Opinion, Berkeley Blogs

A cost of inequality: growth

By Claude Fischer


A recent story in The New York Times, back in its business section, had important news about inequality: Income Inequality May Take Toll on Growth. A couple of economists at the IMF reported research (here) showing that, across many countries, periods of greater income inequality tend to be followed by slow-downs in economic growth.


This is, actually, old news. About twenty years ago the research literature already showed that inequality probably damped the economy (see pp. 126ff here). But this remains important to repeat not just because reporting the baleful effects of inequality now has the imprimatur of the IMF, but also because so many people still resist the news; they insist instead on believing the opposite, that inequality stimulates the economy, to the benefit of everyone. And, of course, this insistence has political implications right now.


Anecdote: Back in 1999, I was invited to give a paper to a conference, held at an eminent law school, exploring the contemporary role of the corporation. I presented the state of knowledge on the empirical question of whether inequality was necessary (or even helpful) for spurring overall economic growth; the research said no and suggested that inequality may well be harmful to the economy. The discussant for my paper was an eminent state jurist, one with considerable influence on corporate law. He summarily dismissed my conclusion and the research it drew on because everyone knows and economic logic tells us that the prospect of getting rich is necessary for people to work hard and to invest. Inequality must be necessary for economic growth. Case closed.

Many Americans have also felt that way. In 1987, 71% of survey respondents (to the GSS) said that it is probably or absolutely the case that in order to get people to work hard, . . . large differences in pay are necessary. But phrasing the issue another way, we see some skepticism. In the same 1987 survey, only 29% agreed that large differences in income are necessary for Americas prosperity. That percentage has slowly shrunk: 29% again in 1996, 28% in 2000, and 24% in 2008 (shrunk basically because Americans in the bottom half have become less persuaded that the differences are necessary).*

"Job creators"

The controversy appears in our current political debates. Governor Romney complains that raising or even keeping our current tax rates on the wealthy will strip the job creators of the funds they need to invest in new businesses and new hires. In other comments, he shows himself sympathetic to the idea that current or higher tax rates undermine Americans desire to work hard. This is totally in tune with the theory that sizable income and wealth gaps are needed for economic growth.

When President Obama defends the tax-the-rich policy, he does so largely on the grounds of fairness and of addressing the deficit. When, however, he argues that we grow the economy from middle out, he is, knowingly or not, alluding to an alternative theory about the sources of economic growth: that income for and spending by the working and middle classes drive growth. The 99% much better incentivize businesses and investors than tax cuts can, because well-off consumers buy the products businesses would sell, thereby creating a virtuous circle. (Even Henry Ford knew that.) Wealthy individuals with no prospective customers do not build business; they buy chalets and gold coins.

To the extent that facts matter in such a politicized debate, it is becoming increasingly clear that equality rather than inequality is a better policy for economic growth.


* Interestingly, Americans in the lower half of the family income distribution were likelier than those in the upper half to endorse the necessity of large income differences! However, that pattern reverses once education is taken into account (the more educated are much more skeptical of inequality); at equal levels of education, those with higher incomes more often claim that inequality is necessary.

Cross-posted from Claude Fischers blog, Made in America: Notes on American life from American history.