Why income inequality is bad for growth

Give credit to the Organisation for Economic Cooperation and Development, or OECD—an organization that has so often either mirrored or defined (depending on your point of view) the consensus on economic policy issues—for so thoroughly embracing the idea that high and growing income inequality may well be bad for growth. The Paris-based organization of leading developed and developing economies late last month issued its latest finding in its report “In It Together: Why Less Inequality Benefits Us All,” which finds that “econometric analysis suggests that income inequality has a sizeable and statistically significant negative impact on growth.” (Emphasis in the original.)

The new report finds that between 1990 and 2010 gross domestic product per person in 19 core OECD countries grew by a total of 28 percent, but would have grown by 33 percent over the same period if inequality had not increased after 1985. This estimate is based on an econometric analysis of 31 high- and middle-income OECD countries, which concluded that lowering inequality by just one “Gini-point” (a standard measure of inequality used by economists) would raise the annual growth rate of GDP by 0.15 percentage points.

In a world where policies that boost growth rates by one or two tenths of a percent per year are a big deal, these kinds of outcomes are at the high end of what we can reasonably hope from most policy interventions. To give an idea of the scale of shifts in inequality under consideration, OECD data show the United States is about six Gini-points more unequal than Canada; between 1983 and 2012 income inequality in the United States increased just over five Gini points.

Indeed, the implied benefits of reducing income inequality are big for the United States, where inequality has always been high and is rising rapidly by OECD standards. Using the same OECD estimates, if the United States could  reduce its inequality to the level in Canada, U.S. GDP would rise about 0.9 percentage points per year. This is a large effect relative to the average annual growth rate since 1970 of U.S. inflation-adjusted GDP of about 2.8 percent.

The OECD believes that inequalities in access to education are the most important factor behind the connection between inequality and growth.  According to the OECD, “One key channel through which inequality negatively affects economic performance is through lowering investment opportunities (particularly in education) of the poorer segments of the population.” This conclusion is based on the observation that children in low-income families trail children in high-income families with respect to educational attainment (degrees earned and years in school) and with respect to scores on international tests of numeracy and literacy. This relationship holds in all the countries studied, but the educational outcome gaps between rich and poor were bigger when inequality was higher, suggesting that higher levels of inequality exaggerated the disadvantages faced by poor children. As the OECD report notes: “Income availability significantly determines the opportunities of education and social mobility.”

The OECD report complements an Equitable Growth report released earlier this year. In “The Economic and Fiscal Consequences of Improving U.S. Educational Outcomes,” Equitable Growth Visiting Fellow Robert Lynch found that improving U.S. educational test scores to levels achieved by Canada would result in greater real GDP growth of $2.7 trillion by 2050, and $17.3 trillion by 2075.

The OECD’s policy discussion and recommendations in this latest report are pretty bold. “Focusing exclusively on growth and assuming that its benefits will automatically trickle down,” the report says, “may undermine growth in the long run.” But, policies that help in “limiting or—ideally—reversing the long-run rise in inequality would not only make societies less unfair, but also richer.” Specific policies discussed include “raising marginal tax rates on the rich … improving tax compliance, eliminating or scaling back tax deductions that tend to benefit higher earners disproportionately, and … reassessing the role of taxes on all forms of property and wealth.”

The econometric analysis behind the conclusions and recommendations is careful, but probably won’t persuade skeptics. The findings are based primarily on a small data set of just over 100 observations on 31 countries at various points over the past four decades. But the results are consistent with a growing body of work finding a negative connection between inequality and growth, including researchers at the International Monetary Fund.

This article is published in collaboration with Washington Center for Equitable Growth. Publication does not imply endorsement of views by the World Economic Forum.

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Author: John Schmitt is Research Director at the Washington Center for Equitable Growth.

Image: U.S. dollar notes are seen in this picture illustration taken at the Bank of Taiwan in Taipei. REUTERS/Nicky Loh