Deinonychus antirrhopus

Inequality and Economic Growth

Lately with President Bush's tax cut being passed, there has been a considerable amount of discussion on inequality. However, there hasn't been much discussion on its impact on economic growth. Most discussions assume it is bad and go from there.

In a sense inequality is bad. Who wants to live in a society where if you are poor you are likely to stay poor. But there is the additional question of does inequality result in lower economic growth?

I have mentioned in passing that the notion that inequality is bad for economic growth is not uncontroversial.

This paper (pdf file) by Francisco Rodriguez provides a sort of overview of some of the research in this area.

The paper goes over various papers that have looked at this question. Despite what appears to be a bias in favor of the notion that inequaility is bad for growth, it does provide some good discussion on the topic.

It seems clear to me that the issue of whether or not inequality is bad for growth or even good for growth is definitely still an open question.

The section on inequality and redistribution is also pretty good. It looks at several approaches to redistribution.

The first are models with a median voter. The author notes several problems with these models, such as that for the model to work well political power must also be symmetrically distributed (definitely a questionable assumption). Although he does not mention that the median voter results typically only apply when there is a single issue. Since most elections are over a range of issues, with redistribution being but one, the use of the median voter is even more problematic.

One interesting suggestion is that inequality is bad for growth and that redistribution is good because with higher incomes the poor can make more efficient investments than with lower incomes. While this might sound strange at first (poor people watching the financial news to try an decide which stocks to invest in) if you include human capital investment (i.e., education) it doesn't seem so strange. The only problem though is that this assumes that the additional income will be used for education, if it isn't then the results probably wouldn't hold.

Another idea is rent seeking (rent seeking is where a group seeks benefits for the group at the expense of others not in the group) can lower growth. Rent seeking in and of itself is non-productive so right off the bat any resources used for rent seeking would likely reduce growth. Further, it is quite likely that rent seeking will divert resources from investments with a higher return to those with a lower return, thus lowering growth.

I am not sure I agree that this means that redistribution will be good for growth though. I suppose this might be the case if redistribution were a one time event. However, if it is not, then I would think some attention needs to be given to possible perverse outcomes of people deciding to take more leisure (i.e. work less, or not as hard) and use the redistributed income to offset the decrease in labor income.

Also, I am not convinced that redistribution will even work here. After all, redistribution is again a type of rent seeking. One issue in rent seeking is competition by different groups for the rents (i.e., benefits). Suppose something is worth $100 to both you and I. Then we would both be willing to spend $99 dollars to "aquire" it, thus most of the benefit does not go to us, but to whomever we are spending the money on to secure this rent. Basically I see it as another reason not to let the government get involved. It is not clear at all to me that he "better" outcome has to result.

Unfortunately the author doesn't really provide any theoretical reasons as to why inequality might be good for growth (which is what some empirical research has shown).

Overall, not a bad paper in that it provides a good starting point of what other papers to look at.

Posted by Steve at June 9, 2003 11:48 AM