What is the relationship between inequality and economic performance? Inequality within many countries has risen over the last 30 years, while that between them has fallen as poorer nations such as China have been ‘catching up’ with richer ones.
Many non-mainstream or heterodox economists, as well as some more mainstream but left-liberal figures such as Joseph Stiglitz, have argued that rising inequality and wage stagnation among middle and lower income groups was part of the cause of the excessive accumulation of private debt which led to the financial crisis.
A 2014 study by the OECD has shown that reducing inequality could significantly boost growth. The study suggests that improved educational attainment among the poorest members of society, as well as some redistribution through taxation and public spending, could lead to larger increases in GDP over a number of years.
The OECD study focusses on the supply-side. So do many economists and commentators arguing for the importance of low tax rates on individual incentives to create wealth. But it ignores the demand-side effects on growth of changes in inequality.
If the poorer members of a society have a higher marginal propensity to consume than the rich, then a narrowing of the distribution of income could lead to faster growth in consumption. This should stimulate investment, providing that the latter is constrained by consumption rather than by saving. At less than full employment, with spare capacity in the economy, this will arguably be the case.
If the consumption levels of the poorer groups in society is raised, this will tend to create a larger market demand for goods and services in the economy. Raising the incomes of the wealthy is more likely to lead to higher savings or the consumption of luxury goods which are produced on a relatively small scale. Greater demand from lower income groups will not only raise GDP but also productivity, due to greater economies of scale in production.
Factors on the demand-side can therefore work in the opposite direction to supply-side incentive effects. The latter do matter, but it is important to not consider them in isolation from other economic forces. The overall outcome of changes in distribution on economic performance may therefore be subject to great uncertainty, due to the complex interaction of a variety of influences.
The effect of changes in distribution on demand-driven growth is usually ignored by mainstream economists. However there is a rich literature on the topic among heterodox schools. Post-Keynesians, in particular, believe that growth is usually demand-driven. If they are right, changes in the balance between classes of income such as wages and profits will have an effect on the evolution of aggregate demand and output. The balance of power between different groups in society can also be an important influence on the distribution of income; as ever, taking a political economy approach to economic and social evolution can be more informative than the narrower economics of mainstream theorizing.