How does equality affect efficiency?

In the pantheon of economic theories, the tradeoff between equality and efficiency used to occupy an exalted position. The American economist Arthur Okun, whose classic work on the topic is called Equality and Efficiency: The Big Tradeoff, believed that public policies revolved around managing the tension between those two values. As recently as 2007, when New York University economist Thomas Sargent, addressing the graduating class at the University of California, Berkeley, summarized the wisdom of economics in 12 short principles, the tradeoff was among them.

The belief that boosting equality requires sacrificing economic efficiency is grounded in one of the most cherished ideas in economics: incentives. Firms and individuals need the prospect of higher incomes to save, invest, work hard, and innovate. If taxation of profitable firms and rich households blunts those prospects, the result is reduced effort and lower economic growth. Communist countries, where egalitarian experiments led to economic disaster, long served as “Exhibit A” in the case against redistributive policies.

In recent years, however, neither economic theory nor empirical evidence has been kind to the presumed tradeoff. Economists have produced new arguments showing why good economic performance is not only compatible with distributive fairness, but may even demand it.

For example, in high-inequality societies, where poor households are deprived of economic and educational opportunities, economic growth is depressed. Then there are the Scandinavian countries, where egalitarian policies evidently have not stood in the way of economic prosperity.

Early this year, economists at the International Monetary Fund produced empirical results that seemed to upend the old consensus. They found that greater equality is associated with faster subsequent medium-term growth, both across and within countries.

Moreover, redistributive policies did not appear to have any detrimental effects on economic performance. We can have our cake, it seems, and eat it, too. That is a striking result – all the more so because it comes from the IMF, an institution hardly known for heterodox or radical ideas.

Economics is a science that can claim to have uncovered few, if any, universal truths. Like almost everything else in social life, the relationship between equality and economic performance is likely to be contingent rather than fixed, depending on the deeper causes of inequality and many mediating factors. So the emerging new consensus on the harmful effects of inequality is as likely to mislead as the old one was.

Consider, for example, the relationship between industrialization and inequality. In a poor country where the bulk of the workforce is employed in traditional agriculture, the rise of urban industrial opportunities is likely to produce inequality, at least during the early stages of industrialization. As farmers move to cities and earn higher pay, income gaps open up. And yet this is the same process that produces economic growth; all successful developing countries have gone through it.

In China, for example, rapid economic growth after the late 1970s was associated with a significant rise in inequality. Roughly half of the increase was the result of urban-rural earnings gaps, which also acted as the engine of growth.
Or consider transfer policies that tax the rich and the middle classes in order to increase the income of poor households. Many countries in Latin America, such as Mexico and Bolivia, undertook such policies in a fiscally prudent manner, ensuring that government deficits would not lead to high debt and macroeconomic instability.

On the other hand, Venezuela’s aggressive redistributive transfers under Hugo Chávez and his successor, Nicolás Maduro, were financed by temporary oil revenues, placing both the transfers and macroeconomic stability at risk. Even though inequality has been reduced in Venezuela (for the time being), the economy’s growth prospects have been severely weakened.

Latin America is the only world region where inequality has declined since the early 1990s. Improved social policies and increased investment in education have been substantial factors. But the decline in the pay differential between skilled and unskilled workers – what economists call the “skill premium” – has also played an important role. Whether this is good news or bad for economic growth depends on why the skill premium has fallen.

If pay differentials have narrowed because of an increase in the relative supply of skilled workers, we can be hopeful that declining inequality in Latin America will not stand in the way of faster growth (and may even be an early indicator of it). But if the underlying cause is the decline in demand for skilled workers, smaller differentials would suggest that the modern, skill-intensive industries on which future growth depends are not expanding sufficiently.

In the advanced countries, the causes of rising inequality are still being debated. Automation and other technological changes, globalization, weaker trade unions, erosion of minimum wages, financialization, and changing norms about acceptable pay gaps within enterprises have all played a role, with different weights in the United States relative to Europe.

Each one of these drivers has a different effect on growth. While technological progress clearly fosters growth, the rise of finance since the 1990s has probably had an adverse effect, via financial crises and the accumulation of debt.
It is good that economists no longer regard the equality-efficiency tradeoff as an iron law. We should not invert the error and conclude that greater equality and better economic performance always go together. After all, there really is only one universal truth in economics: It depends.

This article is published in collaboration with Project Syndicate. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Dani Rodrik is Professor of Social Science at the Institute for Advanced Study, Princeton, New Jersey.

Image: An employee counts Indian rupee currency notes inside a private money exchange office in New Delhi July 5, 2013. REUTERS/Adnan Abidi