Inequality is unjust but it may not hurt growth

Disparity of income is both a virtue and a vice. The virtue of providing rewards for effort and generating economic growth must be balanced against the vice of inequality's manifest injustice.

Riches derived through good fortune, good parents or being born at a good time are far from easy to defend. The problem is to determine an acceptable degree of redistribution, balancing the remaining inequality with the blunted incentives from higher taxes and benefits. Or so we thought.

The past two years have seen huge growth in academic research rejecting this trade-off. Lower inequality boosts growth, its advocates claim, so countries really can have more redistribution, a narrower gap between rich and poor, alongside more sustained economic expansion.

Economic performance varies wildly over time and across countries, yet the evidence suggests inequality explains only a tiny fraction of these differences. Whatever effect the gap between rich and poor may have on growth, other forces dominate, so we should not look to redistribution as the new engine of growth.

Leading the charge towards the new consensus are two somewhat- surprising institutions - the International Monetary Fund (IMF) and the Organisation for Economic Cooperation and Development (OECD). Are these bastions of orthodoxy infusing their policy prescriptions with the most up-to-date evidence or merely following fashion?

There is no doubt that the new ideas are strongly held. Mr Angel Gurria, head of the OECD, is convinced of the new reality. "Addressing high and growing inequality is critical to promote strong and sustained growth," he says, only to be outbid in rhetorical certainty by IMF managing director Christine Lagarde. She reckons that the rich should thank the poor. "Contrary to conventional wisdom, the benefits of higher income are trickling up, not down," she says.

For all the excitement among this global elite, the research results are mundane. Economic performance varies wildly over time and across countries, yet the evidence suggests inequality explains only a tiny fraction of these differences. Whatever effect the gap between rich and poor may have on growth, other forces dominate, so we should not look to redistribution as the new engine of growth.

With the results almost entirely based on cross-country correlations, they also have troubling inconsistencies. Ms Lagarde and the IMF research think that a higher income share for the rich harms economic performance while the OECD says only inequality between the poorest and the middle matters. The Paris-based international organisation concludes that a lack of access to skills among the poor is the mechanism by which higher inequality hits growth at the same time as finding no role for skills in its equations on growth.

If the global results are weak, they also have close to zero policy prescriptions for rich countries where the results have caused the most excitement - the US and the United Kingdom, in particular. Far from being examples of the worst excesses of capitalism, these Anglo-Saxon nations emerge from the IMF data set as countries with relatively strong growth, low inequality and high redistribution.

The most we can say from these global correlations is that successful economies tend to have grown relatively quickly, with most people having reasonable net incomes and longer lifespans, which result in significant redistribution. We have known that for decades. They tell us nothing about what you should do about the top 1 per cent - the inequality debate that dominates politics.

There are always potential policies that can simultaneously boost growth and reduce inequality. Vigorously promoting competition was a centre-left success story of the 1990s that boosted efficiency and fairness.

Where the Tony Blair and Bill Clinton governments failed was in not spotting rents in the financial sector. These exploited implicit government subsidies and took excessive risk with disastrous consequences. Further attacking vested interests and the economic rents that allow the fortunate few to gain at the expense of others is a fruitful avenue for policy. Of course, eliminating economic rents sounds like a boring economics textbook. There are other familiar nostrums to which policymakers should pay greater attention.

Developing countries should bear down on corruption and enhance property rights; southern Europe should cut the employment rights of older workers and equalise them with those of the young; and Britain should weaken absurd house-building restrictions that concen-trate money among landowners.

There is, naturally, still a place for focusing on redistribution and whether the US and others, which have seen increases in inequality, should respond with more onerous taxation of the rich.

But that traditional debate is a much more difficult conversation than simply plumping for the emerging consensus that redistribution is necessarily good for growth. It is, sadly, still the right debate to have.

FINANCIAL TIMES

A version of this article appeared in the print edition of The Straits Times on August 20, 2015, with the headline 'Inequality is unjust but it may not hurt growth'. Print Edition | Subscribe