Does income inequality slow economic growth?

Does income inequality slow economic growth?

Yes!

But the effect is ambiguous.

Income inequality can either propel growth by offering incentives to people to be more productive or impair it by reducing demand and worsening health and education for the poorer, among other reasons.

On the one hand, a higher concentration of income in the hands of a few is reflected in reduced demand by a larger share of poorer individuals, which would invest less in education and health and grow a sense of social and political discontent, jeopardizing human capital and stability. Moreover, more inequality can exacerbate households leverage to compensate for the erosion in relative income, empower the influence of the richer population on the legislative and regulatory processes, and motivate redistribution policies that are often blamed for slowing growth, especially when aggressive.

On the other hand, a certain level of inequality endows the richer population with the means to start businesses, as well as creates incentives for individuals to increase their productivity and invest their saving, hence promoting economic growth.

The single biggest impact on growth is the widening gap between the lower middle class and poor households compared to the rest of society. Education is the key: a lack of investment in education by the poor is the main factor behind inequality hurting growth.

Economists say that some inequality is needed to propel growth. Without the carrot of large financial rewards, risky entrepreneurship and innovation would grind to a halt. In 1975 Arthur Okun, an American economist, argued that societies cannot have both perfect equality and perfect efficiency, but must choose how much of one to sacrifice for the other. While most economists continue to hold that view, the recent rise in inequality has prompted a new look at its economic costs. Inequality could impair growth if those with low incomes suffer poor health and low productivity as a result, or if, as evidence suggests, the poor struggle to finance investments in education. Inequality could also threaten public confidence in growth-boosting policies like free trade, says Dani Rodrik of the Institute for Advanced Study in Princeton.

More recent work suggests that inequality could lead to economic or financial instability. In a 2010 book Raghuram Rajan, now governor of the Reserve Bank of India, argued that governments often respond to inequality by easing the flow of credit to poorer households. Other recent research suggests American households borrowed heavily prior to the crisis to prop up their consumption. But for this rise in household debt, consumption would have stagnated as a result of poor wage growth. Economic eminences such as Ben Bernanke and Larry Summers argue that inequality may also contribute to the world’s “savings glut”, since the rich are less likely to spend an additional dollar than the poor. As savings pile up, interest rates fall, boosting asset prices, encouraging borrowing and making it more difficult for central banks to manage the economy.

Income inequality is converging across countries, and that its impact on economic growth is heterogeneous. While countries are converging toward the sample mean, Europe, the Middle East and Central Asia, and advanced economies are experiencing within convergence.

Looking forward, other challenges remain to further analyze the relationship between income and its distribution.

 

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