The Mythical Link Between Income Inequality and Slow Growth

The Organization for Economic Cooperation and Development recently published a report, “In It Together: Why Less Inequality Benefits All,” that claimed rising income inequality from 1990-2010 depressed cumulative growth across its member countries by 4.7%. The OECD’s suggested solution: government-led redistribution, funded via tax increases on “wealthier individuals” and “multinational corporations.”

“By not addressing inequality,” OECD Secretary-General Ángel Gurria told reporters on May 21, “governments are cutting into the social fabric of their countries and hurting their long-term economic growth.” The report garnered widespread news coverage, and its conclusions dovetailed with the conventional wisdom among many progressive thought leaders. But the report and the conclusions it promotes are flawed.

From 2000-10, many of the 34 OECD countries propped up growth by launching expansive social programs with borrowed money. But not all. The five most “unequal” countries in the OECD report—Israel, the United States, Turkey, Mexico and Chile—largely abstained. They increased sovereign debt by 3% on average compared with a 40% average increase among other OECD members.

When austerity pressures caught up to debt-laden sovereigns in recent years, however, the less leveraged—and not coincidentally, less equal—member countries grew a lot faster than their peers. From 2011-13, according to the World Bank, the five most unequal countries grew nearly five times faster (3.9% cumulative annual average) than the others (0.84%). By using a 2010 cutoff, the OECD has skewed its findings.

Consider Greece. From 1999-2012, its Gini coefficient “improved” by 6% to .34 from .36—more than any other OECD country. (The Gini coefficient measures income distribution, where 0 represents complete equality and 1 represents a society in which a single person has all the income). Greece’s redistributive social transfer spending also grew most quickly among OECD peers from 2000-12. But Greece’s economy has shrunk by more than 20% since 2010 (World Bank data), and today more than a third of its citizens are considered to be at risk of poverty (Eurostat data).

Chile, which has the highest growth rate this decade—4% annual average (latest World Bank data)—is also the most unequal OECD country, with a Gini coefficient of .5. Despite ranking second-lowest among OECD members with respect to both social transfers and government spending (Mexico is lowest), the poverty rate in Chile fell by 6% from 2007-11 (latest OECD data). This is the largest reduction over that period among OECD members.

The OECD’s claim that “redistribution is, at worst, neutral to growth” is also highly suspect. Essentially its analysis focuses on whether or not increasing income taxes to reduce “net inequality” (inequality after redistribution via income taxes) hurts growth. This measure of net inequality is deceptive. It ignores in-kind benefits like health care, education and public housing. It also overlooks the impact of other forms of taxation like value-added taxes (VATs).

Within the OECD, VATs and similar taxes on goods and services actually account for a larger share of tax revenue (33%) than do taxes on personal income (25%). As a result, the income-tax rate is a subpar proxy for redistribution policy. For example, from 1990-2010 the average marginal income-tax rate within the OECD was cut to 44.9% from 50.6%. But the average VAT was raised to 18% from 16.7%, largely offsetting the cut with respect to revenue generation.

A more representative proxy for redistribution is government expenditure as a percentage of GDP, which encompasses all government spending on the provision of goods, services, subsidies, and social benefits. From 1995-2012, OECD member countries that increased government expenditures as a percentage of GDP grew 30% slower than member countries that trimmed government expenditure as a percentage of the economy over that span—average annual growth of 1.9% compared with 2.5%.

The data are even more revealing in recent years. OECD countries that increased government spending as a portion of the economy from 2009-12 contracted by an average of 1.3% annually; countries that trimmed government expenditure grew by an average of 0.9% a year.

If countries most deeply hurt by the crisis were in most need of government spending to boost their economies, they should have experienced a sharper growth inflection. Not true. In OECD countries that increased government spending from 2009-12, growth in 2012 was 3.2% better on average than it was in 2009. The growth in countries that opted for less government spending was 4.9% better.

The point is not that inequality is “good” for growth. Rather, any backward-looking analysis of growth is implicitly flawed because economies change. Technological change will produce bigger winners and losers. And while European OECD members have been far more equal than their peers across the Atlantic, they have also been far less innovative.

Europe has yet to produce a single Internet company valued at more than $10 billion compared with six privately owned startups worth more than $10 billion in the U.S. Perhaps the OECD’s time would be better spent studying the creation of wealth in this new landscape instead of its redistribution in times past.

[“source-wsj.com”]