There is a subtle relationship between inequality, redistribution, taxes and growth, according to research by Weijie Luo, to be presented at the Royal Economic Society”s annual conference at the University of Sussex in Brighton in March 2018. Labour income inequality is bad for growth, the study finds, but inequality driven by differences in capital income is, it seems, good for growth.
The research makes use of new panel data for the OECD on the two different types of inequality. It finds that economic growth is positively and statistically significantly related to capital income inequality. The estimated relationship is sizable: a one standard deviation increase in capital income inequality is statistically correlated with a 0.9% increase in average annual growth over the next five years.
But once capital income inequality is controlled for, then the impact of labour income inequality becomes negative.
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Is inequality harmful for economic growth? A common argument is that a more unequal distribution of income implies divergence between mean and median income and so, under universal suffrage, raises redistribution, under the assumption that the median voter is decisive. Such redistributive policies are financed by distortionary taxes, in principle affecting investment and growth-promoting activities. According to this reasoning inequality is bad for economic growth.
On the other hand, inequality might provide the necessary incentives for a successful economy. Perhaps because of this, earlier cross-country studies generally find little relationship between growth and overall inequality.
The standard argument given above applies to income inequality stemming from differences in taxable labour income. But traditional supplied labour is not the only source of income, especially for the rich, and moreover, the labour share of income has declined in recent years. This study argues and finds evidence that greater capital income inequality instead leads to reduced demand for redistribution and thus higher growth since distortionary taxes fall and investment is facilitated.
The key issue is that labour income is taxable, while income from capital is harder to tax. Evidence abounds of tax evasion or avoidance in the case of the latter. It is harder to escape from PAYE.
Like labour income, the capital income distribution is in practice right-skewed with the majority of individuals endowed with limited (or zero) assets or wealth. Individuals with limited capital income are compelled to supply labour for their income, which is taxed. On the other hand those paid in capital income are to a meaningful extent able to avoid the same tax obligation. In short greater capital income and greater inequality in capital income reduce the capacity of the median voter to redistribute successfully.
If capital income inequality increases, and it is the rich who enjoy capital income, then the labour income tax rate chosen by the median voter falls. While this may be problematic as far as welfare in the short run is concerned, the subsequent rate of growth increases because distortionary taxes fall and capital accumulation is less constrained.
The study makes use of new panel data for the OECD on the two different types of inequality in order to test the hypothesis. As conjectured the study finds that economic growth is positively and statistically significantly related to capital income inequality. The estimated relationship is sizable: a one standard deviation increase in capital income inequality is statistically correlated with a 0.9% increase in average annual growth over the next five years.
Moreover this study also finds that once capital income inequality is controlled for, then the impact of labour income inequality becomes negative, as originally conjectured and in contrast with previous empirical investigation using aggregative measures of inequality.
The bottom line is a subtle relationship between inequality, redistribution, taxes and growth. Labour income inequality is bad for growth, but on the other hand inequality driven by differences in capital income are it seems good for growth.
Inequality and Growth in the Twenty-First Century by Weijie Luo, Department of Economics, University of York.
