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Does reducing inequality hurt growth? The answer may surprise you

One more question remains after my recent discussions about U.S. income inequality: Does reducing income inequality via government taxes and transfers hold back economic growth?

The answer may surprise you.

As you may recall, over the past two weeks, we examined trends over the past 90 years and discussed the causes of rising income inequality. I also pointed out that economic growth is the primary driver of income inequality, but that increases in income inequality do not increase growth.

Income inequality: before and after government
To summarize income distributions, economists use Gini coefficients, which range from 0 (perfect income equality) to 1 (complete income inequality). The Organization for Economic Cooperation and Development (OECD) provides Gini coefficients for industrialized countries before and after governments levy taxes and make transfer payments.


Let's take a look at the numbers and see what they tell us. (Note: My thanks to Andrew Twite, graduate student at the Hubert H. Humphrey School of Public Affairs, for writing to me after reading my Nov. 16 column and reminding me of these data. He kindly put together the figures that appear below.)

The chart below shows two Gini coefficients for each OECD country: one computed before taxes and transfers (in red) and the other after taxes and transfers (in blue).

PreTaxGinis577.png

Click on chart to enlarge

The countries here are ranked from least pre-tax inequality to highest pre-tax inequality. By this measure, the United States is about average in terms of income inequality, with the OECD average Gini at 0.45 and the U.S. Gini equal to 0.46.

Now, let's take the same data and rank the countries by their post-tax inequality from least to most:

AfterTaxGinis586.png

Click on chart to enlarge

The U.S. now ranks at the top, tied with Portugal for the highest income inequality in the OECD. Further, if we compare the red and blue bars, we find that the U.S. is near the bottom in terms of reducing income inequality via taxes and transfers. Only Korea does less to reduce income inequality, and they already start with a more equal income distribution than does the U.S.

Does Big Government hurt economic growth?
One quick response to the charts is: "Sure, the U.S. has higher income inequality, but it probably grows faster, too." But that view is not true.

Peter H. Lindert, a professor of economics at the University of California, Davis, addressed this question in his 2004 book, "Growing Public: Social Spending and Economic Growth since the Eighteen Century." He summarized his findings in his 2004 Clemens Lecture (PDF) at the College of St. Benedict and St. John's University.

Peter H. Lindert
csbsju.edu
Peter H. Lindert

Lindert analyzed data on taxes, transfers and growth in the industrialized countries for three different periods: 1880-1930, 1962-1981 and 1978-1995. His central conclusion:

"Larger welfare states have not had any net cost, either in terms of economic growth or in terms of budget deficits. Had our politics permitted it, we Americans could have had the same economic growth of GDP — with more security, more equality, and longer lives (Clemens Lecture, p. 3)."

You might find this a pretty startling conclusion.

Lindert writes: "Facing facts like these, if you have always believed that the social programs should be very costly, you have a tough choice to make. You can choose to be strong. Stand by your beliefs. Don't let the facts push you around. Or you can be a wimp. I am a wimp. I let the facts push me around. I react to them by asking 'How could that be?' "

He provides a number of intriguing answers to that question. One that I find particularly interesting is that "high-budget welfare states, while taxing heavily overall, actually favor types of taxation that mainstream economists think are better for economic growth (Clemens Lecture, p. 4)." In particular, high-budget welfare states tax corporations at very low rates and rely more heavily on consumption taxes than on income taxes.

A Minnesota connection
Reducing income inequality via the welfare state does not slow economic growth at the national level. How about at the state level? Lindert addresses this issue, too:

"The costs are also invisible among the states of the U.S. States like Connecticut and California [that] have higher taxes and more generous social benefits. Idaho and Alabama don't believe in taxes or social programs. That has been true for a century. So why haven't Connecticut and California become as poor as the national average? Why haven't Idaho and Alabama become as rich as the national average? Of course, places differ in other ways than just their views of taxes and welfare. So we need a deeper statistical analysis that gives many forces their due. I have done that, and so have other economists. The net cost just isn't there. It's zero. The welfare state looks like a free lunch, for the nation as a whole (Clemens Lecture, p. 4)."

Substitute Minnesota for Connecticut or California and the statement remains true. We can put together a reformed tax system that provides a strong social safety net, reduces income inequality and promotes economic growth. State policymakers should stop being so strong — and let the facts push them around a bit more.

