Benefits don’t trickle down: Increase in income share of top 20% by 1% leads to decline in GDP by 0.08% in next five years

poverty-1Excerpts from the latest International Monetary Fund (IMF) report, “Causes and Consequences of Income Inequality: A Global Perspective”, by Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta:

Widening income inequality is the defining challenge of our time. The extent of inequality, its drivers, and what to do about it have become some of the most hotly debated issues by policymakers and researchers alike. Earlier IMF work has shown that income inequality matters for growth and its sustainability. Our analysis suggests that the income distribution itself matters for growth as well. Specifically, if the income share of the top 20 percent (the rich) increases, then GDP growth actually declines over the medium term, suggesting that the benefits do not trickle down. In contrast, an increase in the income share of the bottom 20 percent (the poor) is associated with higher GDP growth.

Inequality within most advanced and emerging markets and developing countries (EMDCs) has increased, a phenomenon that has received considerable attention. A recent Pew Research Center (PRC 2014) survey found that the gap between the rich and the poor is considered a major challenge by more than 60 percent of respondents worldwide, and Pope Francis has spoken out against the “economy of exclusion.” Indeed, the PRC survey found that while education and working hard were seen as important for getting ahead, knowing the right persons and belonging to a wealthy family were also critical, suggesting potential major hurdles to social mobility.

Widening inequality has significant implications for growth and macroeconomic stability, it can concentrate political and decision making power in the hands of a few, lead to a suboptimal use of human resources, cause investment-reducing political and economic instability, and raise crisis risk. The economic and social fallout from the global financial crisis and the resultant headwinds to global growth and employment have heightened the attention to rising income inequality.

Some degree of inequality may not be a problem insofar as it provides the incentives for people to excel, compete, save, and invest to move ahead in life. For example, returns to education and differentiation in labor earnings can spur human capital accumulation and economic growth, despite being associated with higher income inequality. Inequality can also influence growth positively by providing incentives for innovation and entrepreneurship, and, perhaps especially relevant for developing countries, by allowing at least a few individuals to accumulate the minimum needed to start businesses and get a good education.

High and sustained levels of inequality, especially inequality of opportunity can entail large social costs. Entrenched inequality of outcomes can significantly undermine individuals’ educational and occupational choices. Further, inequality of outcomes does not generate the “right” incentives if it rests on rents. In that event, individuals have an incentive to divert their efforts toward securing favored treatment and protection, resulting in resource misallocation, corruption, and nepotism, with attendant adverse social and economic consequences. In particular, citizens can lose confidence in institutions, eroding social cohesion and confidence in the future.

If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth. This positive relationship between disposable income shares and higher growth continues to hold for the second and third quintiles (the middle class).

Higher inequality lowers growth by depriving the ability of lower-income households to stay healthy and accumulate physical and human capital. For instance, it can lead to underinvestment in education as poor children end up in lower-quality schools and are less able to go on to college. As a result, labour productivity could be lower than it would have been in a more equitable world. Countries with higher levels of income inequality tend to have lower levels of mobility between generations, with parent’s earnings being a more important determinant of children’s earnings.

Increasing concentration of incomes could also reduce aggregate demand and undermine growth, because the wealthy spend a lower fraction of their incomes than middle- and lower-income groups. A growing body of evidence suggests that rising influence of the rich and stagnant incomes of the poor and middle class have a causal effect on crises, and thus directly hurt short- and long-term growth. In particular, studies have argued that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation in mortgage-underwriting standards, and allowing lobbyists to push for financial deregulation.

Extreme inequality may damage trust and social cohesion and thus is also associated with conflicts, which discourage investment. Conflicts are particularly prevalent in the management of common resources where, for example, inequality makes resolving disputes more difficult. More broadly, inequality affects the economics of conflict, as it may intensify the grievances felt by certain groups or can reduce the opportunity costs of initiating and joining a violent conflict.

Income inequality affects the pace at which growth enables poverty reduction. Growth is less efficient in lowering poverty in countries with high initial levels of inequality or in which the distributional pattern of growth favors the nonpoor. Moreover, to the extent that economies are periodically subject to shocks of various kinds that undermine growth, higher inequality makes a greater proportion of the population vulnerable to poverty. The top 1 percent now account for around 10 percent of total income in advanced economies. While data on top income shares is scant for most EMDCs, available evidence suggests that the share of top incomes has risen in China and India.

About half of the income of the top 1 percent constitutes non-labour income compared with 30 percent for the top 10 percent as a whole. For instance, corporate profits have been translated into strikingly high executive salaries and bonuses, exacerbating income inequality, a pattern that is observed across both advanced and large emerging market economies.

While health outcomes are broadly similar across income groups in advanced countries, large disparities exist in EMDCs. For example, the infant mortality rate is twice as high in the poor than in the rich households (in terms of wealth) in emerging market economies. Similarly, female mortality rates tend to be disproportionately higher for lower-income groups. Commonly used indicators to gauge access and use of health care are generally favorable in advanced countries, irrespective of the income level of the population. For EMDCs, however, data on access to skilled health personnel for births suggest that there are large disparities in health access across income levels within developing countries, and to a lesser extent in emerging market countries.

Evidence from larger emerging market economies shows a trend of growing earnings gap between high- and low-skilled workers despite a large rise in the supply of highly educated labour (which should reduce the gap). More flexible labour market institutions can foster economic dynamism by reallocating resources to more productive firms and enabling firm restructuring. However, greater flexibility can pose challenges for workers, especially those with low skills, and hence play an important role in explaining inequality developments. A decline in trade union membership (union rate) could reduce the relative bargaining power of labor, exacerbating wage inequality.

In many EMDCs, the combination of rigid hiring and firing and employment protection regulations and weak income protection systems often encourages informality, fueling wage inequality. However, evidence from a large sample of countries suggests that de facto labour market regulations (such as minimum wages, unionization, and social security contributions), on average, tend to improve the income distribution. In particular, a decline in organized labour institutions and the resultant easing of labor markets measured by an increase in labor market flexibilities index by 8½ percent is associated with rising market inequality by 1.1 percent.

In EMDCs, making labor markets more inclusive and creating incentives for lowering informality is a key challenge. Workers in these countries often lack equal access to productive job opportunities and do not benefit evenly from economic growth. Many individuals with low skills, in particular, remain trapped in precarious jobs, often in the informal and unregulated economy. In such jobs, even full-time employment tends to be insufficient to lift households out of poverty. Thus, creating accessible, productive, and rewarding jobs is key to escaping poverty and reducing inequality. Informal workers need to have the necessary legal, financial, and educational means to access formal sector employment. Higher formal sector employment also requires better incentives for firms to become formal.

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