Growing Income Inequality – a Brake on Economic Growth?

For more than 30 years we have observed a growing inequality in income distribution in almost all developed countries. Economist rarely talk about this issue because evaluating any distribution of income is always a value judgement and hence a topic with little objective criteria. Nevertheless, we can observe a growing interest amongst economists and ordinary citizens alike in the question of income distribution as there are more and more hints that income inequality has a negative impact on economic growth – and economic growth is undoubtedly an objective indicator.

Theoretical growth effects of income inequality

From a purely theoretical point of view it is not clear if an increase in income inequality has positive or negative impact on the development of real gross domestic product (GDP). Increases in income inequality have growth-promoting effects as well as growth-dampening effects.

Which of these effects are predominant in reality? The answer to this question depends strongly on the degree of income inequality already reached. If the income of an economy is distributed perfectly equal, there is hardly any incentive for individuals to intensify their work efforts. Hence, with an increase in income inequality, we can be expected that growth-promoting incentives predominate, and that the GDP increases.

However, if income is very unequally distributed people have no great incentive to work either. In this case, an increase in income inequality is expected to have a negative impact on economic growth. As a result, it can thus be assumed that the relationship between the degree of income inequality and economic growth – measured on the basis of real GDP – follows an inverted U-shaped pattern.

Empirical growth effects of income inequality

The forgoing shows that the relationship between the degree of income inequality and economic growth is not linear. As a consequence, empirical studies dealing with the relationship between income inequality and economic growth produce very different results. For a long time, it was considered to be relatively certain that the increase of income inequality had a growth-promoting effect. Especially in the 1950s and 1960s, empirical studies implied that income inequality, thanks to the higher savings propensity of high-income persons, leads to higher investment levels, and thus has a positive effect on economic growth.

However, current studies increasingly identify growth-dampening effects of a growing income inequality. In an International Monetary Fund discussion paper, Ostry, Berg and Tsangarides indicate in the context of an overview of current work on this topic that most empirical studies show income inequality to have a growth-dampening effect. Their own calculations (173 countries, over a time period of 1960 to 2010) show a negative relationship between income inequality and economic growth. Nevertheless, they also note that there are indeed studies that come to a contrary conclusion.

This ambivalent picture is compatible with the relationships depicted in Fig. 2, and can be explained as follows: If a positive relationship between income inequality and economic growth is found for a group of countries, it suggests that the levels of income inequality in the countries covered by the calculations range between the values II_min and II* (Fig. 2). In the case of a negative relationship between these two factors, the level of income inequality in the countries analysed by contrast lies between II* and II_max. And if the group of countries considered contains economies whose income inequality lies in both areas, it is possible that no statistical correlation at all between income inequality and economic growth will be found.

So, where do we stand in developed countries? We will analyse this topic in our next Blogpost, using Germany as an example.