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29/09/2016

Inequality harms economic growth for the poor

Euro & Finance

Inequality harms economic growth for the poor

Inequality in plain sight in Brussels' European quarter.

[Joel Schalit/Flickr]

Recent economic thinking has discredited the idea that high inequality stimulates economic growth. Public investment in education is the key to both cutting inequality and achieving sustainable growth, argue Roy Van der Weide, Branko Milanovic and Mario Negre.

Branko Milanovic is Visiting Presidential Professor at the The Graduate Center, City University of New York, and senior scholar at the Luxembourg Income Study Centre. Roy Van der Weide works as an economist at the Poverty and Inequality Unit of the World Bank Research Department. Mario Negre is senior economist at the Poverty and Inequality Unit of the World Bank Research Department and senior researcher at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE).

With the recent adoption by the UN of the new Sustainable Development Goals (SDGs), an important global agenda has been set for the 2015-2030 period. An issue that seems to have attracted considerable attention in the process of setting up the goals is income inequality. While this is by no means a new topic, a growing consensus seems to be emerging that inequality needs to be tackled.

A good chunk of the economic and political thinking since the 1950s has considered the effect of inequality on growth to be positive. A certain concentration of wealth was thought to facilitate the accumulation of savings that would fund growth-enhancing investments. In addition, more unequal societies were believed to provide stronger incentives for individuals to work harder in order to succeed. But, as is often the case in economics, one can also think of arguments that would predict an opposite relationship. For example, it can be argued that in modern societies the key to stimulating growth is the accumulation of human capital – that is education – rather than the accumulation of financial capital. If a significant share of the population has imperfect access to good quality education, then future growth may be constrained. Think of a society where good schools are not for everyone; where good schools come with high tuition fees or are tied to specific neighbourhoods; a society where affordable public schools are falling behind because the rich do not have an interest in investing in them. A similar argument can be applied to healthcare.

The question of whether high inequality today bodes well for future rates of income growth and poverty reduction has recently acquired added relevance because of the slowdown of growth in rich countries and simultaneously rising inequality. The relationship between inequality and future growth has been extensively researched but, unfortunately, the results have proved to be inconclusive. We argue that by looking at the growth of average incomes (or GDP per capita) important heterogeneities are being overlooked. The question we should be asking is: how do individuals at different rungs of the socio-economic ladder fare in societies with different levels of inequality? This is precisely what two of us have done in a recent study.

Using data from the United States spanning the years 1960-2010 – a period of substantial transformation of America’s economy and society during which growth moved from being pro-poor to being pro-rich – the study establishes an important stylised fact: high levels of income inequality are associated with lower future growth rates for the poor and the middle classes. No such negative correlation is found to hold for the rich. If anything, higher inequality is found to help their future growth prospects. In other words, highly unequal societies are found to stimulate the type of economic growth that further enhances inequality, at least in the United States for the time period under consideration.

What makes it so hard to put a halt to this cycle and – in the case of the United States – put the country back on a trajectory where growth is shared by all? We hypothesise that when inequality is high and top incomes are significantly greater than the incomes of the middle classes, the rich prefer to opt out of publicly-funded and publicly-provided education, health care and other services, as they increasingly consume them privately. This can be seen as “social separatism”. Indeed, when asked if they would be willing to cut public spending on education and health as a way to reduce the deficit, 58 % of the rich in the United States are in favour of such cuts versus only 21 % among the rest of the population. The public goods that the rich are not interested in investing in are, however, crucial for real income growth among the poor. Unfortunately for the poor, the preferences of the rich have been found to carry more weight in public decision-making than the preferences of the poor, or even those of the median voter. It is a model of society where high inequality, combined with credit constraints and the influence of the rich on the political process, results in a steady state of low government spending, which in turn holds back the rise of poor people’s incomes and perpetuates inequality.

While this study does not provide direct evidence for it, policies that would arguably reduce inequality and improve the growth prospects of the poor and the middle classes include curbing the influence of money in politics, confronting socio-economic segregation and ensuring that every child, regardless of socio-economic background, has access to a good quality education.