• Economic Research

Inequality: for richer, for poorer

Income inequality is rising across developed countries. What are the implications for economic growth?

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Developed economies are becoming more unequal.

According to the Organisation for Economic Cooperation and Development (OECD), the disparity between the highest and lowest earners in rich countries is greater than it has been for 30 years.1

The key metric for measuring income inequality is the ‘Gini coefficient’, on which 0 marks a society of perfect equality and 1 a society in which all income is hoarded by one person. The average Gini score across developed economies is 0.31, but some countries fare worse than others. Denmark has a Gini of 0.25, while the US score now stands at 0.39 – higher than at any time since the Great Depression of the 1930s.

So why does this matter? Income inequality has been linked to social ills: unequal societies have a shorter life expectancy and higher crime rates.2 Inequality also harms long-term economic growth: the rise in inequality between 1990 and 2010 is estimated to have knocked 4.5 percentage points off cumulative growth in OECD countries.3 And there are political implications too, as evidenced by the resurgence of populism in Western Europe and the US.

“Because US income inequality has risen so much, the bottom 50 per cent of the adult population has been shut out from economic growth since 1980,” says Emmanuel Saez, professor of economics and director of the Center for Equitable Growth at the University of California, Berkeley. “An economy that does not work for such a large fraction of the population is bound to generate discontent and anger, as we have seen in the last political cycle.”

To have and have not

Saez and his colleague Thomas Piketty have studied US income data going back to the 1920s, shedding light on how the top one per cent of earners has streaked ahead (see figure 1), partly due to a rise in executive compensation and a fall in marginal tax rates.4 The top one per cent earns nearly 20 per cent of all US personal income.5

While America has seen the most dramatic rise in inequality, the trend has been observed across the developed world. The reasons for this go beyond inflated executive pay. In a globalised economy, skills in technology-driven sectors such as IT are richly rewarded, while the wages of workers in sectors with less in-demand skills have stagnated.

No society has ever been completely equal and studies show a certain amount of inequality is beneficial for growth, especially in emerging economies. Past a certain point in an economy’s development, however, income inequality is more likely to impose a drag on overall growth.

Savings and consumption

Since richer households are more likely to save an additional dollar of their income than poorer ones, skewing the economy towards the latter hampers consumer industries and may contribute to the world’s ‘savings glut’.6

Inequality also leads to a lack of opportunity. Research shows that as inequality rises, fewer people go to university: a rise of six percentage points on the Gini coefficient lowers the probability of poorer people graduating from university by four percentage points. Because the poorest 40 per cent are less able to invest in skills and education, they are less able to compete for jobs in an economy increasingly geared around technological savvy; the gap becomes even wider and overall productivity declines.7

Lower productivity is bad news for investors, says Stewart Robertson, Senior Economist for the UK and Europe at Aviva Investors. “If you look at the dividend discount model of equity valuation, the return you receive is the dividend yield plus the rate of growth over time. If the rate of growth is linked to nominal GDP, that’s going to be lower in an environment of sluggish productivity growth.”

Another way in which inequality affects growth is through propelling the rise of politicians whose policies damage the economy. Branko Milanovic, a professor at City University of New York, produced the so-called ‘elephant’ curve that shows how the gains from globalisation were unevenly spread between 1988 and 2008 (see figure 2).

The middle earners on the chart (the elephant’s ‘back’) represent the rising middle classes of emerging-market economies such as China, who greatly benefited from the rise in global trade and investment. The dip in the elephant’s trunk represents those in developed economies whose wages have all but stagnated over the same period. The tip of the trunk represents the world’s richest; the highest earners in developed economies who have continued to see their incomes soar.

The elephant curve reveals some of the economic drivers behind populist political outcomes such as the UK’s vote to leave the European Union and the election of Donald Trump as US president, according to Milanovic.

What next?

The rise of artificial intelligence and automation over the coming years may make the problem even worse. These technologies may deliver productivity gains, but if the proceeds only enrich those at the top, depriving the rest of the society of the means to adapt to a quickly-changing economy, inequality is likely to rise still further.8

However, the OECD argues there is plenty policymakers can do to remedy inequality, from implementing redistributive tax policies, to increasing the participation of women in the workforce, to widening access to education and training.

If properly enacted, redistributive policies can reduce inequality without harming the economy.9 And the gains could be significant. For example, raising living standards for the poorest 40 per cent in the UK to the relative level of France would boost annual GDP growth by 0.3 per cent every year for 25 years, according to the OECD – the equivalent of a 13 per cent rise in the current growth rate.10 Such an improvement would be good news for rich and poor alike.

Figure 1. Pretax income growth in the US, 1980-2014
chart - showing pretax income growth in the US from 1980 - 2014
Figure 2. The ‘elephant’ curve: change in real income by global percentile, 1988-2008
The elephant curve: change in real income by global percentile 1988 - 2008

References


1
 The gap between rich and poor, OECD, December 2015

2 The spirit level: Why equality is better for everyone, Richard Wilkinson and Kate Pickett, 2009

3 OECD, 2015

4 Inequality in the long runScience journal, May 2014

5 ‘The top 1 per cent in international and historical perspective,’ Journal of Economic Perspectives, 2013

6 ‘How inequality affects growth,’ The Economist, June 2015

7 The spirit level

8 ‘Technology and Inequality’, MIT Technology Review, October 2014

9 Redistribution, inequality and growth, IMF, February 2014

10 In it together: why less inequality benefits all, OECD, 2015

11 See ‘New data: inequality runs deeper than previously thought,’ Chicago Booth Review, May 201

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