How inequality makes us poorer

I welcome the Deaton report into inequality. I especially like its emphasis (pdf) upon the causes of inequality:

To understand whether inequality is a problem, we need to understand the sources of inequality, views of what is fair and the implications of inequality as well as the levels of inequality. Are present levels of inequalities due to well-deserved rewards or to unfair bargaining power, regulatory failure or political capture?

I fear, however, that there might be something missing here – the impact that inequality has upon economic performance.

My chart shows the point. It shows the 20-year annualized rate of growth in GDP per worker-hour. It’s clear that this was much stronger during the relatively egalitarian period from 1945 to the mid-70s than it was before or since, when inequality was higher. 

This might, of course, be coincidence: maybe WWII caused both a backlog of investment and innovation which allowed a subsequent growth spurt and a desire for greater equality.

Or it might not. This is not the only evidence for the possibility that inequality is bad for growth. Roland Benabou gave the example (pdf) of how egalitarian South Korea has done much better than the unequal Philippines. And IMF researchers have found (pdf) a “strong negative relation” between inequality and the rate and duration of subsequent growth spells across 153 countries between 1960 and 2010.

Correlations, of course, are only suggestive. They pose the question: what is the mechanism whereby inequality might reduce growth? Here are eight possibilities:

1. Inequality encourages the rich to invest not innovation but in what Sam Bowles calls “guard labour” (pdf) – means of entrenching their privilege and power. This might involve restrictive copyright laws, ways of overseeing and controlling workers, or the corporate rent-seeking and lobbying that has led to what Brink Lindsey and Steven Teles call the “captured economy.” An especially costly form of this rent-seeking was banks’ lobbying for a “too big to fail” subsidy. This encouraged over-expansion of the banking system and the subsequent crisis, which has had a massively adverse effect upon economic growth.

2. Unequal corporate hierarchies – what Jeffrey Nielsen calls rank-based organizations - can demotivate junior employees. One study of Italian football teams, for example, has found that “high pay dispersion has a detrimental impact on team performance.” That’s consistent with a study of Bundesliga and NBA teams by Benno Torgler and colleagues which found that “positional concerns and envy reduce individual performance.”

3. “Economic inequality leads to less trust” say (pdf) Eric Uslaner and Mitchell Brown. And we’ve good evidence that less trust means less growth. One reason for this is simply that if people don’t trust each other they’ll not enter into transactions where there’s a risk of them being ripped off.

4. Inequality can prevent productivity-enhancing changes, as Sam Bowles has described. We have good evidence that coops can be more efficient than hierarchical ones, but the spread of them is prevented by credit constraints. Poverty reduces education levels by making it impossible to afford books, or encouraging bright but poor students to leave earlier than they should, and women and BAME people might avoid careers for which they are otherwise well-suited because of a lack of role models.

5. Inequality can cause the rich to be fearful of future redistribution or nationalization, which will make them loath to invest. National Grid is belly-aching, maybe rightly, that Labour’s plan to nationalize it will delay investment. But it should instead ask: why is Labour proposing such a thing, and why is it popular?

6. Inequalities of power – in the sense of workers’ voices being less heard than they were in the post-war period and trades unions becoming less powerful – have allowed governments to abandon the aim of truly full employment and given firms more ability to boost profits by suppressing wages and conditions. That has disincentivized investments in labour-saving technologies.

7. The high-powered incentives that generate inequality within companies can backfire. As Benabou and Tirole have shown (pdf), they encourage bosses to hit measured targets and neglect less measurable things that are nevertheless important for a firm’s success such as a healthy corporate culture. Or they might crowd out intrinsic motivations such as professional ethics. Big bank bonuses, for example, encouraged mis-selling and rigging markets rather than productive activities.

8. High management pay can entrench what Joel Mokyr calls the “forces of conservatism” which are antagonistic to technical progress. Reaping the full benefits of new technologies often requires organizational change. But why bother investing in this if you are doing very nicely thanks to the increased (pdf) market power of your firm? And if you have, or hope to have, a big salary from a corporate bureaucracy why should you set up a new company?

