How should our economy grow?

Leave Europe alone, we are really doing it ourselves here. (Stefan Mey)

"How should our economy grow?"
by Martin Baur, Carsten Colombier and Sandra Daguet
Unequal income distribution inhibits economic growth

[This article published on 2/2/2015 is translated from the German on the Internet, https://dievolkswirtschaft.ch/de/2015/02/ungleiche-einkommensverteilung-hemmt-wirtschaftswachstum/.]

An increasingly unequal distribution of income and wealth slows down economic growth. This is supported by empirical findings in economics. By contrast, government redistribution measures can have a positive impact on growth - in net terms - as recent findings by the IMF and OECD suggest. Ideally, well-designed redistributive measures achieve a double dividend: They reduce inequality while promoting growth.

Distributional issues play a prominent role in politics. Numerous philosophers have tried to find the basis for a "just" distribution of income to justify redistributive measures. According to utilitarians, income should be distributed so that the marginal utilities of income are balanced across society. According to U.S. moral philosopher John Rawls, in turn, individuals should agree behind the veil of uncertainty on a redistributive formula that maximizes the income of the poorest member of society. In practical politics, these theories are of little use because they are based on the state's desire to maximize the social welfare of its citizens.

In contrast, the public choice literature concludes that real-world redistribution can usually be seen as the result of a struggle between groups within a particular institutional framework. In this context, most of the transfers flow to politically influential and well-organized groups. These take the funds from groups least able to resist them.[1]

Kuznets' optimistic view
Questions of the distribution of income and wealth among classes and individuals and related issues of poverty, redistribution, and economic development are basic topics of economic research. Since the 19th century, economics has been concerned with questions about the interplay between distribution and economic development. Already "classics" such as David Ricardo and Karl Marx have examined which groups benefited from economic growth in 19th century England, a period characterized by rising income and wealth inequality and persistent poverty. Both conclude, for different reasons, that inequality increases over the course of economic development and negatively affects it.

Beginning in the 1950s, the availability of the first distributional data made it possible to examine these issues not only theoretically but also empirically. In particular, the relationship between a country's level of development and income distribution has received much attention. At the time, U.S. economist Simon Kuznets assumed that income inequality would decrease as the economy developed. Using data from several countries, he concluded that income inequality in a country develops in three phases: Inequality first rises, reaches a peak, and then spontaneously declines. This bell-shaped progression has since become known as the Kuznets curve.

According to Kuznets, the increasing industrialization of a previously agricultural society triggered this development. For his assumptions, he relied in particular on the decline in high American incomes between 1913 and 1948. A majority of economists supported Kuznets' theory in the years that followed. It was not until the mid-1990s that researchers began to question the Kuznets curve, based on better data.[2]

Piketty sparks a revolution
In particular, French economist Thomas Piketty's book, Le Capital au XXIe Siècle, sparked a major media response in 2013. Piketty uses solid and empirical time series to question Kuznets' statements. Unlike Kuznets, in Piketty's work, the share of the richest one percent of the U.S. population in national income (before taxes and transfers) changes along a u-shaped curve: between the two world wars, inequality decreases, until the late 1970s it remains stable, and since 1980 it increases again (see chart 1). According to Atkinson and Leigh (2010), a similar trend can also be observed in Australia, Canada, New Zealand and the United Kingdom.

In France and other countries in continental Europe, as well as Japan[3], the curve follows a similar course until the 1980s. In contrast to the Anglo-Saxon countries, however, there is no marked increase in inequality at the end of the period, and instead of a U-shape, the curve takes an L-shape.

In Switzerland, the development is more regular. Thanks to Switzerland's economic and political stability, the curve for high incomes follows a relatively flat course.[4] According to a recent study, however, inequalities have tended to increase in recent times: The share of the top one percent in national income increased by 31% between 1981 and 2009; for the richest one percent of the population, the increase was as much as 11% over the same period.[5]

World wars reduce inequalities
According to Piketty, the decline in inequality observed by Kuznets in the first half of the 20th century cannot be attributed to a specific phase of economic development,[6] but is rather the result of various political and economic shocks such as the two world wars and the Great Depression, he writes. In France, for example, the decline was due in particular to the collapse of high capital incomes rather than to a structural process that reduced inequality.

