Inequality, non-linearities & growth

Might there be a non-linear relationship between inequality and growth? A new paper suggests so. It finds that "there is a range of values of changes in inequality where the link [with GDP growth] is weak", but that big reductions in inequality do boost growth. It concludes:

Not all polices that reduce inequality will lead to faster economic growth. Instead, only those that greatly reduce inequality will.

The paper is purely statistical, which poses the question: what sort of mechanisms might generate such a pattern?

One possibility is that inequality depresses growth by generating a culture hostile to prosperity. For example, it might lead to mutual distrust (pdf) which is bad for growth, or to learned helplessness among the poor which saps their energy - say, to stay on in education or to take more initiative at work. It requires a big change in inequality to remove these cultural obstacles to growth. A change in the Gini coefficient of one or two percentage points doesn't much change culture.

A second possibility is that inequality is bad for growth because it imposes credit constraints upon workers which prevents them from forming worker coops even though it might be efficient to do so. A small reduction in inequality might not be sufficient to overcome these constraints.   

Thirdly, whilst modest redistribution might have some benefits - for example in shifting incomes from those with a low propensity to consume to those with a higher - it can also have an adverse effect. If it leads to expectations of further redistribution, it could depress investment as capitalists anticipate low post-tax returns. However, a big redistribution might not have such ill-effects if it reduces the risk of future further tax rises by, in effect, buying off discontent. This is what James Buchanan had in mind when he wrote:

The rich man, who may sense the vulnerability of his nominal claims in the existing state of affairs and who may, at the same time, desire that the range of collective or state action be restricted, can potentially agree on a once-and-for-all or quasi-permanent transfer of wealth to the poor man, a transfer made in exchange for the latter's agreement to a genuinely new constitution that will overtly limit governmentally directed fiscal transfers. (The Limits of Liberty, 7.10.40)

He wrote that in the mid-70s - a time when the threat of redistribution might well have been depressing investment and growth.

Now, I'm not saying all this to say that radical redistribution is definitely a good thing; that requires a lot more arguing. I do so instead to challenge a common prior among social democrats - which might well arise from a presumption that the economy is a simple linear system - that mild reformism and "moderation" is sensible and "realistic" whereas radicalism is economically unsound. It ain't necessarily so.

Comments

[Luis Enrique]

I am very sure you know this, but your intro makes it sound like this

http://en.wikipedia.org/wiki/Kuznets_curve

is a new idea

[chris]

Yes. But that's about the causality from growth to inequality. I'm talking about the other direction, from inequality to growth

[Magnus Carlsen]

Er, Kuznets is about GDP per capita in levels, not growth.

[magistra]

One possibility is that in a very unequal society, a lot of productive effort is put into solving the minor problems of the very rich. The classic example is having large numbers of servants for minor tasks (like bootboys); a modern example would be work put into apps that focus on selling restaurant reservations or the like. It's only with a much more equal society that these reserves of physical or mental energy can get diverted into things with wider potential.

[Luis Enrique]

MC. True, good point. although associated with idea that inequality rises for a while as growth / transition progresses.

[David]

Simple....
Once the rich have the means, they buy regulation that puts up barriers to new entrants; thereby stifling growth.
David.

[Richard]

One possibility: people compete mostly for stature (rank within and organization or a subpopulation). When income differentials are large it is a large component of stature; when income differentials are small other factors (technical skills, ability to negotiate, creativity) come into play. Those additional skills (and not just the skills that get someone a bonus this year or this quarter) are the ones that increase productivity.