My point here is that what matters is not so much the level of inequality as the effect it has. And it might well be a pernicious one. If inequality has contributed to weaker growth, then it is very likely to have contributed to the rise of populism and to Brexit and the divisions with which both are associated. In this way, inequality does political damage too.

From this perspective, pointing out that the Gini coefficient has been flat for years (which is true if we ignore housing costs) is like saying that because the bus has stopped moving we need not care about the man who has been run over by it. It misses the main point.

Comments

[Tasker Dunham]

You suggest plausible mechanisms by which inequality might have a negative effect, but what are the mechanisms by which greater equality might have a positive effect?

[David]

To a laymans eye a straight line can be drawn from 1780 to 1970, so playing post conflict catch-up looks very likely.
Is it a UK chart or global or developed countries?
The downward trend is dramatic.
Inequality?
Or de-regulation. or real investment moving to developing countries, or information technology and the move to services and away from manufacturing? What some call "Globalisation".

[georgesdelatour]

In general I like this article.

However, I still don’t think we’re getting at “the causes of inequality”.

Gini coefficients are measured both before taxes and transfers and after taxes and transfers. It’s the pre-taxes and transfers figures which are especially revealing. They show that some societies are very equal even before their government has enacted any policies to make them so. South Korea is just such a society. Ditto Iceland.

Other societies, such as Brazil, are very unequal both before and after taxes and transfers. Basically, Iceland will still probably come out a lot more equal than Brazil, even if Iceland adopts Ron Paul policies and Brazil adopts Bernie Sanders policies.

Suppose we discover that countries with coastlines are generally richer than landlocked countries (I suspect that this may be true BTW, though Switzerland is an obvious exception). The problem is, there aren’t any policies a landlocked country’s government can enact to acquire a coastline, short of war. I don’t think the Iceland / Brazil inequality disparity is as brutally immutable as our hypothetical coastline / landlocked disparity. But I still suspect we’re dealing with disparities rooted in geography, history, culture and demography.

[Kester]

One way to counter inequality would be a 100% land value tax and basic income.

A land/location value tax (LVT), also called a site valuation tax, split rate tax, or site-value rating, is an ad valorem levy on the unimproved value of land. Unlike property taxes, it disregards the value of buildings, personal property and other improvements to real estate, only "location, location, location" value remaining. A land value tax is a progressive tax, in that the tax burden falls on titleholders in proportion to the value of locations, the ownership of which is highly correlated with overall wealth and income.

Bearing this in mind, can it really be right that land owners (from the largest to the smallest, and including indirect landowners, i.e. the banks who collect land rents via mortgage lending) are allowed to enjoy or collect all this rental value for little or no payment, even though it is clearly the whole of society which creates rental values - whether directly or indirectly, whether through their own presence, the work they do or the taxes they have deducted from their earnings?

A tax on land values is merely a user charge and largely voluntary - if you want to live in a nice house, you pay more, and in return for that payment you get a direct tangible benefit in return, which you would have to pay for anyway, with or without LVT.

So if it is acceptable for private landowners to collect land rents, it is more than acceptable for "society as a whole" to collect those rents. The current tax system just boils down to welfare for the wealthy, paid for by taxes on the middle (who also have to pay for welfare for those at the bottom).

[andrew]

Not sure about No6

6. Inequalities of power –
... That has disincentivized investments in labour-saving technologies.

Well, it may have in places like the UK, but that is still happening in France etc, and if that new tech makes money in the UK, pretty sure it will be used.

[vdMandele]

I am missing 2 possible economic arguments against inequality:
-Higher inequality leads to a lower velocity of money: rich people hoard, poor people (need to) spend. As more money gets concentrated more, demand therefore goes down, eventually lowering economic activity.
-Even if /productivity/ would be more efficient in a more unequal world, it is almost without question that inequality leads to inefficient /spending/. If you don't believe me, just watch Elon Musk shoot a Tesla into orbit.