In the U.S., on the other hand, the causes of the shocks of the 1930s and 1940s are more likely to be found in the aftermath of the Great Depression than in the events of the war itself, since the U.S. hardly faced any physical destruction of capital. According to Piketty, the swelling of inequality there from 1980 onward is strongly related to the phenomenon of "top managers," a group of executives in large corporations with very high incomes, mostly determined by themselves without significant reference to productivity. About two-thirds of the income growth of the top one percent is based on this phenomenon, the rest is due to the favorable development of capital income. France and continental Europe also experience the rise of top managers, but to a lesser extent, which explains the difference between the U-shaped American curve and the L-shaped French curve.

Tax policy as the key
The large differences between countries with comparable levels of technological development suggest a strong influence of public institutions and policies. Alvaredo et al. (2013) attribute the historical evolution of inequalities to several factors: tax policy, labor market regulations such as the minimum wage, and correlation between capital and labor income. In particular, tax policy influences inequality (see chart 2). According to Atkinson and Leigh (2010), there is a correlation between the reduction of marginal income tax rates and the rising share of high incomes in national income. Alvaredo et al. (2013) also find a strong correlation between reductions in high-income tax rates and the growing share of the richest one percent in national income.

In contrast, government transfers, income taxes, and social security contributions reduce income inequality. According to a report by the Organization for Economic Cooperation and Development (OECD), this redistributive effect is most pronounced in the Nordic countries of Denmark, Norway, Finland and Sweden, as well as in Slovenia, the Czech Republic, Slovakia and Belgium.[7] Since the 1990s, however, redistribution via taxes and transfers has become less effective in most countries, the OECD experts write.

Piketty divides his observations into converging and diverging forces, with the latter reinforcing inequalities. Diverging forces include the phenomenon of top managers and the accumulation and concentration of wealth in an environment of low economic and population growth and high returns on capital. Most convergent unfolds the process of knowledge diffusion and investment in skills and education: in the long run, the best means to reduce inequalities, increase labor productivity, and increase global economic growth.

How inequality affects economic growth.
Since the turn of the millennium, economists have increasingly focused on the question of how income and wealth distribution affect economic growth.[8] A distinction must be made between primary distribution through the market mechanism and government redistributive measures such as a progressive income tax or transfers.

Earlier studies still emphasized that inequality creates incentives for lower income groups to work their way up (see chart 3).[9] Moreover, wealthier households can save more, which makes it easier to finance investment.

But the matter is more complex: for human capital formation is also an essential prerequisite for sustainable economic growth. The extent to which human capital grows depends heavily on the population's access to education and health care systems.

Occupational skills and the health of the workforce are interrelated: With better health, life expectancy increases, and it pays to invest in one's education, for example.[10] Moreover, we work more productively when we are in good health. Finally, better health reduces the fertility rate. This allows parents to provide their children with a better education.

Unequal income and wealth distribution, on the other hand, impedes the ability of broad segments of the population to invest in education and health. Due to imperfect financial markets, households with too little income and capital are denied access to education loans or the financing of health services on the free market. Thus, human capital accumulation slows and, as a result, economic growth. An initial unequal distribution of income can also dampen aggregate demand and thus economic growth, as such a small market is relatively unattractive to many providers.

Social unrest slows growth
In a democracy with unequal income and wealth distribution, the behavior of voters and politicians can also influence economic growth.[11] In a simple political economy model, politicians are guided by the voter who is in the political center. For this so-called median voter, the stronger the primary inequality of distribution through the market mechanism, the more redistribution is desired. However, it can be assumed that this has a negative impact on economic growth due to distorting taxes and transfers.

If, on the other hand, the inequality distribution is reduced via increased spending on education, positive growth effects may result. In addition, too much inequality can destabilize the political system through social unrest, creating great uncertainty for investors, for example with regard to the protection of property rights.[12] As a result, capital accumulation and economic growth are slowed down. Redistributive measures can be growth-enhancing in this case.
The empirical literature is clear in its answer to the question of how primary income distribution affects economic growth: The vast majority, especially of recent studies, conclude that unequal distribution has a noticeable negative impact on economic growth in the long run.[13] Recent OECD results also show that a reduction in inequality in favor of lower and middle incomes, i.e. the poorest 40% of all households in an economy, would significantly boost economic growth.[14] This contradicts Okun's old thesis that there is a trade-off between distribution and growth.[15]