Utopia, you are standing in it!

Tim Taylor, the editor of the Journal of Economic Perspectives, has written a superb blog post on why we should be sceptical about a strong relationship between inequality and economic growth. Taylor was writing in response to the OECD’s recent report "In It Together: Why Less Inequality Benefits All,".

Taylor’s basic point is economists have enough trouble working out what causes economic growth so trawling within that subset of causes to quantify the effects of rising or falling inequality inequality seems to be torturing the data to confess. The empirical literature is simply inconclusive as Taylor says:

A variety of studies have undertaken to prove a connection from inequality to slower growth, but a full reading of the available evidence is that the evidence on this connection is inconclusive.

Most discussions of the link between inequality and growth are notoriously poor of theories connecting two. There are three credible theories in all listed in the OECD’s report:

The report first points out (pp. 60-61 that as a matter of theory, one can think up arguments why greater inequality might be associated with less growth, or might be associated with more growth. For example, inequality could result less growth if:

1) People become upset about rising inequality and react by demanding regulations and redistributions that slow down the ability of an economy to produce growth;

2) A high degree of persistent inequality will limit the ability and incentives of those in the lower part of the income distribution to obtain more education and job experience; or

3) It may be that development and widespread adoption of new technologies requires demand from a broad middle class, and greater inequality could limit the extent of the middle class.

About the best theoretical link between inequality and economic growth is what Taylor calls the "frustrated people killing the goose that lays the golden eggs." Excessive inequality within a society results in predatory government reactions at the behest of left-wing or right-wing populists.

Taylor refers to killing the goose that laid the golden egg as dysfunctional societal and government responses to inequality. He is right but that is not how responses to inequality based on higher taxes and more regulation are sold. Thomas Piketty is quite open about he wants a top tax rate of 83% and a global wealth tax to put an end to high incomes:

When a government taxes a certain level of income or inheritance at a rate of 70 or 80 percent, the primary goal is obviously not to raise additional revenue (because these very high brackets never yield much).

It is rather to put an end to such incomes and large estates, which lawmakers have for one reason or another come to regard as socially unacceptable and economically unproductive…

The left-wing parties don’t say let’s put up taxes and redistribute so that is not something worse and more destructive down the road. Their argument is redistribution will increase growth or at least not harm it. That assumes the Left is addressing this issue of not killing the goose that lays the golden egg at all.

Once you discuss the relationship between inequality and growth in any sensible way you must remember your John Rawls. Incentives encourage people to work, save and invest and channels them into the occupations where they make the most of their talents. Taylor explains:

In the other side, inequality could in theory be associated with faster economic growth if: 1) Higher inequality provides greater incentives for people to get educated, work harder, and take risks, which could lead to innovations that boost growth; 2) Those with high incomes tend to save more, and so an unequal distribution of income will tend to have more high savers, which in turn spurs capital accumulation in the economy.

Taylor also points out that the OECD’s report is seriously incomplete by any standards because it fails to mention that inequality initially increases in any poor country undergoing economic development:

The report doesn’t mention a third hypothesis that seems relevant in a number of developing economies, which is that fast growth may first emerge in certain regions or industries, leading to greater inequality for a time, before the gains from that growth diffuse more widely across the economy.

At a point in its report, the OECD owns up to the inconclusive connection between economic growth and rising inequality as Taylor notes:

The large empirical literature attempting to summarize the direction in which inequality affects growth is summarised in the literature review in Cingano (2014, Annex II).

That survey highlights that there is no consensus on the sign and strength of the relationship; furthermore, few works seek to identify which of the possible theoretical effects is at work. This is partly tradeable to the multiple empirical challenges facing this literature. 

The OECD’s report responds to this inclusiveness by setting out an inventory of tools with which you can torture the data to confess to what you want as Taylor notes:

There’s an old saying that "absence of evidence is not evidence of absence," in other words, the fact that the existing evidence doesn’t firmly show a connection from greater inequality to slower growth is not proof that such a connection doesn’t exist.

But anyone who has looked at economic studies on the determinants of economic growth knows that the problem of finding out what influences growth is very difficult, and the solutions aren’t always obvious.

The chosen theory of the OECD about the connection between inequality and economic growth is inequality leads to less investment in human capital at the bottom part of the income distribution.

[Inequality] tends to drag down GDP growth, due to the rising distance of the lower 40% from the rest of society. Lower income people have been prevented from realising their human capital potential, which is bad for the economy as a whole

I found this choice of explanation curious. So did Taylor as the problem already seems to have been solved:

There are a few common patterns in economic growth. All high-income countries have near-universal K-12 public education to build up human capital, along with encouragement of higher education. All high-income countries have economies where most jobs are interrelated with private and public capital investment, thus leading to higher productivity and wages.

All high-income economies are relatively open to foreign trade. In addition, high-growth economies are societies that are willing to allow and even encourage a reasonable amount of disruption to existing patterns of jobs, consumption, and ownership. After all, economic growth means change.

In New Zealand, interest free student loans are available to invest in higher education as well as living allowances for those with parents on a low income. There are countries in Europe with low levels of investment in higher education but that’s because of high income taxes not because of inequality.

The OECD’s report is fundamentally flawed which is disappointing because most research from the OECD is to a good standard.

via CONVERSABLE ECONOMIST: Does Inequality Reduce Economic Growth: A Skeptical View.