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Inequality is Bad for Income Growth of the Poor (but not for that of the rich)

BY ROY VAN DER WEIDE and BRANKO MILANOVIC 13/03/2015

We are the 99%
“We are the 99%” themed poster on the streets

The link between inequality and growth is one of the oldest issues in economics. In classical economics, high income inequality was justified by the need to have the rich who save a significant part of their income, invest it and thus help growth (Kaldor, 1956). Another argument for a positive association is that more unequal societies provide stronger incentives for individuals to work harder in order to succeed. As is often the case in economics, one can also think of arguments that predict an association of the opposite sign. Consider the possibility of imperfect credit markets where poor individuals might, for example, find it harder to finance their education. Absent deep financial markets, more unequal societies may then be more prone to wasting human resources, which is bad for growth (Galor and Moav, 2006; Galor, 2009). This view was, in the case of Galor and Moav (2006), integrated in their overall argument that, in modern societies, the key to fast growth is not capital accumulation but improvements in human capital.

Empirical studies on the inequality-growth relationship took off in the 1990s. Most of the work was cross-country (Persson and Tabellini, 1994; Li and Zou, 1998; Forbes, 2000; Barro, 2000; Banerjee and Duflo, 2003). The literature ended up by producing few convincing results, perhaps not surprisingly given the ambiguity of the theoretical predictions: the influence of inequality on future growth was found to range from positive (mostly for rich countries and over a short time horizon), to neutral, to negative (generally, over the longer-term).

One of the problems of that literature was that, partly because of a lack of micro data, it looked at the relationship between total measures of inequality and growth, which potentially overlooks important heterogeneities; total income inequality is the result of many different factors, some of these factors may be good while others are bad for growth. A breakthrough came with attempts to ‘unpack’ inequality. Sarah Voitchovsky in 2005 published a paper in which she investigated the effect of inequality among the poor and inequality among the rich (thus ‘unpacking’ inequality) on GDP per capita growth. She found that inequality among the rich helps growth, and inequality among the poor hampers it. Marrero and Rodriguez (2012; 2013) decompose inequality into ‘inequality of opportunity’ and ‘inequality of efforts’. In two separate applications, one to the EU and one to the US, they find that inequality of opportunity is detrimental to growth while inequality of efforts tends to help growth. Despite the intuitive appeal, other studies have since failed to reproduce these results when applied to data for other countries (Ferreira et al., 2014).

Remarkably, all of the above mentioned studies focus exclusively on growth of average income or GDP per capita. This seems rather paradoxical. Measures of inequality summarize at any given point in time how incomes are distributed across the population. Yet when we investigate inequality’s relationship to future income growth we appear only interested in how it might affect growth of the average. One would think that we would specifically be interested in how individuals at different steps of the socio-economic ladder would fare in societies with different levels of inequality. Indeed, the logical next step would be to also unpack growth.

In our paper, van der Weide and Milanovic (2014), we use very large US micro-censuses that sample 1 percent and more recently 5 percent of households in each state, conducted from 1960 every ten years, to ask the following question: How does state-level inequality among the poor and the rich in a given year affect state-wide growth rates of disposable income of the poor, middle class and the rich over the next ten years?

The half-century, 1960-2010, which the data covers has been indeed a period of substantial transformation of America’s economy and society: labor participation rates among women that in 1960 were half of those of men became almost equal by 2010; the demographic structure changed: the share of non-Hispanic whites declined from 85 percent in 1960 to 65 percent in 2010; the education level increased: the percentage of adults with bachelor and higher degree increased from 10 to 33. However, above all stood a very important two-fold economic development: US per capita growth rate decelerated significantly, and growth moved from being pro-poor (i.e. with growth rates higher among the poor than among the rich) to being pro-rich (the reverse). This change can be observed in Figure 1: growth rates in the period 1960-70 were higher than those in the period 1990-2000 for all percentiles of income distribution but the richest 1 percent.

US Growth by Percentile
Source: van der Weide and Milanovic (2014)

When we look across 49 states (we leave Alaska and DC, which are clear outliers, out of the analysis) how state-level inequality is correlated with future growth rates at different percentiles of the income distribution, we find a strong negative effect on the growth rate of the poor and an almost equally strong positive effect on the growth rate of the rich. This means that the type of growth that inequality stimulates is the type that further advances inequality. When we unpack inequality too, into inequality among the poor (bottom inequality) and inequality among the rich (top inequality), we find that it is mostly top inequality that is holding back growth at the bottom.

How can these results be explained? We are here reduced to hypotheses about the channels of influence since we cannot test them directly. A possibility which seems to us most compelling is that the rich, when inequality is high and their incomes are significantly greater than the incomes of the middle classes, prefer to opt out of publicly-funded and publicly-provided education, health and other services, as they increasingly consume them privately. We term this ‘social separatism’, which is also the type of behavior observed among the rich in developing countries, most notably in Brazil (Ferreira, 1995). An example from the US is the vastly different preferences of the rich when it comes to the cuts in Medicare, education and infrastructure spending as a way to reduce federal deficit. According to survey data reported by Page, Bartels and Seawright (2011), 58 percent of the rich are in favor of such cuts versus only 21 percent among the rest of the population. The public goods that the rich are not interested to invest in are, however, crucial for real income growth of the poor. It is a model of society sketched by Bénabou (2000) where high inequality, combined with credit constraints and influence of the rich on the political process, results in a steady-state of low government spending and persistent high inequality.

the type of growth that inequality stimulates is the type that further advances inequality.

