Want growth and jobs? First tackle inequality.

Cormac Staunton: A recent article by Ben Olinsky at the Center for American Progress brings together a number of key findings to show how greater economic equality can be a key driver of economic growth.

In Ireland this is often considered counter-intuitive because we experienced rapid growth alongside rising inequality from the late 1980’s. However, as the paper makes clear, Ireland (along with South Korea) was very much an outlier in this respect.

As Ireland now struggles for growth in the post-crisis period, there are a number of questions highlighted by the paper that are also important for us to consider:

• Should we raise or lower taxes on high incomes?
• Should we cut spending or make strategic investments in education, research, and infrastructure?
• Should we raise or lower the minimum wage?
• Should we effectively regulate financial markets or allow the free market to sort it out?

The evidence from the three papers analysed by Olinsky is that economic policies that rely on “trickle-down” theories and the resulting inequality are bad for the economy. It is a reminder for us in Ireland that our reliance on these theories of growth is out-dated, counter-productive and in some cases harmful.

The paper identifies a number of explicit linkages between inequality and economic inefficiency, which lead to reduced growth and greater economic instability. Investment growth, productivity growth, employment growth, middle-class income growth, national fiscal health, and overall economic growth are all shown to be weaker or have declined under trickle-down policies.

The paper suggests a number of policies to combat inequality and to strengthen those on low incomes through a progressive economic agenda, which would in turn have a positive impact on the economy.

The message for Ireland is clear: we should focus on growing the economy from the “middle out” or the “bottom up” instead of from the top down.

Five reasons why inequality is bad for the economy

1. Increasing inequality is bad for growth
It is often assumed that tax cuts for those on high incomes, while deepening inequality, will lead to economic growth. However, empirical evidence does not back this up. For example in the US, in 1981 the marginal tax rate for the highest income bracket in the US was 70 per cent, but that fell to just 28 per cent by 1989. Taxes on high incomes were further cut in early 2000s. Yet economic growth in the US was greater after the tax increases of 1993 than in the periods after income tax cuts in the 1980s and early 2000s.

2. Inequality is bad for investment
Inequality leads to a lack of resources for public investment, which can have longer term costs. For example, when children lack sufficient access to educational resources and after-school activities such as art and music, they become less-effective ‘inputs’ into the economy, thus depressing the rate of growth.

There is also a strong correlation showing that as the size of government shrinks, inequality increases. In a cross country study, nearly 60 per cent of the variation in inequality was accounted for by size of government. This then creates a perpetuating cycle of spending cuts, low investment and increasing inequality.

3. Inequality affects consumption
Income inequality promotes inefficient patterns of consumption in a number of ways. Firstly, where individuals feel pressured to consume more than is efficient as a sign of social status, such as overly large and expensive housing, this wastes resources that could be used for productive investments.

Secondly, because of rising inequality, middle- and low-income families are forced to borrow to sustain their standards of living. This creates excessive middle-class debt, generating instability in financial markets, lower economic growth, and the potential for a market crash.

On the other side, the marginal propensity to consume is lowest amongst those on highest incomes. Redistributing income away from the top and to the middle and the bottom will generate increased consumer spending and thus stimulate the economy, a particularly important mechanism in periods of recession and weak growth.

4. Inequality reduces risk-taking
A core component of a healthy labour market, which is necessary for a strong economy, is the ability for individuals to start their own businesses. Job insecurity and a lowering of the social ‘safety net’ can reduce the incentives for risk-taking entrepreneurial behaviour. Social programmes can give aspiring entrepreneurs the security that is necessary to take risks for ventures that could be beneficial to economic growth.

5. Inequality produces inefficient labour markets
A well-functioning economy needs a healthy labour market that allows workers to find jobs that take advantage of their unique skills and experiences. However, with rising inequality many workers may be reluctant to change occupation or sector because they are worried about ending up worse off.

Policies designed to combat inequality lead to a more efficient labour market. A more progressive tax system and increased access to social services and transfers tend to encourage labour-market mobility and afford individuals, particularly those on low incomes, the possibility of changing occupations and sectors.

Increasing economic equality means that workers take jobs that best utilize their skills, suggesting a further link between fighting inequality and growing the economy.

The paper by Ben Olinsky and links to all the papers quoted is available here.

Cormac Staunton is TASC's Policy Analyst. You can follow him on Twitter @Cormac_Staunton