Growth and inequality: A close relationship?

 

Inequality has risen in the OECD area. Could policies aimed solely at growth be responsible? Can inequality undermine economic growth? New evidence suggests there is a possibility.


Income inequality has widened in most OECD member countries during the past two or three decades. These trends are well documented (see references). According to a traditional measure of inequality, the Gini coefficient, income inequality rose by 10% from the mid-1980s to the late 2000s, while the ratio of top income decile to bottom income decile reached its highest level in 30 years.


However, between countries the rise in income inequality has been far from uniform, and a decline has even been observed in some countries. From the mid-90s until the late 2000s, the OECD area experienced a sort of “inequality convergence”, as inequality increased in countries such as Sweden, Denmark and Finland, but fell in countries such as Turkey, Mexico and Chile.


Within countries, indicators of inequality, such as the Gini coefficient, say little about who has benefited or lost from these trends. A closer look at the situation of households provides a more complete picture and shows that in many OECD countries, gains in disposable incomes have fallen short of increases in GDP. This has been particularly the case for poorer households: in nearly all OECD countries for which data are available, GDP growth was substantially higher than households’ income growth in the lowest quintile.


Middle income households have generally fared better, even though they also lag behind GDP growth in a large number of countries. There is a growing gap between low- and middle-income households which is particularly pronounced in Finland, Israel, Sweden, Spain and the US. More generally, growing income disparities between lowand middle-income households have been more widespread and pronounced than the average, as measured by the Gini coefficient. Some countries have seen widening disparities in the lower half of income distribution, taking place even when overall inequality has been narrowing–this pattern is particularly striking in Spain. In other countries, such as Australia, the United Kingdom and the US, between 20% and 50% of total income gains generated have accrued to the top 1% of households, pointing to rising inequalities also within the upper half of income distribution.


As OECD countries try to encourage recovery, how do growth enhancing policies affect income inequality? Identifying the trade-offs between growth and inequality is no simple task. True, in a majority of OECD countries, GDP growth over the past two or three decades has been associated with growing income disparities. Recent OECD work has shown that this increase to a large extent reflects skill-biased technological change (OECD @ 100). However, the potential policy drivers of these changes in income distribution–within and between countries–are less clear. To shed light on this issue, one recent study by Causa et al. has investigated the long-run impact that structural reforms have had on GDP per capita and household income distribution. Based on this analysis, reforms that favour growth can be distinguished according to whether they increase, reduce or have no impact on disposable income inequality. It reveals some interesting trends. Indeed, several growth-enhancing reforms contributed to narrower inequality by delivering stronger income gains for households at the bottom of the distribution compared with the average household. Such is the case, for instance, of reducing regulatory barriers to domestic competition, trade and inward foreign direct investment, as well as stepping up job-search support and activation programmes.


However, a tightening of unemployment benefits for the long-term unemployed lifts average household incomes in the study, but reduces disposable incomes at the bottom of the distribution, an indication that it may raise inequality.


Finally, a few reforms leading to higher GDP per capita have an even impact on all households, regardless of income group. Examples include measures that aim at promoting investment in information and communications technology and at raising the average level of education in the working age population, as well as reductions in marginal income taxes for wage earners.


All of this begs another question much debated nowadays: does growing inequality undermine growth?


A certain degree of income and wealth inequality is a characteristic of market economies, which are based on trust, property rights, enterprise and the rule of law. The notion that one can enjoy the benefits from one’s own efforts has always been a powerful incentive to invest in human capital, new ideas and new products, as well as to undertake risky commercial ventures. But beyond a certain point, and not least during an economic crisis, growing income inequalities can undermine the foundations of market economies. They can eventually lead to inequalities of opportunity. This smothers social mobility, and weakens incentives to invest in knowledge. The result is a misallocation of skills, and even waste through more unemployment, ultimately undermining efficiency and growth potential.


On the face of it, all of this may seem to make perfect sense, but finding supporting evidence of a clear relationship between growth and inequality is far from straightforward. Knowing the initial level of inequality as well as the shape of income distribution, for instance, whether there is a relatively large middle class or if inequality is driven relatively more by income development in the bottom or upper part of the distribution, is important. Indeed, inequality in different parts of income distribution can affect GDP differently: in developing countries, inequalities in the upper end are sometimes associated with positive effects on GDP, while inequalities in the bottom end can induce negative effects.


To explore the question further, our study estimated a relationship for GDP per capita in which a change in income inequality was added to standard growth drivers such as physical and human capital. The idea was to test whether the change in income inequality over time has had a significant impact on GDP per capita on average across OECD countries, and if this influence differs according to whether inequality is measured in the lower or upper part of the distribution. The results show that the impact is invariably negative and statistically significant: a 1% increase in inequality lowers GDP by 0.6% to 1.1%. So, in OECD countries at least, higher levels of inequality can reduce GDP per capita. Moreover, the magnitude of the effect is similar, regardless of whether the rise in inequality takes place mainly in the upper or lower half of the distribution.


References

Causa, Orsetta, Alain de Serres and Nicolas Ruiz (2014), “Can growth-enhancing policies lift all boats? An analysis based on household disposable incomes”, OECD Economics Department Working Papers, OECD Publishing, Paris, forthcoming.

OECD (2011), Divided We Stand, Paris

OECD (2014), “OECD@100: Policies for a shifting world” (ECO/CPE(2014)11)

OECD (2013), “Crisis squeezes income and puts pressure on inequality and poverty”

 

OECD work on Economy

OECD work on Income Distribution and Poverty

OECD work on Social and Welfare Issues

OECD Forum 2014 Issues

 

‌‌Orsetta Causa

Orsetta Causa
OECD Economics Department 

 

Alain de Serres

Alain de Serres, 
OECD Economics Department and

 

Nicolas Ruiz

Nicolas Ruiz,
OECD Economics Department 

© OECD

@OECD Yearbook 2014

 

 

 

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