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Inequality and growth

By Matthew Smith - posted Monday, 31 July 2017


The recent public concerns raised by Bill Shorten, leader of the Labor opposition, and others, about the widening income inequality in Australia is not before time. 

Like all advanced capitalist countries there has been a persistent redistribution of income in favor of the highest income earners in Australia since the late 1970s. 

Hence, according to the reputable ‘World Wealth and Income Database’, in 1977 the top 10% income earners had a 24% share of total Australian income, by 2014 it rose to 32%. The top 1% rose from 4.7% to 9.1% over the same period. In other advanced capitalist nations this long-term trend in income inequality has been even more marked, with the top 10% in the United States increasing its share of income from 31% in 1977 to 50% in 2015; in Germany it rose from 32% in 1977 to 39% in 2014, in France from 32% to 37%, in the United Kingdom from 28% to 40%, and in Japan 32% in 1977 to 42% in 2010. This trend in inequality has generally been associated with a sizable decline in the share of the bottom 50% income earners.  

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Since the path-breaking study by the French economist Thomas Piketty, Capital in the Twenty-First Century, in 2014, most economic scholars in the academic community have well accepted the occurrence of this ongoing trend in income inequality in advanced capitalist nations, which has been mirrored by increasing wealth inequality. More broadly, comprehension of the phenomenon has raised considerable questions about the morality of an economic system that produces increasing inequality and, moreover, is associated with an increase in poverty, especially in nations with weak social welfare systems.

There are a number of factors which have contributed to this growing income inequality: the reduction and removal of capital and property taxes; a general shift from direct to indirect taxation as well as a weakening in corporate tax compliance; the widespread adoption of user-pay for public services; the adoption of pro-business industrial relations laws aimed at weakening organized labor; the emerging power of corporate management to appropriate large earnings; the migration of manufacturing mainly to Asian developing nations associated with globalization; and, most importantly, persistent labor unemployment (and underemployment) that has undermined the bargaining power of labor to share in the income gain of productivity growth.  

An overarching element has been the adoption by governments of ‘neo-liberal’ policies of market deregulation and privatization in an attempt to reduce the role of government and, connectively, a decided shift in the objectives of macroeconomic policy from maintaining full-employment to that of reducing price inflation and keeping it low to ensure the higher real value of returns on portfolio wealth.

But besides the immorality of this growing income inequality that is noticeably undermining the stability of liberal political systems, what are its economic implications, if any? Some argue that inequality is necessary to provide the incentives for greater sacrifice and harder work that delivers stronger economic growth. 

Actually, in orthodox economics, there is little definitively that can be said about the effect of changes in the distribution of income on growth. In orthodox supply-driven growth theory, trend growth basically depends on the growth of labor and capital inputs as well as technical progress such that greater inequality in the distribution of income will only affect the structure of demand for goods and services with more luxuries consumed in proportion to necessaries. 

However, depending on the particular supply-driven growth model chosen, greater inequality in distribution can be argued to contribute to stronger growth through a higher saving rate. But these orthodox growth models suppose unrealistically that economies grow continuously at full-employment and, moreover, have serious theoretical problems that mean they are only valid for ‘fantasy’ economies which produce a single product.            

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To understand why greater inequality in the distribution of income has a detrimental effect on economic growth we have to refer to the alternative demand-led theory of growth which has its origins in John Maynard Keynes’s theory of output and employment of The General Theory (1936).  In this growth theory it is the growth in aggregate demand which determines the growth of national output and employment. In this theory trend growth is conceived to occur normally along with the existence of unemployed labor and unutilized capital stock.

In the demand-led theory of growth a change in the distribution of national income effects growth by effecting the growth of aggregate demand. Hence, the redistribution of income progressively from lower to higher income earners will tend to reduce the long run growth rate of consumption which, will, in turn, constrain the growth of private capacity-adjusting investment and, overall, aggregate demand. This will occur because high-income earners typically spend a smaller proportion of their income than low-income earners. What is called the long-run propensity to consume in society, being the ratio of consumption spending to  household income, will decline (while symmetrically the saving rate increases), reducing the income and employment multiplier effects of private capital and government spending. In addition, low growth in private expenditure, income and employment will tend to reduce the growth in taxation revenue and tend to discourage government spending.

From the standpoint of this more theoretically valid and realistic growth theory policymakers ought to have a strong interest in maintaining a more equal distribution of income in order to promote higher economic growth and higher living standards for all. And the historical evidence supports this argument. In the post-World War II period of 1947-1977, when there was a reduction in the inequality of income distribution and policymakers gave priority to maintaining very low unemployment, the average growth rate of the advanced capitalist nations, including Australia, was significantly higher than the following 30-year period of 1978-2008, when income inequality grew. If the current structural inequality in income distribution is not addressed by policymakers and continues to widen, growth in Australia and other advanced capitalist nations will be weighed down by low consumption growth.

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About the Author

Matthew Smith is a Senior Lecturer at the School of Economics, University of Sydney, with publications in growth economics.

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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