A follow-up to last week's column
Last week, I mentioned a Congressional Budget Office study of lifetime tax rates, but I forgot to include the companion study of income inequality that applies these data. The latter study is available here and contains the evidence for my statement that "tax policy was probably a wash in terms of income inequality." I regret the omission.

Interestingly, a new paper on this very topic appeared on Monday. The paper (PDF), by Piketty, Saez, and Stantcheva uses the income data I discussed in my last two columns to more carefully parse the relationship between top marginal tax rates and the share of income going to the top 1 percent of income earners. They find that cuts in top marginal tax rates increase the income share of the top 1 percent in both the U.S. and in the U.K. Further, they find that higher marginal tax rates across countries are associated with lower shares of income received by the top 1 percent.

So, perhaps tax policy contributed more to income inequality than I thought. We'll have to wait and see where the research leads us.

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Comments (12)

Thank you for this thorough and fascinating analysis. Seems to vindicate the Wellstone mantra: "We all do better when we all do better..."

When a country uses taxes to educate and promote social welfare for all, income inequity will decline.

When a country uses taxes to promote businesses and provide a crutch for capitalism, income inequity will rise.

A rising tide lifts all boats but some boats are tethered to the bottom. Government policy should, at a minimum, create some slack.

Excellent series of articles. I love the links to the references.

Since when did social engineering become part of the econ curriculum?

When governments attempt to control the economy for the good of the people they end up controlling the people for the good of the economy, which is an anathema to a free society. Not that any of you want a free society.

Can you ask the opposite question: Does increasing income inequality hurt growth?

I would guess that reducing inequality doesn't hurt growth, and increasing inequality does. Makes dealing with it common sense.

Also, isn't an easy explanation of why lower tax rates at the top influence behavior of the decision makers.

When tax rates were high on the top step, it made more sense to pay employees more, and write off that top tier.

As tax rates lowered, it wasn't so much the taxes, but the decisions they influenced. The decision makers took much more of profit for their own income.

When tax rates lower for the 99% they have no such control.

Not a bad article. It certainly is well defended, but I think it misses the mark.
When American unfunded liabilities are double the GDP of the world, looking at the tax side of the equation doesn't help much.

If the budget is a government’s primary concern, then the evidence is that reforms which close loopholes and broaden the tax base are a more efficient way to bring in more money than higher taxes for the rich.

What these studies point to is the fact that tax policy is one of the factors creating the income and wealth inequality in this country. Tax policy is one area where them that has get more from the government. As the recent articles about Henry Paulson are making clear, the Federal Reserve was propping up the largest banks in this country with massive amounts of interest free loans to qualify them for TARP. These free loans dwarfed the actual TARP bailout funds which were already huge.

This was followed immediately by record bonuses and executive compensation, all while the economy was tanking because of the irresponsibility of these same people. I don't get why the right is so fanatically opposed to higher taxes on the 1%. The government giveth; the government taketh away seems me to be a fair maxim to follow here.

Well I have to say that Mr. Johnston's articles here are getting better and better. His content actually matches his titles, and he's actually drawing some substantive conclusions.

The conclusions mentioned in this article would only surprise someone who drank too much of the Chicago School "small government" cool-aid however. The Chicago school free market model was never supported by much in the way of evidence, and was actually contrary to most of the evidence. It is a faith based ideology more than economic theory. All you ever had to do was look around the world in the 20th century- were the wealthiest and most prosperous nations the ones with the smallest governments? No, quite the opposite. Here in the US we saw the most prosperous era in our history following the creation of huge welfare programs that narrowed disparity. It has been observed many times that the high disparity free market theories of Friedman et al could only be implemented in dictatorships around the world in the 60s and 70s, and even then none of these countries leaped to the head of the pack in world economics.

I appreciate the follow to last weeks article, but I remain baffled by this refusal to admit that tax policy can create wealth disparity. First Johnston give us a study that doesn't really address the question, and concludes tax policy is a wash. Then he follows up a CBO study that he forgot to include last week, problem is THAT study contradicts Johnston's interpretation, in fact is day the exact opposite:

"Although an increasing concentration of market income was the primary force behind growing inequality in the
distribution of after-tax household income, shifts in government transfers (cash payments to individuals and
estimates of the value of in-kind benefits) and federal taxes also contributed to that increase in inequality."

This study actually concludes explicitly that tax policy changes have contributed to inequality. How does Johnston get a "wash" out of this?

