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Home > Blogs > Anthony Harrington > Can inequality be reduced without harming growth? Part Two

Can inequality be reduced without harming growth? Part Two

Can inequality be reduced without harming growth? Part Two Anthony Harrington

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One of the standard left wing answers to the growing gap between the very rich, the so called "1 percenters", and ordinary households, whose share of the national pie in advanced markets has been trending down since roughly the 1980s, is massive income redistribution. Nobody needs billionaires, the argument goes, so bring on the 100% tax rate for incomes over x, where "x" is defined as whatever earnings rate the speaker feels is likely to hammer the super wealthy while leaving "ordinary households" unscathed. If this smells a bit like the politics of envy or a nostalgic hankering after some ideal socialist state, that doesn't bother the dyed-in-the-wool left winger. That's their Nirvana, after all.

The fact that introducing penal tax distribution measures in one country simply generates a frantic capital flight out of that country never seems to dent the Left's rhetoric on this point. In fact, the Left then generally counters with the idea of introducing serious capital controls which is one way to go. But there were excellent reasons for modern economies moving to free floating exchange rates (admittedly with hefty central bank interventions from time to time) and going back to an outmoded approach to solve the inequality issue doesn't seem ideal. Other attempts at solving the inequality challenge focus instead on a whole basket of measures, including programs to combat youth and long term unemployment; fine tuning the welfare safety net; and, yes, the whole paraphernalia of labor institutions, including the minimum wage and union legislation.

One of the IMF's latest reflections on ways for governments to combat rising inequality in both advanced and developing economies takes exactly such a portfolio approach. Interestingly, the IMF has rather changed its tune over the last decade. It's earlier reflections on inequality were more directed at boosting employment, and as Baker and his co-authors note in the report cited in Part One of this blog, in its earlier thinking, the IMF was all about "reducing rigidities in labor markets". This basically boiled down to removing various protections for employees and making it much easier for them to be hired and fired by their employers, on the grounds that this would produce more competitive companies. Driving down wages and increasing inequality was, by implication, not seen as a particular problem if it led to the economy thriving. Inequitable income distribution was not exactly the focus.

Today's IMF approaches things a bit differently. It now favors means testing of benefits so they can be phased out at an appropriate level of income, to avoid benefits becoming a disincentive to employment, plus improving access to education, particularly for the poor, and, of course, the introduction of tax policies that seek to achieve "distributive objectives in an efficient manner that is consistent with fiscal sustainability", whatever that means. Importantly, the IMF paper points out that studies show that progressive income tax policies that are not excessive do have a role in decreasing inequality - if the rest of the "package" of measures is properly designed. Tax policies have been found to reduce inequality by an average of around a third, as measured by the Gini coefficient, the paper's authors say.

The Economist recently gave some thought to the question of how inequality and growth relate to each other. In a capitalist society, which The Economist cherishes, the idea of allowing substantial rewards for entrepreneurship and innovation is held to be an essential incentive, leading to out-performance and growth. By definition then, the State can't just swing in and siphon off all the rewards, keeping the entrepreneur on much the same income level as a factory worker. Mao's Cultural Revolution, an attempt at "leveling" if ever there was one, was a howling disaster and his successors have gone 180 degrees in the opposite direction.

The Economist cites Arthur Okun, a US economist who argued in 1975 that societies cannot have both perfect equality and perfect efficiency. There is an essential trade off, though where the balance lies is up to each society to sort out for itself, The Economist suggests. The authors cite a 2011 study by the IMF which finds some empirical evidence for the idea that a lower Gini coefficient for a country enhances its chances of keeping a growth spurt going for longer, which is a roundabout way of saying that the more inequality you have, the quicker the economy nosedives.

While all this academic theorizing is all very well, the street level view of the problem is pretty straightforward. When the elites capture too much of the revenue stream being generated in a country, things can turn ugly very quickly. In democracies, this keeps governments conspicuously tinkering with "equality solutions" while doing their best to avoid irritating business too seriously, in case their major companies decide to shift to more benign environs. That is probably the best we can hope for. After all, God help the country where a serious "equality champion" gets his/her hands on the levers of power...

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Tags: economic growth , IMF , income inequality , income redistribution , International Monetary Fund
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