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On Income Inequality and Economic Growth

By       Message Seymour Patterson     Permalink
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Recently, a polling of some economists on the nagging poor performance of the U.S. economy concluded that the source of the problem is growing income inequality. Paul Krugman made the case that a shrinking economic pie and a declining share of that pie have contributed to the rise in income inequality. And Stiglitz ( CommonDreams ) faults a weak middle class unable to support aggregate spending. He refers to "the hollowing of the middle class in the 1970s," which has hurt tax revenues.

We now also have income inequality, which often leads to economic instability. This is the result of government policies that adversely affect a more equal distribution of income. Among them are cuts in marginal top tax rates, persistent unemployment, and the weakening of unions (through the implementation of right-to-work laws). Certainly, these are not the only factors that impact how income is distributed in any society. It also depends on such things as education, skill, talent, race, sex, age, and so on. Collectively, all these things contribute to the overall measure of income inequality within a group or the broader population.  

Income inequality refers to differences in the distribution of the economic pie among groups (households or individuals) within the population. It has implications for economic growth, because there are differences in spending habits between low-income recipients and people in high-income brackets. The former tend to spend more on consumption than the latter. And more consumption (i.e. spending) is needed in bad economic times to increase profits, which in turn encourage producers to hire more workers to produce more goods to meet the higher spending demand. The increase in income inequality, therefore, is a reverse Robin Hood pathology that can stymie economic growth.  

Consider two measures of money income distribution among 118,682,000 U.S. households in 2010 that speak to both the disparity in income and the rise in that disparity. One measure shows the actual distribution for different income brackets as a share of households. For instance, in 2010 13.7 percent of households had incomes below $15,000; 17.7 percent had incomes between $50,000 and $74,999; and 3.9 percent of households had incomes of $200,000 and over. What this tells us, with some caveats, is that there are more people (13 percent) with incomes below $15,000 than there are people (3.9 percent) with incomes of $200,000 and above.

On the other hand, an overall measure of income inequality is the Gini Coefficient (or Index), which for the U.S. in 2010 was 0.469 (in 1979 it was 0.404). A Gini index of 0 implies perfect income equality (i.e. no inequality), while a Gini index of 1 means perfect inequality. An index of 0.469 might suggest a rise in inequality in the U.S. between 1979 and 2010. (See   Wikipedia   Table C for data.) Why does any of this matter? Income inequality is a fact of life, and some people might even celebrate it as necessary for economic growth because it gives people something to strive for. If people had equal shares of income, there would be no incentive to work hard and succeed. The counterargument to this, however, is that income inequality has a negative effect on economic growth, since it can cause a shift of funds from investment in human capital (education) to an increase in high-end consumption (yachts, for example).   

Cuts in Top Marginal Tax Rates  

Elsewhere (   Marginal Tax Rates   ) I have addressed the effects of cuts in the top marginal rates on economic performance. Here, however, I relate these cuts to the rise in income inequality. Cuts in the top marginal tax rates increase income inequality on the face of it, reducing the progressivity of the tax. With these cuts, the people at the top see an immediate rise in their after-tax incomes.

Some might argue that these cuts are needed to stimulate economic growth, because they encourage greater investment in difficult economic times. They maintain that top marginal tax rates cuts don't lead to income inequality and stifle economic growth. On the contrary, these tax cuts stir the job creators into action, leading to a flurry of new investment, hiring, and economic growth. This begs an important question, however. If job creators see untapped profitable investment opportunities in the marketplace, why do they need the incentives of tax cuts to pounce on them?

I'll posit that these cuts do in fact increase the income gap between the rich and the poor. Why? I have argued this before and I will not repeat the rigor of the argument here. However, high income tax rates on top earners are, in a counterintuitive way, incentives to invest and grow the economy. That's because these taxes are confiscatory and people (the rich) have an incentive to avoid them. There are two easy ways to legally avoid paying top tax rates to the government. First, you can spend pretax earnings on growing your business through investment in capital improvements, better working conditions, and human capital (i.e. education and training), etc. Second, you can pay the people who work for you more. In either case, you will report lower profits on your income (earning) statement and pay less in taxes to Uncle Sam.

