligacy, and exacerbate fiscal woes. Yet lifting them—and forcing citizens to pay market rates to fill their tanks—is politically explosive,” explains CFR’s Isobel Coleman.

Additionally, high levels of inequality arguably undermine government responsiveness to citizens’ interests and concerns by giving a small number of wealthy people disproportionate influence over the political process. This can subvert the institutions that help to promote economic growth. "When political power or influence is concentrated among a small segment of the population, that group is able to shape policies or institutions to its advantage,” argue University of Rochester economist Stanley Engerman and UCLA economist Kenneth Sokoloff. In a paper that examines the causal reasons for the differences between present-day development outcomes in the United States and Canada versus Latin America (all of which have colonial pasts), Engerman and Sokoloff argue that relatively high levels of equality in the United States paved the way to publicly provided schooling and infrastructure as well as voting, while "extreme inequality" in Latin America slowed down the development of these institutions, which were less in the interest of the elite. Many Latin American countries, the authors write, “came to exhibit persistence over time in evolving institutions that restricted access to economic opportunities and generated lower rates of public investment in schools and other infrastructure considered conducive to growth.”

Others argue that growth may suffer because of inequality of opportunity—the different levels of access that rich people and poor people have to high-quality schooling, healthcare, safe living environments, reliable transportation, and more. In this view, wealth determines the extent to which people can bolster their human capital through education and training; human capital can drive economic growth. In the United States, as of 2010, 82 percent of high school graduates from high-income families attended college versus 52 percent of high school graduates from low-income families. And in 2010, a young adult who had a bachelor’s degree earned a median $45,000 a year versus the median $29,900 for a young adult who had only a high school degree. It is not hard to see how inequality can direct economic advantage to certain parts of society across the generations. When this happens, people who might otherwise make stronger contributions to economic growth by working in high-skill jobs or innovating have a much smaller chance of being able to get the education necessary to do so.

Also, inequality may prevent resources in the economy from being used at optimal efficiency. The wealthiest may not allocate their disproportionate share of economic resources in ways that lead to maximum growth or enable the poor to share in growth. In “imperfect markets,” MIT economist Esther Duflo writes, “…the identity of who holds resources in an economy matters for how they are used. The poor can stay poor even if the economy as a whole grows. And growth can be slowed down because resources are not used in the most efficient way possible.” As she writes, people at the bottom of the income distribution do not have the same access to market resources (such as loans) that wealthier people do. This means that an entire segment of society is prevented from pursuing activities as effectively as they otherwise could.

Inequality also appears to make economic growth spells shorter. Even if highly unequal countries can achieve growth, they are hard pressed to sustain it, as IMF economists Andrew Berg and Jonathan Ostry explain. “We find that longer growth spells are robustly associated with more equality in the income distribution. For example, closing, say, half the inequality gap between Latin America and emerging Asia would, according to our central estimates, more than double the expected duration of a growth spell.” The authors suggest that inequality could shorten economic growth spells because poor people are not able to invest in human capital and because political instability (associated with inequality) could discourage investment, among other reasons.

Others, however, believe the effects of inequality on growth are more nuanced, or even nonexistent. “Both high and low levels of inequality diminish growth,” argue economists Fuad Hasanov of the IMF and Oded Izraeli of Oakland University, reviewing four decades of evidence from the United States. Harvard economist Robert Barro breaks down the inequality-growth relationship further. He writes that “there is an indication that inequality retards growth in poor countries but encourages growth in richer places. Growth tends to fall with greater inequality when per capita GDP is below around $2000 (1985 U.S. dollars) and to rise with inequality when per capita GDP is above $2000.”

Barro writes that one interpretation for this dynamic is that "credit-market problems"—for example the previously mentioned difficulties that poor people confront in accessing resources like loans—are "more serious in poorer countries," and thus can limit growth. However, in richer countries, this lack of access is less of a problem, and consequently, the "growth-promoting aspects of inequality may dominate." Barro’s literature review suggests that one such aspect may be the effect of savings on economic growth: according to some economic models, as income increases, savings increase, which can lead to an increase in investment. Conversely, policies that transfer income from the rich to poor can lower savings, lower investment, and thus lower economic growth. All this considered, though, Barro concludes that "evidence from a broad panel of countries shows little overall relation between income inequality and rates of growth and investment."

Finally, some view income inequality as a good thing—an invaluable incentive for individuals to undertake economic activities that will lead to growth. “The unconstrained opportunity for individuals to create value for society—and the fact that their income reflects the value they create—encourages innovation and entrepreneurship… Redistribution of wealth increases the costs of entrepreneurship and innovation, with the result being lower overall economic growth for everyone,” argues Thomas A. Garrett of the St. Louis Fed. “The more government attempts to equalize incomes, the less an economy produces. Who wants to produce when one doesn’t receive the full benefits of his or her labor?” asks David Weinberger of the Heritage Foundation.

What do you think?

Does inequality damage the prospects for shared and sustainable growth, or might it be a useful incentive? Let us know your thoughts, and stay tuned for future Question of the Week posts. The next installment of this series will focus on the other side of the inequality-growth relationship: is inequality an inevitable outcome of economic growth?