The link between inequality and sustainable development

The debate over how inequality affects growth has been raging for decades.  Mostly, the discussion centers on developed nations.  In particular, the issue has come to the fore in recent election cycles in Europe and the US.  But this is an important issue for all nations, and especially small island developing states, to deal with as they struggle with how to create policies that boost sustainable development while building their middle class.

Photo: ant.photos

The Economist recently published a special report on the world economy that focused directly on the causes and consequences of growing inequality in the world today.  In this article we outline their sober reporting, along with the prescriptions they recommend.

The changing face of inequality

Until the industrial revolution the income gap between the richest and poorest nations was small.  The gap within nations, on the other hand, could be extreme – caused mainly by a ruling elite that held the reins of power and amassed significant wealth.  Social mobility and educational opportunities were practically nonexistent outside of this ruling class.

The industrial revolution brought with it substantial increases in productivity, which led to better wages and a growing middle class.  Factory workers, for instance, lived far better than rural laborers.  During this period income gaps between the newly industrializing countries widened significantly over less developed nations.

Over time, as the middle class grew with these economies, the gains they enjoyed became codified through legislation, tax policy, and institutional reforms.  Unions, for example, locked in wage and pension benefits, while increasingly progressive income taxes caused a form of redistribution to the poor.  As a result, the income gap between those with the highest and lowest incomes within developed countries shrank.  This trend accelerated following World War I and continued until the 1970s.

Beginning in the 1980s, however, two trends caused a reversal of the narrowing income gap.  The industrial revolution gave way to the information revolution, which caused a further burst in productivity.  Except this time the gains were shared throughout the world, allowing those in developing countries to compete with workers in the developed world.  This, in turn, caused stagnation in wages within the middle class in developed countries as many jobs were exported overseas.

At about the same time, again mostly in developed countries, policy changes led to fewer regulations, particularly in the financial sector, and changes to the tax code that reduced marginal tax rates.  These changes created growing wealth at the top of the income scale, and ever widening gaps in income equality.

The consequences of sustained inequality

Just as changes in legislation and tax policy lessened income gaps following the Great Depression, recent changes in the opposite direction have led to reversals and widening inequality in developed countries, especially in the US.  Some argue that globalisation is largely to blame, but several studies have found that only 10-15% of the wage gap can be explained by a flattening economic landscape.

Another argument made in support of less progressive tax schemes suggests that high marginal tax rates are inefficient as an income redistribution tool.  Evidence suggests this may be true, especially when the top marginal rates exceed 80%.  However, recent studies show that inequality, in and of itself, can be inefficient.  As The Economist reports, “they found that growth was more persistent in more equal countries, and that income distribution mattered more for the length of growth spells than either the degree of trade liberalization or the quality of a country’s political institutions.”

Likewise, links have been found between higher rates of income inequality and social mobility.  In other words, the larger the income gap the fewer the opportunities available for those at the lower ends of the scale.

What these studies suggest, collectively, is that inequality leads to lower growth rates.  It might even lead to macroeconomic instability, as suggested by Raghuram Rajan in his recent award winning book, Fault Lines.

How to increase growth and lessen inequality

But what to do?  As much as left leaning politicians might pine for a modern-day Robin Hood, blaming an entire sector or class certainly isn’t the answer.  Following their analysis, The Economist suggests three broad reforms to spur growth and lessen inequality.

First is the need to restrict cronyism and enhance competition, through the removal of corporate subsidies, increased enforcement of competition laws, improved financial regulations, and more effective corporate governance.  Essentially, these reforms level the playing field rather than serve entrenched interests.

Second is a shift in government spending – from income transfers to increases in educational outlays, fewer subsidies and more social safety nets, and less for older, richer people and more for younger, poorer people.  Essentially, such shifts amount to an attack on inequality through more targeted and progressive social spending.

Lastly, The Economist suggests reforming the tax code so that it is more efficient and fairer.  “In most countries other than America,” they report, “government spending is a much more important tool for combating inequality than the tax system.”  In instances where the state is already large, rebalancing government spending is preferable to raising more revenues.

In this regard, small island developing states face a careful balancing act.  For many, given their limited resources and economic prospects, the government has been an employer of last resort, bloating both the size of the state and budgets.  In situations such as this there can be less room to maneuver without painful consequences.  The status quo, on the other hand, is not an option.

What are your thoughts?  What has your country done to successfully meet the challenge of inequality head on?