Trade, Development, and Immigration

Does inequality hurt economic growth?

The headline is quite simple: ‘Inequality hurts economic growth, finds OECD research’. The reality is somewhat more complex. Here are four things you need to know about the new OECD report:

  1. It’s not really about inequality. If a rich man earns an extra £10 a year, it adds to inequality in the same way it does if a poor man earns £10 less each year. That’s why the likes of Thomas Piketty – who really is worried about inequality – get very wound up about the Mark Zuckerbergs of this world. But the new OECD report explicitly says that ‘no evidence is found that those with high incomes pulling away from the rest of the population harms growth’. It’s really about low incomes. ‘Poverty’ would be a better word than inequality.

  2. The mechanism by which low incomes are found to inhibit economic growth is that ‘increased income disparities depress skills development among individuals with poorer parental education background’. In other words, if you’re poor and your parents didn’t get much of an education, you’re not as likely to develop the skills you might otherwise and you’ll struggle to engage with the labour market. If there are a lot of people in that situation in a country, people without the human capital to engage with the opportunities that a growing capitalist economy creates, then that will diminish economic growth over time. That is not really surprising. It fits with a conventional understanding of how social and educational dysfunction is preventing some people responding to the incentive to develop human capital, which is not great for growth.

  3. The report does not contain much evidence about what kinds of policies might help. Their well-trumpeted findings about the effects of redistribution are based on ‘a partial and relatively crude measure of redistribution’. If you are interested in what policies might work, there are two obvious candidates: a) education reforms, this report inadvertently makes an excellent case for schools that answer to parents, not bureaucracies captured by producer interests (and further reforms so such schools can expand more quickly); b) welfare reforms to engage people in the labour market: research by RAND looking at the US welfare reform experiments strongly suggests that the right mix is improved financial incentives and robust work requirements.

  4. The final results are still a bit…funny. The economies where inequality increased the most in the run up to the crisis were ‘the English-speaking countries’ and ‘Israel, Germany and Sweden’. Those economies did not do badly at all over the period. That raises the question of whether there are other growth effects related to inequality which they have missed, or controlled away (perhaps related to those entrepreneurs who make a lot of money but still only capture about 2 per cent of the benefits created by their innovations, we get the rest).

There is nothing wrong with a new contribution to the debate over the structure of our economy and those who are to some extent left on the outside looking in when it grows. This is an interesting report. Sadly the OECD has gone for the sexy headline about inequality, trying to cash in on Piketty-mania.

The danger is that the report could therefore contribute to a focus on crude redistribution, instead of more challenging but more effective policy reforms to address the obstacles to people investing in education and engaging in the labour market (where they will build up their human capital). That would be a sad result for a supranational organisation that is supposed to help inform policy but has instead been chasing headlines.

Matthew Sinclair is a senior consultant at Europe Economics.