Reducing inequality need not hurt growth
How times have changed. The US has become the world’s largest producer of oil and gas, and is now also an oil exporter. It is also becoming a free trade sceptic. China is now the flagbearer of free trade and is also leading climate change activism. Ageing Europe is electing young leaders, with the latest being a 31-year-old prime minister in waiting.
Into this new normal is the unusual stance of the International Monetary Fund (IMF). The latest IMF report, called the Fiscal Monitor, is cautioning about increasing inequality in the world. Not Thomas Piketty, this is the IMF! The report says that income inequality is the highest it has been in more than half of all member countries of the IMF. Traditionally, the development and inclusive growth agenda has been with the World Bank, whereas the IMF’s mandate is rescuing countries from currency, fiscal and financial crises. The IMF now is advocating redistributive policies, and is asking rich countries to spread their wealth more evenly among their own people. In effect, the IMF is asking for higher taxes for the very rich which it says will reduce inequality without sacrificing economic growth. This is in direct contradiction to the proposed tax reform plan of US President Donald Trump (the biggest shareholder of the IMF).
The Trump plan is to cut personal and corporate income taxes, give tax amnesty to bring back profits parked overseas, and eliminate the estate tax (meant for the rich). The Trump plan would, of course, bring great benefit to the very rich, the top 1% earners. That plan is being touted as the largest tax cut in US history, and is being justified as promoting large-scale job creation. The IMF seems to be giving a thumbs down to the Trump plan. Whichever side of the debate you are on, the fact is that both sides are concerned about rising inequality. Ironically, it is that same inequality and extreme polarization which led to the election of Trump.
So let us ask, is rising inequality inimical to growth? This is an age-old question. On one side you have Simon Kuznets, who said that inequality is just a by-product of growth and no cause for worry. Kuznets’ hypothesis was that in the early stages of development, inequality gets worse. This seems natural since the fast-growing sectors race ahead, while others lag behind. The disparity widens. But then eventually growth benefits percolate outside the fast-growing sectors, and competition drives down the premiums, leading to a convergence in growth rates across sectors. Thereby leading to lesser inequality. This was the Kuznets curve, with inequality rising and then falling.
On the opposing side is Thomas Piketty, who has questioned (some say debunked) the Kuznets curve. In his magnum opus, Capital, he says that economic growth just makes wealth inequality worse. There is a causality from growth to inequality, which is inevitable, which leads to the concentration of wealth in fewer and fewer hands. Growth necessarily leads to worsening inequality, which Piketty demonstrated using data across countries. This is not the place to discuss Piketty and his critics or to support Kuznets. But suffice it to say that there comes a time when inequality, whether of income or wealth, becomes “too much”. How much is too much?
Think of inequality as a public good (or public bad) not unlike pollution. Pollution is a by-product of industrial and economic activity, and hence can never be zero. But above a threshold it is seen as excessive and needs to be regulated. What is that threshold? This is a question that every society has to answer for itself. The same is true for inequality. It is a question not of efficiency or optimality, but of fairness and justice. How much is too much? Is it suffocating all of us? Is it hurting economic growth? Extreme inequality leads to political tensions, social instability, frustrated aspirations, loss of trust in governments, breakdown of law and order, discouraged investors, charges of crony capitalism, and drying up of investment and eventually growth itself. Hence lesser inequality is a public good that modern economies have to provide their citizens.
Each society decides what is an acceptable level of inequality for it. The Scandinavians have some of the lowest gini coefficients in the world, and they also happen to be high-income countries. In a recent paper, Piketty and co-author Lucas Chancel observe that over the period of 1980-2014, the gains to the top 1% income earners were most disproportionate in India as compared to all other countries. In particular, cumulative gain in real per capita income for all of India over the 35-year period was only one-fourth of what the top 1% earned. Piketty admits to the inadequacy of his data, but his paper serves as a warning bell. We are well past the threshold beyond which inequality is detrimental to growth. Reducing it (like reducing pollution) should be a priority for fiscal policy (as the IMF too recommends).
This need not entail higher tax rates, but, in fact, the elimination of exemptions and tax loopholes and a widening of the tax net. For instance, the annual Union budget gives an estimate of the value of tax giveaways, which are bigger than the entire fiscal deficit. Surely there’s room to trim those freebies (also known as tax shelters). Then there is also the expenditure strategy of substantially enhancing the outlay on education and health. Income disparity can also be reduced by increasing the participation of women and reducing the gender pay gap. All these measures are growth friendly. There may, in fact, be a “Laffer curve” phenomenon here, wherein reducing inequality becomes growth enhancing in some range of the gini.
Ajit Ranade is chief economist at Aditya Birla Group.
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