Thursday, September 22, 2011

Inequality and Growth: Do We Need the Rich to Prosper?

One of the general themes of the recent debates about budgets is that if we burden the wealthy with a too progressive tax system it will create a disincentive for them to make the kinds of investments that are vital to grow the economy. It is a powerful argument and one with a long historical tradition in economics popularized by Arthur Okun (of 'Okun's Law') who called it the equity/efficiency trade off. It is powerful, but it also appears to be wrong.

From the IMF:

Do societies inevitably face an invidious choice between efficient production and equitable wealth and income distribution? Are social justice and social product at war with one another?

In a word, no.

In recent work (Berg, Ostry, and Zettelmeyer, 2011; and Berg and Ostry, 2011), we discovered that when growth is looked at over the long term, the trade-off between efficiency and equality may not exist. In fact equality appears to be an important ingredient in promoting and sustaining growth. The difference between countries that can sustain rapid growth for many years or even decades and the many others that see growth spurts fade quickly may be the level of inequality. Countries may find that improving equality may also improve efficiency, understood as more sustainable long-run growth.

Actually, I think the verdict is far from in on this one, I am not convinced we have the data we need to settle this question. But the bulk of the evidence points to inequality being more of a drag on growth then a boost.  Certainly there is no good modern evidence to support the equality v. equity tradeoff.

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