Excerpts from the latest International Monetary Fund (IMF) report, “Causes and Consequences of Income Inequality: A Global Perspective”, by Era Dabla-Norris, Kalpana Kochhar, Frantisek Rick
Excerpts from the latest International Monetary Fund (IMF) report, “Causes and Consequences of Income Inequality: A Global Perspective”, by Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta:
Widening income inequality is the defining challenge of our time. The extent of inequality, its drivers, and what to do about it have become some of the most hotly debated issues by policymakers and researchers alike. Earlier IMF work has shown that income inequality matters for growth and its sustainability. Our analysis suggests that the income distribution itself matters for growth as well. Specifically, if the income share of the top 20 percent (the rich) increases, then GDP growth actually declines over the medium term, suggesting that the benefits do not trickle down. In contrast, an increase in the income share of the bottom 20 percent (the poor) is associated with higher GDP growth.
Inequality within most advanced and emerging markets and developing countries (EMDCs) has increased, a phenomenon that has received considerable attention. A recent Pew Research Center (PRC 2014) survey found that the gap between the rich and the poor is considered a major challenge by more than 60 percent of respondents worldwide, and Pope Francis has spoken out against the “economy of exclusion.” Indeed, the PRC survey found that while education and working hard were seen as important for getting ahead, knowing the right persons and belonging to a wealthy family were also critical, suggesting potential major hurdles to social mobility.
Widening inequality has significant implications for growth and macroeconomic stability, it can concentrate political and decision making power in the hands of a few, lead to a suboptimal use of human resources, cause investment-reducing political and economic instability, and raise crisis risk. The economic and social fallout from the global financial crisis and the resultant headwinds to global growth and employment have heightened the attention to rising income inequality.
Some degree of inequality may not be a problem insofar as it provides the incentives for people to excel, compete, save, and invest to move ahead in life. For example, returns to education and differentiation in labor earnings can spur human capital accumulation and economic growth, despite being associated with higher income inequality. Inequality can also influence growth positively by providing incentives for innovation and entrepreneurship, and, perhaps especially relevant for developing countries, by allowing at least a few individuals to accumulate the minimum needed to start businesses and get a good education.
High and sustained levels of inequality, especially inequality of opportunity can entail large social costs. Entrenched inequality of outcomes can significantly undermine individuals’ educational and occupational choices. Further, inequality of outcomes does not generate the “right” incentives if it rests on rents. In that event, individuals have an incentive to divert their efforts toward securing favored treatment and protection, resulting in resource misallocation, corruption, and nepotism, with attendant adverse social and economic consequences. In particular, citizens can lose confidence in institutions, eroding social cohesion and confidence in the future.
If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth. This positive relationship between disposable income shares and higher growth continues to hold for the second and third quintiles (the middle class).
Higher inequality lowers growth by depriving the ability of lower-income households to stay healthy and accumulate physical and human capital. For instance, it can lead to underinvestment in education as poor children end up in lower-quality schools and are less able to go on to college. As a result, labour productivity could be lower than it would have been in a more equitable world. Countries with higher levels of income inequality tend to have lower levels of mobility between generations, with parent’s earnings being a more important determinant of children’s earnings.
Increasing concentration of incomes could also reduce aggregate demand and undermine growth, because the wealthy spend a lower fraction of their incomes than middle- and lower-income groups. A growing body of evidence suggests that rising influence of the rich and stagnant incomes of the poor and middle class have a causal effect on crises, and thus directly hurt short- and long-term growth. In particular, studies have argued that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation in mortgage-underwriting standards, and allowing lobbyists to push for financial deregulation.
Extreme inequality may damage trust and social cohesion and thus is also associated with conflicts, which discourage investment. Conflicts are particularly prevalent in the management of common resources where, for example, inequality makes resolving disputes more difficult. More broadly, inequality affects the economics of conflict, as it may intensify the gri