At a time when there’s much talk about the 99 percent versus the 1 percent, it’s worth noting that many economists believe income inequality is not only a good thing but also necessary for strong and sustained economic growth.
Before we take a closer look at that argument, some perspective is in order.
A century ago, income was distributed very unequally in our country. The highest-income households got many times the income of the poorer ones. From the end of the Great Depression to the mid-1970s, it became more equal.
Now, it is moving sharply back in the other direction, and we are returning to a degree of inequality not seen in decades. Most of the increased national income over the past 20 years has gone to the highest-income 20 percent of the population and an unprecedented share of that to the top 1 percent.
Some economists, myself included, think this is one of the most important issues of the day. But surveys of the general public show less concern about income inequality per se. (However, if you ask them about abolishing such programs as Social Security, unemployment insurance or farm subsidies that were established to reduce inequality, they generally demur.)
Charles Lane, a Washington Post editorial writer, laid out the argument against government action to reduce inequality in an op-ed published in this newspaper Dec. 26 under the headline “The rich-poor gap: Obama’s leaky bucket.” He cited a Gallup poll in which 52 percent of Americans said the gap between rich and poor was “an acceptable part of our economic system,” while 45 percent said the gap “needs to be fixed” as evidence that we worry less about inequality than we used to.
But the heart of his column was based on “Equality and Efficiency: the Big Tradeoff,” a short but influential book written by Arthur Okun in 1975. Okun was a Yale prof and moderate Republican Keynesian who served in the Nixon administration.
Okun’s argument, and that of many other economists, starts with the premise that a free-market economy with minimal government intervention is the most efficient way of transforming economic resources into goods and services to meet people’s needs. Interfere with that free market in order to help spread the rewards more equally and you reduce efficiency, making society worse off.
The specific role of unequal rewards is that they provide an incentive for individuals to work harder, take risks and innovate. If everyone ends up with the same income, regardless of ability, effort and risk, there is little reason for anyone to put themselves out. Growth is dribbled away. That’s the trade-off.
Nearly any economist would agree with this general argument. The question of just how much inequality one needs to provide such incentives is open to debate, however.
And given how influential the efficiency-equity trade-off assumption is, there has been remarkably little research on it in the real world.
Most economists recognize that the perfectly competitive, perfectly efficient free market is an idealized situation that exists only in the abstract.
In the real world, there usually is some level of “market failure,” whether in the form of monopoly power, imperfect information, external costs or public goods, that undercuts the efficiency of markets. These market imperfections can, and often do, contribute to income inequality. Government actions to address such issues may make an economy more efficient while also decreasing inequality.
In Okun’s day, one heard many anecdotal arguments about the growth-inequality trade-off. Countries like Brazil, Mexico and Iran then had rapid economic growth. They also had highly unequal income distribution. Hence, some argued, the second was causing the first.
It was equally true, however, that countries with unequal income distribution tended to be poor. If one simply ended the most stupid economic policies in such countries, they achieved rapid growth of their gross domestic product on a percentage basis. That is mostly what happened in China in the decade after 1978. But such growth wasn’t necessarily due to incentives for work or innovation springing from highly unequal incomes.
Similarly, one can find cases where decreases in inequality were accompanied by stagnant growth. Lane cites the example of Greece, which had the greatest reduction in inequality of any European Union country after 1985 but lackluster growth.
But there are always counterexamples. U.S. economic growth has been slower as inequality has increased. France has more equal income distribution than we do and much more government intervention in free markets, but output per hour worked is just as high there as here. The Asian tiger economies of South Korea, Taiwan, Hong Kong and Singapore had less unequal income distribution than once fast-growing countries like Iran or Brazil, and their growth turned out to be both faster and far longer-lasting.
That meshes with the findings of Andrew Berg and Jonathan Ostry, two International Monetary Fund economists who are doing the most methodically sound research in this area. They find that economic growth in countries with high or growing inequality tends to peter out more quickly.
This is an area where political views will always dominate empirical research. If you are a liberal, however, understand that some level of inequality may be necessary for incentives to growth. If you are a conservative, understand that the reasons for growth are complex and that in many situations, inequality can hinder rather than promote growth.
© 2012 Edward Lotterman
Chanarambie Consulting, Inc.