Most strikingly the research shows that economic growth declines if the share of income held by the top 20% increases. On the other hand, a growth in the share of income at the bottom 20% leads to higher economic growth. The research also provides further insight into why inequality affects growth.
While previous IMF research had shown that higher overall inequality is linked with lower growth, what is different about this paper is that it shows that it’s what happens at various parts of the income distribution that is important.
Specifically, the research finds that if the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years. This is a further discrediting of the "trickle down" theory.
Likewise, a similar increase in the income share of the bottom 20 percent is associated with 0.38 percentage point higher growth. This positive relationship between disposable income shares and higher growth continues to hold for the second and third quintiles (the middle class). In their words:
“The poor and the middle class matter the most for growth via a number of interrelated economic, social, and political channels.”
Inequality and Growth
The papers discusses how higher inequality can reduce aggregate demand and undermine growth, because the wealthy spend a lower fraction of their incomes than middle- and lower-income groups.
In addition, inequality dampens investment, and hence growth, by fuelling economic, financial, and political instability. A growing body of evidence suggests that rising influence of the rich and stagnant incomes of the poor and middle class have a causal effect on crises, and thus directly hurt short- and long-term growth.
In particular, they point out that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, over-extension of credit, and a relaxation in mortgage-underwriting standards, and allowing lobbyists to push for financial deregulation.
At the same time, enhanced power by the elite could result in a more limited provision of public goods that boost productivity and growth, and which disproportionately benefit the poor.
What Can Be Done?
The IMF paper shows that Governments in advanced economies have historically addressed inequality through public policy—primarily progressive taxes and social transfers such as public retirement benefits.
However, they argue that many advanced countries have now seen an increase in net income inequality, indicating gaps in existing tax-and-transfer systems to counteract rising market inequality.
In particular they show how the progressivity of tax systems has declined in some advanced economies over the past few decades. they show how rising pre-tax income concentration at the top of the distribution in many advance economies has also coincided with declining top marginal tax rates (from 59 percent in 1980 to 30 percent in 2009).
Note Ireland’s position in the diagram above. This is something we should be concerned about given that we have recently cut the top rate of income tax and there are plans to do so again.
Fiscal policy already plays a significant role in addressing income inequality in many advanced economies. It plays a critical role in ensuring stability and can thus help avert (or minimize) crises that disproportionately hurt the poor.
The IMF paper shows that fiscal redistribution, carried out in a manner that is consistent with other macroeconomic objectives, can help raise the income share of the poor and middle class, and thus support growth.
The paper suggests that the redistributive role of fiscal policy could be reinforced by greater reliance on wealth and property taxes, more progressive income taxation, removing opportunities for tax avoidance and evasion, better targeting of social benefits. In addition, they suggest reducing tax expenditures that benefit high-income groups most and removing tax reliefs.
Labour Market Policy
Well-designed labour market policies and institutions can reduce inequality, and, at the same time, not be a drag on efficiency. Policies that reduce labour market imperfections and institutional failures that affect job creation can help support poor and middle-income workers. In particular the paper points out the importance of appropriately set minimum wages and spending on well-designed active labour market policies.
Race to the Top
Far from being a trade-off between growth and equality, the paper concludes that reforms aimed at raising average living standards can also influence the distribution of income. Indeed, tackling inequality goes beyond the remit of labour, social welfare, financial inclusion, and tax policies.
According to the IMF paper, the key to minimizing the downside of both globalisation and technological change in advanced economies is a policy agenda of a race to the top, instead of a race to the bottom. This includes policies to encourage innovation, reduce burdensome product market regulations that stifle competition and technology diffusion, move goods produced upwards in the value chain, and ensure that this rise benefits everyone.
Policies to improve skills for all, to ensure that a nation’s infrastructure meets its needs, and to encourage innovation and technology adoption are therefore essential to driving growth and ensuring a more inclusive prosperity.
Cormac Staunton is Policy Analyst at TASC. You can follow him on Twitter @cormac_staunton