On the other hand, cuts in top tax rates lead to smaller increases in wages and fewer capital improvements, but more spending on high-end goods. So the gap between the wage earner and the profit seeker widens--i.e. income inequality grows and economic growth suffers. To lend a bit of lucidity to this point, consider the following illustration: First note that, according to   Forbes   ,   there are 403 billionaires in the U.S. in a population of 314 million. They represent a tiny sliver of the U.S. population, but they are in the top 1 percent of income earners and have enormous buying power. To be in the top 1 percent, you have to earn an average gross income of $343,927 or more. And if you are so blessed, since the Great Recession you have seen your fortunes rise: about 95 percent of all U.S. gains in income went to the top 1 percent. But if your source of income is wages and salaries, your slice of the economic pie shrank. (See   Harry Bruinius   .)

Some people think there's nothing wrong with this. Some think this is good and that the problem is not the inequality in income distribution but envy, and that rising inequality is good for the economy because rich people tend to spend less of their additional income than poor or middle-class people. The rich save and invest; the poor consume (spend). Perhaps this is so, because if you are rich all your basic needs can be easily met. When all factors are considered, the logical inference is that to grow the economy it might be wiser for policymakers to reduce inequality through tax policies that favor the middle class (and the poor). This would lead to a spurt in consumption that would find its way back to government coffers in the form of more revenues from economic growth.  

Persistent Unemployment  

The U.S. economy has been recovering since the Great Recession of 2008, albeit very slowly. The unemployment rate sits a 7.3 percent, which is high. It might have been lower if it were not for sequestration and, at least temporarily, the government shutdown. The loss of government jobs at the state level only exacerbated the employment and income inequality problem. Unemployment does not only represent lost opportunities for the unemployed; it also represents a loss in potential domestic output. Persistent high unemployment increases inequality, which has consequences for long-term economic growth.

But there is also another problem that unemployment is associated with. With high unemployment, a redundancy of workers means wages don't rise further, thereby contributing to income inequality. Moreover, any productivity gains in labor simply translate into higher wages for CEOs and other individuals in the upper income classes. To understand how this happens, consider the relationship between profits, revenue, and labor costs. Profits are the result of the difference between revenues (from, say, sales) and costs. To increase profits you can increase sales or reduce costs, or find some combination of both that produces more sales and lowers costs. Costs can be reduced through layoffs and/or lower wages. Both factors can be in play during a recession. But more insidious are policies that enable companies to profit from keeping unemployment high, or that increase profit shares by failing to pass on the benefits of productivity increases to workers in the form of higher wages. The result of such policies is to keep more income flowing to the top while worker income stagnates or falls. That can only lead to more income inequality, which harms long-term economic growth.  

The Weakening of Unions Strategy   

Over the years, the assiduous assault on unions in the workplace has borne fruit. Unions are weak. Wisconsin governor Scott Walker's successful campaign against public unions in 2011 is among the most recent, contentious, and public contest. But the assault on unions is a long-standing effort that has legal standing. Since the passage of Taft-Hartley in 1947, 22 states have adopted right-to-work laws. If you live in one of these states you don't have to join a union and pay union duties as a condition of employment. But these workers are still entitled to negotiated union benefits. On the surface this seems like a good thing--giving workers the choice to join or not to join a union. However, it has the effect of weakening unions, because workers can become freeloaders or free riders. And weak unions cannot be a counterweight against management when management tries to ride roughshod over their workers. While wages have virtually stagnated, profits have been going through the roof, thus widening the inequality between worker income and CEO income.  

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Seymour Patterson received a Ph.D. in economics from the University of Oklahoma in 1980. He has taught courses and done research in international economics and economic development. He has been the recipient of two Fulbright awards--the first in (more...)

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On Income Inequality and Economic Growth