After returning from an unpaid internship in Austria for the last three months, I was very interested to see Boris Johnson’s latest comments on inequality. After reading a number of articles focusing specifically on his comments relating to IQ, I believe many had not picked up upon another important part of his argument – the implied justification that the current level of income inequality is acceptable because it a key and necessary driver of economic growth.
The argument that inequality drives economic growth goes back to the roots of economic theory itself. The theory argues that inequality generates incentives for individuals to work hard, compete and innovate within a market economy. A level of inequality allows for there to be winners and losers from this process and drives economic progress as individuals strive to reach the top. The theory therefore predicts that more unequal countries should grow at a faster rate. However, despite the strengths of this argument there are a number of reasons why an unequal distribution of income and assets within an economy may do precisely the opposite.
Many economists argue that highly unequal income distributions can lead to a number of economic efficiencies. Firstly, when the vast majority of wealth is concentrated in the hands of the few, it means that a smaller fraction of the population qualifies for credit because they lack the necessary collateral to obtain loans. As a result they may not be able to invest in the education of their children or gain sufficient funds to start a business. Productive investments within an economy, which stimulate growth, are therefore foregone.
Secondly, a higher level of inequality may lower the overall level of consumption within an economy. This is because people with lower incomes tend to spend a higher proportion of their income than those at the top. Consequently, if most of the national income is concentrated at the top, it is argued that overall consumption may fall. Moreover, the wealthy tend to spend a higher proportion of their incomes on luxury import and foreign travel whilst they may also seek tax havens for their saving abroad. This affects the economy through a process known as capital flight, such investments do not contribute to a country’s productive resources and can therefore hinder the prospects for economic growth.
Other authors have looked at the political economy implications of high levels of inequality for economic growth. For instance, when wealth is concentrated in the hands of the few, these individuals may take measures to safeguard their assets or capture more wealth instead of increasing their own productivity. Individuals may partake in disruptive rent seeking activities such as excessive lobbying, provide large political donations or engage in bribery. In turn, all of this leads to inefficient use of resources as they are diverted away from productive activites which could stimulate economic growth.
A more recent argument is that high levels of income inequality may precipitate credit bubbles and financial crises. Here the argument is that when incomes grow at the top and those at the bottom stagnate, the demand for cheap credit increases. At the same time there is a push by those at the top for policies that sustain and build upon their wealth, such as lobbying for looser financial regulations. As explained by an influential study by the IMF, the end result is a viscious cycle of inequality whereby more and more individuals at the bottom have to borrow to keep afloat thus increasing the risk of a financial crisis.
This point I find particularly relevant as I believe it builds upon the Marxist theory that rising inequality would lead to the ultimate collapse of an economy. The basic argument here is that as business owners become richer by applying downward pressure on wages, the economy will come to a point where no one can afford to buy what the business owners are selling. At this point the economy will stagnate and reach the point of collapse. From this viewpoint, credit is just merely just a mechanism that allows individuals to spend above their means thus postponing the inevitable credit crisis.
But what about the empirical evidence. Take the much cited case study of the Philippines and South Korea for example. In the early 1960s, both of the countries were similar on a number of macroeconomic indicators. They had comparable levels of GDP per capita, urbanisation, population size and primary and secondary education. However, over the period 1960-1988, the per capita income in the Philippines grew, on average, by only 1.8% a year. In contrast, per capita income in South Korea grew, on average, by 6.2% a year over the same time period. However, what is most interesting about this story is that, compared to South Korea, the Philippines exhibited a significantly more unequal distribution of income over the period measured. In 1965 the Philippines’ gini coefficient was nearly 17 points higher than that of South Korea. This clearly contradicts the argument that more unequal economies grow at a faster rate.
A number of more rigorous empirical studies have also found that high levels of income inequality have a negative impact upon growth. For instance, a frequently cited study by Alesina and Rodrik (1994) finds that the gini coefficient has a consistently negative effect upon economic growth. Likewise, Deininger and Squire (1997) investigate whether initial income inequality has a strong impact upon long term growth rates. They find that link between income inequality and economic growth is not strong however they do find that inequality in the distribution of assets (in this case land) exerts a strong negative effect upon growth.
On the whole the empirical evidence on the relationship between income inequality and economic growth is inconclusive at best. The studies conducted suffer from numerous data issues. For instance, inequality is measured in many different ways across countries making comparisons difficult. Conclusions made from many of the studies available are therefore tentative at best. As a result there is no clear evidence that income inequality has any impact on growth whatsoever.
The debate has still not been won by either side. While many accept (and I do too) that a level of inequality is necessary to drive economic development, it is not justification for the significant increases in income inequality we have seen over the past few decades. Furthermore, high levels of income inequality can have far more widespread ramifications for a country besides economic growth. As this interesting lecture by Richard Wilkinson shows, high levels of income inequality can have negative impacts upon a number of socio-economic factors such as health, life expectancy and levels of trust within society. Furthermore, a number of a studies have found a negative relationship between inequality and levels of overall happiness.
Nonetheless these are issues which will not be regularly mentioned within the political sphere. There is still a strong focus on crude indicators such as economic growth to gauge the success of our economy. Unfortunately politicians such as Boris Johnson are still very focused on this narrow gauge of development and therefore fail to see the negative socio-economic impacts that the forces of greed, envy and ultimately, inequality, can lead to.