What are the political implications? If the current economic processes which generate high inequality also help increase the future income growth of the rich, the question may be asked, why would the rich support a policy that would slow their future income growth and thereby reduce their share of the pie? This, in our opinion, is a major issue: is there a ‘public interest’ or a democratic (majoritarian) pressure that might convince the rich to accept such a policy change?

These questions have recently acquired added relevance because of the slowdown of growth in rich countries and the simultaneous rise in inequality. Also, the World Bank, which is mostly concerned with developing countries, has recently increased its focus on tracking the inclusiveness of growth. It has installed the boosting of shared prosperity, the growth of the bottom 40 percent, as a companion objective to reducing global poverty to 3 percent by 2030. Getting the growth incidence curves to bend in favour of the poor will arguably be pivotal in reaching this ambitious global poverty target (World Bank, 2015). Policies that will prove to be a successful means to this end will in all likelihood be addressing inequality in the process.

The question of whether public policies should be concerned with inequality has inspired extensive debate over the years. The opinions among economists and politicians about the importance of inequality for future growth continue to be very much divided. Some believe that any policy that would curb inequality would also be curbing future growth. Others, such as ourselves, believe that some of the important factors that are responsible for the rise in inequality are inherently bad. Think of inequality of opportunity and the erosion of democracy that have introduced obstacles and inefficiencies that will lower the future growth prospects for many.

ROY VAN DER WEIDE

An economist on the Poverty and Inequality team within the Development Economics Research Group of the World Bank. His publications cover a wide array of topics, which include inequality of opportunity, income growth versus poverty reduction, small area estimation of poverty and inequality, index number theory, price volatility, and behavioural economics.

BRANKO MILANOVIC

A leading scholar on income inequality. He was previously lead economist in the World Bank’s Research Group and is currently a visiting presidential professor at City University of New York Graduate Center and an affiliated senior scholar at the Luxembourg Income Study. He frequently blogs at http://glineq.blogspot.co.uk/.

References

Bénabou, R 2000, `Unequal societies: Income distribution and social contract’, American Economic Review, 90(1), pp. 96-121.

Banerjee, A & Duflo, E 2003, `Inequality and growth: What can the data say?’, Journal of Economic Growth, 8(3), pp. 267-299.

Barro, R 2000, `Inequality and growth in a panel of countries’, Journal of Economic Growth, 5, pp. 5-32.

Ferreira, F 1995, `Roads to Equality: Wealth Distribution Dynamics with Public-Private Capital Complementarity’, LSE STICERD Theoretical Economics DP No. 95/286.

Ferreira, F, Lakner, C, Lugo, M & Ozler, B 2014, `Inequality of opportunity and economic growth: A cross-country analysis’, World Bank Policy Research Working Paper, 6915, June 2014.

Forbes, K 2000, `A reassessment of the relationship between inequality and growth’, American Economic Review, 90(4), pp. 869-887.

Galor, O 2009, `Inequality and economic development: An overview’, Introduction to Oded Galor, Inequality and economic development: The modern perspective.

Galor, O & Moav, O 2006, `From physical capital to human capital accumulation: inequality and the process of development’, Review of Economic Studies, 71(4), pp. 1001-1026.

Kaldor, N 1956, `Alternative theories of distribution’, Review of Economic Studies, 23, pp. 83-100.

Li, H & Zou, H 1998, `Income inequality is not harmful for growth: Theory and evidence’, Review of Development Economics, Wiley Blackwell, 2(3), pp. 318-34, October.

Marrero, G & Rodriguez, J 2012, `Inequality of opportunity in Europe’, Review of Income and Wealth, 58(4), pp. 597-621.

Marrero, G & Rodriguez, J 2013, `Inequality of opportunity and growth’, Journal of Development Economics, 104 (C), pp. 107-122.

Page, B, Bartels, L & Seawright, J 2011, `Democracy and the policy preferences of the wealthy Americans’, American Political Science Association Paper, September.

Persson, T & Tabellini, G 1994, `Is inequality harmful for growth?: Theory and evidence’,  American Economic Review, 84, pp. 600-621.

Van der Weide, R & Milanovic, B 2014, `Inequality is bad for income growth of the poor (but not for that of the rich)’, World Bank Policy Research Working Paper, No. 6963.

Voitchovsky, S 2005, `Does the profile of income inequality matter for economic growth?’, Journal of Economic Growth, 10, pp. 273-296.

World Bank 2015, `A measured approach to ending poverty and boosting shared prosperity: Concepts, data, and the twin goals’, Policy Research Report, The World Bank.

 

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