I stumbled across Branko Milanovic’s blog post The Schumpeter Hotel: Income Inequality and Social Mobility today when I spotted it on Mark Thoma’s blog Economist’s View. As it fits great into Thomas Piketty’s TED Talk New thoughts on capital in the twenty-first century, I decided to dedicate my post to this topic today. My aim is to summarize what I have taken away from Milanovic’s blog post and mainly his working paper Inequality Is Bad for Growth of the Poor together with Roy van der Weide.
Income inequality is observed to be on the rise in America coupled with falling social mobility. To my understanding this is a more or less accepted fact. The main question, however, is whether this is socially desirable in terms of its effects on the growth rate. There has been considerable research on the link between inequality and growth in the past. Milanovic and van der Weide provide a good overview of the existing literature in their working paper in case you are interested. What is striking though is the bandwidth of findings. Some studies find a significant positive relationship between inequality and growth, others a negative link and some remain inconclusive. This contradiction was the starting point for new research which decomposes the inequality regressor into two distinctive regressors, namely inequality among the poor and inequality among the rich. This methodology allows to test the hypothesis whether bottom and top inequality affect a country’s growth somewhat differently. This in turn might be able to explain the some of the varying results of earlier research.
Milanovic and van der Weide use this new methodology in their working paper. They present results for a regression of growth at different percentiles of state income distribution on an overall Gini as well as a bottom and top Gini. (The Gini coefficient is the proxy for income inequality.) To me, the results from the regression with the bottom and top Gini are more interesting, so I will focus on them here. In their dataset on the U.S. from 1960 to 2010 the bottom Gini is statistically significant for the bottom 10 percent and top 10 percent. However, it has a negative effect on the former but a positive effect on the latter group. In comparison, the top Gini is only statistically significant from the 10th to the 50th percentile and it has a negative effect on growth. In short, higher income inequality in the bottom 40 percent of the population decreases income growth of the poor but increases income growth of the rich. Higher income inequality in the top 40 percent of the population decreases income growth of the poorer and lower middle class excluding the very poor.
Milanovic and van der Weide proceed by analysing the channels of the effects they observed. This is where their working paper is really strong in my opinion and they offer a compelling explanation for their findings. They see the top Gini as a proxy for societal fragmentation and argue that social separatism in the top end of the income distribution might have negative effects on the poor. With a highly fragmented upper class the superrich may drop out of the social system altogether. They then can consume education, health etc. in parallel to the public system. This may set off an elephant race among the rich to strive for higher and higher quality of the services they consume. This will benefit their growth prospects excessively but will not contribute to the bottom’s growth at all. What is more, the superrich’s lack of interest in the public system of healthcare, education and infrastructure might lead to its deterioration if the rich can lobby the government to reduce taxes or at least spending in these areas in favour of their interests. This in turn would ultimately harm the poor who rely on these public goods completely explaining the negative effect they found.
The bottom Gini’s negative effect on the poor can be explained relatively easily. The higher the poor’s income inequality the more their income growth prospects suffer. On the other hand the bottom Gini’s significant positive effect on the rich’s growth is a bit harder to explain. Milanovic and van der Weide see higher social fragmentation among the poor as a potential factor benefitting the rich in form of lower prices of the services they consume. They mention low remuneration as an example. As far as I understood the paper argues here that the rich might be able to get ahead at the cost of the poor (exploitation).
Overall, the working paper and also the blog give a good overview on more recent work on income inequality and its effect on income growth with a much more nuanced effects of a disaggregated bottom and top Gini as inequality measure for different income groups. This was a really good evening read to indulge in!
Thanks for reading!
Van der Weide, R., and Milanovic, B. (2014). Inequality Is Bad for Growth of the Poor. Policy Research Working Paper, No. 6963. Washington, D.C.: World Bank. Available at: http://www-wds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2014/07/02/000158349_20140702092235/Rendered/PDF/WPS6963.pdf [Accessed 04/04/2016].