Beyond that, I just don't get this, it looks like basic math to me. Listen, you make a million dollars in 1982 with a tax rate of 75%, you get to keep $250K. Your tax rate drops to 50% in 1984, and you get to keep $500K. then your tax rate drops again in 1986 to 29%, and now get to keep $700K. Meanwhile, no one else is getting anywhere the same tax cuts. And your seriously questioning whether or not the tax cuts made the wealthy wealthier? We also capital gains and corporate tax cuts that primarily benefit he wealthy, and don't forget that these tax rates are theoretical to begin with, we haven't started talking about the various tax breaks and dodges the wealthy use ON TOP of their tax breaks. I honestly don't see how you can have a debate about this. You look at the last century of data and you see increased disparity with low tax rates on the wealthy up until the great depression. You see decreased disparity after tax rates as high as 94% are levied on the wealthiest Americans. Then you see disparity start to increase again when Kennedy cuts those tax rates in the 60s, and disparity practically explodes with Reagan and Bush II tax cuts.

The last tax related thing to consider is the fact that the Reagan and Bush tax policies also indirectly helped the wealthy. Those tax cuts on the federal level were all followed by tax increased on the state on local levels to make up the difference, and those state and local tax hikes his the middle and lower classes the hardest. When you look at state data over the last 30, in the tax incidence studies for instance, you see that the 20-30 year trend has been towards more regressivity rather than progressive tax structures. This means the tax burden on the state and local level has been shifted off of the wealthy as well. This helps explain why the lowest deciles have actually seen a decrease in after tax income over the last 30 years.

It's probably not accurate to blame it all on tax policy however, there was another huge policy shift that increased the disparity, financial deregulation. Every one one of these tax policy shifts has been accompanied by massive efforts at deregulation of the financial sector. This is where the wealthy make their money. Unlike other people, the use money to make more money, they don't just work longer hours, or get promotions. This is why despite several moderate and severe recession the wealthy have seen a 200+% increase in wealth over the last 30 years while everyone barely held or lost ground. Most of us never made any money on derivatives. Most of us have to earn another degree, get a promotion, or work longer hours to make more money. The wealthy send an e-mail or make a phone call to their accountants or brokers. When we loosen the restrictions and oversight on what they can do to make money... they make more money, until they crash the economy. And even then, they get out first and get bailouts.

I think the real question is to what extent is large disparity an inequality actually bad for the economy? We know for a fact that periods of massive inequality tend to trigger big recessions and depressions, and enhance economic instability. Total equality requires a command economy of some kind, which has it's own problems. So how much inequality can a good economy tolerate?

Sorry about all the typos in my last two posts, I'm very busy these days and didn't have to time to check my writing.

"I just don't get this, it looks like basic math to me. Listen, you make a million dollars in 1982 with a tax rate of 75%, you get to keep $250K. Your tax rate drops to 50% in 1984, and you get to keep $500K. then your tax rate drops again in 1986 to 29%, and now get to keep $700K. Meanwhile, no one else is getting anywhere the same tax cuts. And your seriously questioning whether or not the tax cuts made the wealthy wealthier?"

The flaw in your thinking is that you believe the government owns your labor and your wages and it gets to decide how much it will allow you to keep.

That's a sharecropper system. Sharecroppers don't own the land, he's simply working it for the real owner and "gets to keep" an agreed-upon payment. Allowing you to keep more of someone else's crops would be increasing your wealth because it originally belonged to someone else.

But in a free society, your labor is your own. Your wages are your own. You are billed a tax to contribute to your share of the cost of government. But as soon as you start operating under your misguided assumption that "the government allows you to keep ..." you're a slave in mind if not body.

Dennis #11 says:

"The flaw in your thinking is that you believe the government owns your labor and your wages and it gets to decide how much it will allow you to keep."

Dennis, the problem is you obviously think you've accessed my "beliefs". I'm not sure how you think you've done this, perhaps it's similar magic to that which governs your economic plans.

At any rate, your assumptions about my beliefs are wrong, and I dare say the beliefs you describe are simply incoherent. My government doesn't have to own my labor in order to levy taxes, it's right to levy taxes is stipulated in the Constitution.

If you want to know a "belief" of mine I'll tell you: I believe it's responsibility as a citizen to pay taxes, not simply because it's the law, but because I have no wish transform my country into Somalia or Bangladesh. This has nothing do with government ownership of my labor.

My beliefs on this matter are mundane and uninteresting. How but we talk about the data being offered for consideration? This isn't a religious debate, it's an attempt to sort some policy questions using evidence instead of ideology for a change.