Growing Pains The Myth of Inequality

Reducing poverty does not necessarily lead to economic growth as some prominent studies have claimed recently. Their results are a misinterpretation of data and analysis.

In the debate over poverty and economic inequality it's become increasingly difficult for facts and credible research to prevail. Instead, the debate is dominated by alarmist appeals and adventurous theories.

It becomes even more questionable when important consultancies latch onto this trend. Recent studies by the Organisation for Economic Co-operation and Development and the International Monetary Fund have claimed that inequality will harm economic growth, while greater equality would lead to greater prosperity everywhere. The OECD, for example, estimates that Germany's GDP would be 6 percent greater today if inequality had not been on the rise since 1985.

Because economic studies often emphasize conflicts between growth and distribution targets, the OECD results appear to be revolutionary. But they're not. The conclusions are a misinterpretation of the present data and analysis results.

The correlation between growth and the Gini coefficient (a commonly used measure of inequality) shows no causal effect of inequality on grown rates. Inequality and growth are influenced by a multitude of factors, including technological changes and the globalization of business, as well as political measures.

The policies of Margaret Thatcher brought climbing income disparity, but also an economic boom. Ángel Gurría, OECD Secretary General

The study also assumes that inequality and growth in emerging markets such as Turkey or Mexico correlate with highly developed welfare states like Sweden or Germany. That's nonsense.

The study fails to examine whether the results also apply when the base year, or the growth phases being studied, are changed. The German Council of Economic Experts carried out these analyses in its most recent appraisal and showed that the claimed negative correlation between inequality and growth is not robust. When one alters the specifications, the portents also sometimes change.

It's also irritating that the studies from the IMF and the OECD contradict each other. The IMF claims that inequality due to growing high-end incomes is bad for growth, the OECD maintains the opposite: that high incomes would not affect the growth, it's low incomes that are the problem. At the same time, the OECD comes to the conclusion that educational investment doesn't affect economic growth. How that fits in is a mystery.

On the question of how inequality and growth are connected, there's a comprehensive body of literature. Overall, the finding is that there is no strong relationship, neither negative nor positive. That's not surprising when one considers the economic impact channels that connect inequality and growth. For example, higher investment in education for children can reduce inequality from disadvantaged backgrounds and enhance growth.

On the other hand, when a highly developed welfare state is in a predicament because of redistributive taxes and regulations are stifling performance and reducing incentive to invest, deregulation and tax cuts lead to greater inequality but also to more growth. Great Britain in the 1980s or Sweden in the 1990s are good examples.

The policies of Margaret Thatcher brought climbing income disparity, but also an economic boom. At the beginning of the 1990s, Sweden was in a severe economic crisis, partly as a result of escalating welfare costs. The politicians devised a raft of reforms which revitalized the economy but at the same time increased income disparity.

The economic policy mix should aim for growth that benefits all levels of society, not just the wealthy. But it's wishful thinking to assume that lower inequality leads automatically to more growth and that redistribution policies can be built up without consideration for their effects on growth. Nor is it an economic framework that effective policy can be built around.


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