Inequality and Growth: The Relationship Isn't Simple

Wealth inequality seems to be the topic du jour. Two books have helped to trigger these discussions. Angus Deaton’s The Great Escape documents that the past 250 years of economic growth have greatly improved health and living conditions but have also resulted in wide gaps in wealth, both within countries and across countries. The second book, Capital in the 21st Century by Thomas Piketty, has garnered even more attention.

Piketty’s thesis is that because the rate of return on capital (equity) is greater than the growth rate of the economy, the financial wealth of people who own equity will grow faster than the wealth of people who depend on labor income, which is closely related to the growth rate of the economy. Thus, Piketty advocates very high marginal tax rates and a global wealth tax to avoid an increasingly unequal distribution of financial wealth.¹

Both books have set off debates, often characterized by simplistic arguments. Some argue that policies that reduce inequality will always increase growth. Others examine international correlations between growth and inequality, looking for causal relationships and implicitly ignoring great differences between policies.²

Trade-offs between growth and inequality can exist. For example, the very high marginal tax rates, which are advocated by Piketty, would likely reduce both inequality and economic output by reducing work incentives.

Economists widely believe that some basic spending on infrastructure, education and health care often both reduce inequality and increase output. In addition, financial market policies that provide incentives for saving (or that even require saving, as in Singapore) can also increase growth and reduce inequality. Replacing payroll and income taxes with taxes on consumption and negative externalities, such as pollution, could also potentially leave both the rich and the poor better off.

Economic policymaking should reject simplistic explanations of the relation between policies to reduce inequality and growth. Instead, we should choose specific policies that assist ordinary people to be more productive and to save money.

Notes and References

¹ Some of the finest minds in the economics profession have reviewed Piketty's book. The list includes those on the left (such as Paul Krugman, Brad DeLong, Robert Shiller, Larry Summers and Robert Solow) as well as those on the right (such as Martin Feldstein, Ken Rogoff, Tyler Cowen and Allan Meltzer). Recently, Chris Giles of the Financial Times has asserted serious problems with Piketty’s data after examining the data sets that Piketty made publicly available. I take no position on these charges or on Piketty’s response.

² See Matthew O’Brien’s article “Fixing Inequality Won’t Hurt the Economy” from The Atlantic and the IMF Staff Discussion Note “Redistribution, Inequality and Growth” by Jonathan Ostry, Andrew Berg and Charalambos Tsangarides.

Additional Resources

• On the Economy: Chasing Returns Has a High Cost for Investors
• On the Economy: Young Families Still Lag Everyone Else in Recovery from Recession
• Economic Synopses: Where Is the Slack in the Labor Market?