Inequality can be both good and bad for growth, depending on what inequality and whose growth. Unequal societies may be holding back one segment of the population while helping another. Similarly, high levels of inequality may be due to a variety of factors; some good, some bad for growth.
This column tests this hypothesis by “unpacking” both inequality and growth: Inequality is decomposed into inequality of opportunity, due to factors that are beyond the individual’s control, and residual inequality, while growth is measured at different steps of the income ladder. An application to the United States covering 1960 to 2010 finds that it is mostly inequality of opportunity that is limiting the growth prospects of the poor. That would suggest that policies that equalize individual opportunity may promote not only equity but also economic growth – above all for poor individuals.
Inequality can be both good and bad for growth
Much has been written about the relationship between inequality and economic growth, yet a consensus on (even) the sign of this relationship has yet to emerge: Is high inequality today good or bad for future income growth prospects? What makes this a difficult question to answer is the fact that there are arguably a variety of different channels via which inequality impacts on growth. Early thinking viewed inequality as a positive factor. Kaldor (1956), for example, considers income inequality as necessary in order to provide for savings (the rich save more than the poor), and thus key for capital accumulation and economic growth. Also, more unequal societies may provide stronger incentives which ultimately motivate individuals to work harder in order to succeed.
More recent studies explore the conditions under which inequality may act as a negative factor. One strand of this literature appeals to the Meltzer-Richard’s median voter hypothesis, see e.g. Persson and Tabellini (1994) and Alesina and Rodrik (1994). It is argued that high inequality leads a relatively poor median voter to vote for high tax rates, which in turn reduce incentives for investment and cause low growth. However, one could argue that a poor median voter might also vote for redistributive policies that are not necessarily bad for growth, as for example, investments in public education (Saint Paul and Verdier, 1996). Galor and Zeira (1993) and Banerjee and Newman (1993) put the emphasis on credit market imperfections, namely the inability of the poor to get loans to finance their education and to be entrepreneurs. More unequal societies may then be more prone to wasting human resources, which would lead to lower growth. This view was, in the case of Galor, integrated with his overall argument that, in modern societies, the key to fast growth is not capital accumulation but improvements in human capital (Galor and Moav, 2006).
Inequality of opportunity is mostly bad for growth
Marrero and Rodríguez (2012, 2013) decompose total inequality into an inequality of opportunity (IO) component (Roemer, 1993), the inequality that is due to circumstances outside the person’s control such as parental education, race, country of origin, and a residual inequality component that is assumed to be due to effort and luck (Bourguignon et al., 2007). In two separate applications, one to the European Union member countries and one to the US states, they find strong evidence that levels of inequality of opportunity are negatively correlated with growth while the residual (“good inequality”) tends to help growth. The rationale is that IO may harm economic growth because it favors human capital accumulation by individuals with better social origins, rather than by individuals with more talent. Perceptions of unequal opportunities may also reduce investments in human capital to the extent that they affect individual aspirations.
Other empirical studies have obtained similar results. Hsieh et al. (2013) find that occupational barriers faced by minorities was bad for growth in the US between 1960 and 2008. Bradbury and Triest (2016), using measures of absolute and relative intergenerational mobility as proxies for equality of opportunity, find that mobility has a positive effect on future economic growth. It has proven harder to reproduce the negative relationship between IO and growth using cross-country data, see Ferreira et al. (2014), either because the relationship does not hold true in all countries, or because the data are not strictly comparable across countries.
Inequality of opportunity is particularly bad for the poor
To study how IO affects the income growth of individuals at different steps of the socio-economic ladder, one must also unpack growth. In an earlier study, van der Weide and Milanovic (2014) found that higher inequality favors the growth prospects of some (the rich) while it limits the growth prospects of others (the poor). To what extent is this relationship channeled through inequality of opportunity? Marrero, Rodríguez and van der Weide (2016) try to answer this question by “unpacking” both inequality and growth.
Using individual level data for the United States covering the period 1960 to 2010, they compute state level measures of IO, total inequality, and income growth rates at different steps of the income distribution. The same data is used to derive a set of controls including variables on education, employment and demographics. The IO measure of choice quantifies the degree to which race and gender determine a person’s income success (the IPUMS-USA does not include information on parental education). Alternative measures of IO are considered for robustness.
The study confirms that total inequality is negatively correlated with future income growth of the poor and positively correlated with income growth of the rich. Adding IO to the regression reveals that this correlation between inequality and growth is largely channeled through IO, leaving the effect of total inequality mostly insignificant. The robustness analysis confirms that this is particularly true for the poor: It is mostly IO that is holding back the growth prospects at the bottom end of the income distribution. While there appears to be a positive correlation between total inequality (as well as IO) and income growth of the rich, this association is not as robust. This result, if confirmed by more studies, is potentially very important: it identifies the type of inequality which holds back growth chances of the poor.
Future research will hopefully shed light on how IO is affecting a person’s income success. It is conceivable that IO proxies, unequal access to good schooling or discrimination in the labor market, to name two candidate channels, either of which signifies that inefficiencies that will disproportionally affect the growth prospects of the disadvantaged.
Promoting inclusive growth
This would suggest that policies that equalize individual opportunity may promote not only equity but also economic growth – above all for poor individuals. One way of equalizing opportunity is by increasing public spending on the education of children from disadvantaged backgrounds or promoting cash transfers conditional on school attendance. Empirical findings for Europe show that reducing high school dropout rates is an effective way of increasing opportunities (Marrero and Rodríguez, 2012). An equalization of the quality of public and private education too will arguably help to reduce IO. Other policy interventions may include reducing long-term unemployment, improving access to child care etc. In curbing IO these policies promote not only social justice but plausibly also economic growth. It is unclear however where the push for such inclusive growth policies will be coming from, when those in power stand to gain the least from such policies.