Published in The National Business Review (Auckland), 3 June 2016
Perhaps the defining global economic issue of this decade has been inequality. The notion that a free market economy promotes inequality is having an impact on the political climate.
Concerns about inequality are responsible for the rise of populist leaders. They are behind calls for more redistributionist policies to compensate the losers of globalisation. They are at least partly to blame for the growing public suspicion of and resistance to trade agreements.
What is remarkable about this development is the fact that these concerns are increasingly shared not just by the critics of the market economy but also by its proponents.
In early 2014, the International Monetary Fund claimed to have found three facts about inequality: First, that more unequal societies tended to redistribute more. Second, that lower net inequality was correlated with faster and more durable growth. And third that redistribution appears generally benign in terms of its impact on growth.
Later that year, the OECD joined in with its own research report. That too claimed reducing income inequality would actually boost economic growth. And just like their IMF colleagues, the OECD claimed there was “no evidence that redistributive policies, such as taxes and social benefits, harm economic growth, provided these policies are well designed, targeted and implemented.”
From a first principles economics perspective, both findings are surprising and counterintuitive. They are just not what economists would expect, all other things being equal.
To put it in the simplest terms, without a redistribution mechanism people would work hard to make money. That is because they would be able to keep all the income they generate. It is therefore hard to imagine that a redistributive system designed to reduce income inequality would have a positive effect on general income levels. Quite the reverse is true: We would expect the decline in income inequality to be achieved at the expense of lower incomes.
Now, of course there may still be reasons to have a degree of income redistribution built into the system regardless of such economic efficiency considerations. Democratic societies might just not tolerate extreme differences in income or insist on providing a “safety net.” It may well be necessary to introduce some taxes and benefits.
But we would still not expect such measures to have a positive impact on average incomes. If they did, they would put a big question mark over some core assumptions of economic theory. There is still hope for economics, however. And it comes in the unlikely form of a working paper written by two Danish economists, Torben Andersen and Jonas Maibom, both of the University of Aarhus: “The trade-off between efficiency and equity” (CEPR Discussion Paper 11189). Thankfully, the authors also produced a non-technical summary of their findings on the Centre for Economic Policy Research’s Vox portal (see link below).
The scatter diagram shows OECD economies (in 2010) by their Gini coefficient and their per capita incomes. Countries toward the right of the plot are characterised by greater income equality than countries on the left.
What is not surprising is the linear regression. The upward sloping blue line is compatible with the findings from the OECD and the IMF. That is, it suggests that rising equality goes hand in hand with rising per capita incomes.
What is new is the red line that on top. They call it the “frontier of the possibility set.” This is the maximum income for any level of equity and vice versa. At the frontier it is impossible to improve one measure without harming the other.
It shows countries that have opted for different combinations of per capita incomes and inequality. On one extreme, the US has high incomes and equally high levels of income inequality. On the other extreme, Scandinavian countries have a much greater focus on equality which comes at the price of a (modest) reduction in per capita incomes.
As the authors note: “It is interesting that countries that are often highlighted in policy discussions as ‘model examples’ like the US, Switzerland and the Nordic countries have consistently been at or close to the frontier. For countries well inside the opportunity set, it is an implication of this study that they have scope for improvements in both economic performance and income equality by moving closer to the frontier.”
This means countries that have stable and growth-conducive economic and political institutions have to make a choice between higher per capita incomes and lower inequality.
It is therefore not telling us much that, on average, lower inequality correlates with higher incomes. It could well be that some of these countries are just not achieving enough per capita income given their inequality levels because they are held back by their socio-political settings.
Take Greece. No one would think of Greece as a well-managed economy. Its inequality as measured by the Gini coefficient, however, is not far off that of the US. But this does not mean Greece should aim to redistribute more to get richer. Rather, the country needs to implement structural reforms to increase its per capita incomes.
Messrs Andersen and Maibom have managed to debunk (or at least call into question) the much hyped studies by the OECD and the IMF and their calls for greater redistribution. And they show that there is still hope for economics.