One of the most significant developments in applied economics in recent
times is something we've heard little about in Australia, where we seem
to be living in our own little cocoon, oblivious to advances in the rest
of the world.
For decades, economic policy in Australia - and most
other developed countries - has been based on the assumption that
there's a trade-off between economic efficiency and fairness (or
"equity" as economists prefer to call it).
If governments try to
make the distribution of income between households less unequal by, say,
using taxes and government spending to redistribute income from rich to
poor, or by setting a reasonable minimum wage, it's long been believed,
this will make the economy less efficient and so cause it to grow more
slowly.
On the other hand, if governments don't do as much to
redistribute income away from high-income earners, this will provide
stronger incentives for people to work harder, invest and accept risk in
the pursuit of greater profits.
This, in turn, will cause the
economy to grow faster, leaving us all better off. What's more, the rich
have a higher propensity to save, and greater saving will finance
additional productive investment.
So, sorry about that, but we have to go easy on high-income earners because this makes the economy work better.
This
belief that fairness reduces growth but unfairness fosters it lies
behind many of the tax "reforms" we've seen over the years.
The
moves to cut the top income tax rate from 67 per cent to 47 per cent, to
tax capital gains at half the rate applying to other income, to end the
double taxation of dividends and to use introduction of the goods and
services tax to increase indirect taxation and cut income tax, are all
motivated by the belief this would be better for the economy.
Trouble
is, there's been surprisingly little empirical evidence to support this
theory - a theory, you'll be surprised to hear, rich people really like
(just ask the Business Council).
In recent years, however, the
academic tide has turned and researchers are finding increasing evidence
that inequality may actually be bad for economic growth. The tide has
turned so far it's reached the international economic agencies (though
not our econocrats).
Early this year, three researchers at the
International Monetary Fund, Jonathan Ostry, Andrew Berg, and
Charalambos Tsangarides, published a paper on Redistribution, Inequality
and Growth, which found that lower inequality was reliably correlated
with faster and longer-lasting economic growth.
What's more, they found
that redistribution - the thing economists have long assumed would
dampen incentives - seems to have no adverse effect on growth, except
perhaps in extreme cases.
"We should be careful not to assume that
there is a big trade-off between redistribution and growth. The best
available macro-economic data do not support that conclusion," they
found.
And now, this week, the Organisation for Economic
Co-operation and Development has published a paper by Federico Cingano,
Trends in Income Inequality and its Impact on Economic Growth, that
comes to similar conclusions.
In most OECD countries, the gap
between rich and poor is at its highest in 30 years. In the 1980s, the
top 10 per cent of households earnt seven times what the poorest 10 per
cent earnt. Today it's 9 1/2 times. (In Oz it's 8 1/2 times.)
Cingano says that doing something about this trend has moved to the top of the policy agenda in many countries.
"This
partly due to worries that a persistently unbalanced sharing of the
growth dividend will result in social resentment, fuelling populist and
protectionist sentiments and leading to political instability," he says.
But
another, growing reason for policy-makers' interest in inequality is
its possible effect in reducing economic growth and slowing the recovery
from the Great Recession.
His econometric comparisons of the
performance of OECD countries over the past 30 years confirm earlier
findings that increasing income inequality has an adverse effect on
later economic growth. In New Zealand, for instance, its total growth
over the 20 years to 2010 would have been more than 10 per cent greater
had its income disparity not widened as much as it did over the 20 years
to 2005.
For both the United States and Britain, their cumulative
growth would have been more than 20 per cent greater.
You could
argue that just because inequality reduces the rate of economic growth,
this doesn't mean government measures to redistribute income will make
things better. Those measures could, by reducing economic incentives,
make their own contribution to reducing growth.
You could argue
it, but you'd get no support from Cingano's analysis of the evidence.
"These results suggest that inequality in disposable incomes is bad for
growth, and that redistribution is, at worst, neutral to growth," he
finds.
But get this: he found that what does most to inhibit
growth is an increasing gap between low-income households (the bottom 40
per cent) and the rest of the population.
"In contrast, no
evidence is found that those with high incomes pulling away from the
rest of the population harm growth," he says.
So the rich attract
most envy and resentment, but they're not what inhibits growth. What is
it about inequality in the bottom half of the distribution that leads to
weaker economic growth in later years?
Cingano finds support for
the "human capital accumulation theory", suggesting that lower relative
increases in the incomes of families in the bottom half make it harder
for them to invest in the education and training that increases the
value of their labour and the size of their contribution to growth.
But
I've got an idea. Why not get a businessman, say, David Gonski, to
propose ways of making sure the socially and economically disadvantaged
get a good education?
And why don't we hugely increase university fees?
That's bound to make us grow a lot faster.
