Michael Keating. Is there a trade-off between equality and efficiency?

Aug 18, 2015

A critical policy issue has always been whether greater equality inevitably comes at a cost to the economic growth. For example, historically economists have typically believed that there is a trade-off between increased equality and efficiency. Even those economists who favour policies to improve equality have generally acknowledged that the transfers involved could reduce incentives and result in some loss of national income – with the critical question being by how much? Thus those economists who favour redistribution to lower inequality think that such action comes at little or at least an acceptable cost to economic output. While the counter-argument from conservative economists is that inequality is a necessary evil if we want higher incomes all round.

Recent research published by the traditionally conservative International Monetary Fund (IMF) has however questioned this conclusion that increased equality comes at a cost to growth. Instead the IMF research has found that higher inequality is associated with lower output growth over the medium term. More specifically the IMF found that ‘If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.8 percentage points lower in the following five years, … [while] a similar increase in the income share of the bottom 20 percent is associated with 0.38 percentage points higher growth’ (emphasis in the original).[1]

Somewhat surprisingly these important conclusions from this widely respected international organisation have received almost no media attention in Australia, while the barrage of comment in favour of so-called ‘industrial relations reform’ and lower taxes continues unabated, notwithstanding the risks they represent for future income equality. Accordingly what follows is a summary explanation of the reasoning that has led the IMF to conclude that ‘Widening income inequality is the defining challenge of our time’, and how best to reduce this inequality and what are the benefits.

The increase in inequality

The IMF found that ‘Measures of inequality …. of both gross and net incomes have increased substantially since 1990 in most of the developed world’. The principal drivers of this increased inequality have been an increase in the share of the top 10 percent, and even more so the top 1 percent. Much of this increase at the top reflects the appropriation of increased economic rents, and as such they are totally unnecessary to economic growth.

In addition, technological progress has probably been biased in favour of increasing skills, thus increasing the wage premium for skills, and the substitution of new capital investment for unskilled labour. Consequently technological progress has also improved the income share of people with skills and/or capital, both of which tend to be concentrated among the top income people. Most importantly technological progress has impacted on middle level jobs in the goods sector of the economy (the traditional blue collar jobs) and that hollowing out of the middle has almost certainly been the biggest driver of increased inequality in Australia as conventionally measured[2].

Some readers may be surprised to learn that shifting jobs offshore in response to increasing globalisation has been a much less important driver of inequality, and of course that “off-shoring” is itself dependent on improved transport and communications technology.

How can reducing inequality improve economic growth

The main reason for the IMF finding that inequality can damage economic growth is because higher inequality can deprive the ability of lower-income households to stay healthy and accumulate physical and human capital. Furthermore, ‘countries with higher income inequality tend to have lower levels of mobility between generations, with parent’s earnings being a more important determinant of children’s earnings’. In effect, inequality can perpetuate itself, and reduce the potential growth of human capital which is vital for future economic growth.

In addition, the IMF notes that:

  • A prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation of mortgage underwriting standards.
  • Higher top income shares coupled with financial liberalisation, which itself could be a policy response to rising income inequality, are associated with substantially larger external deficits, which can be challenging for macroeconomic and/or financial stability, and thus growth.
  • In addition to affecting growth drivers, inequality can result in poor public policy choices if it leads to a backlash that fuels protectionist pressures against growth enhancing economic reforms.


Policies to reduce income inequality and improve economic growth

The IMF finds that ‘Redistribution through the tax and transfer system is … positively related to growth for most countries, and is negatively related to growth only for the most strongly redistributive countries’. For that reason alone it is important to maintain the taxable capacity of the government so that it can afford these transfers.

In addition, the IMF found that ‘In a world in which technological change is increasing productivity and simultaneously mechanising jobs, raising skill levels is critical for reducing the dispersion of earnings. Improving education quality, eliminating financial barriers to higher education, and providing support for apprenticeship programs are all key to boosting skill levels in both tradable and non-tradable sectors.’ These educated individuals will then be better able to cope with technological and other changes that directly influence productivity levels.

Active labour market policies that support job search and skill matching can also be important. Moreover, policies that reduce labour market dualism, such as gaps in employment protection between permanent and temporary workers, and appropriately set minimum wages, can help to reduce inequality, while fostering greater labour market flexibility.


The IMF concludes that ‘The key to minimising the downside of globalisation and technological change in advanced economies is a policy agenda of a race to the top, instead of a race to the bottom’.

Unfortunately too often the so-called ‘reform agenda’ proposed by business and its supporters in the media seems to be closer to a race to the bottom with its focus on cost-cutting rather than more innovation and increasing productivity. Instead we need to improve the skills of our workforce and how those skills are actually used. And in the government’s case it is important that it retains its capacity to intervene successfully, including its fiscal capacity to support the income transfers and investment in human capital that are required if we are to achieve improved equality and economic growth. 

[1] This analysis was based on a sample of 159 advanced, emerging and developing economies for the period 1980-2012. It is reported in IMF Staff Discussion Note, Causes and Consequences of Income Inequality: A Global Perspective by Era Dabla-Norris, Kalpana Kochhar, Nujin Suphapiphat, Frantisek Ricka, Evridiki Tsounta.

[2] If middle-level jobs disappear that means that the shares of jobs at the top and the bottom increase relative to the jobs in the middle, and mathematically that means that the top decile is re-defined upwards in terms of incomes and the bottom decile is re-defined downwards in terms of incomes. Consequently the income distribution can then appear more unequal even though there may have been no change in any individual’s income or relative rate of pay for those people who continue in their jobs.

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