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Inequality and Efficiency

The Economist last year did a special report on the ‘World Economy’ focusing on the growing inequality. An area that was addressed was the trade-off between inequality and efficiency.

Last century inequality was seen as essential for investment and growth because rich people save more.

John Maynard Keynes – “precisely the inequality of the distribution of wealth which made possible those vast accumulations of fixed wealth and of capital improvements which distinguished [the Gilded Age] from all others”

Milton Friedman – stated that greater inequality would encourage people to work harder and improve productivity.

Gary Becker – inequality encourages people to invest in their education. Redistribution, in contrast, brings inefficiencies as higher taxes and government handouts deter hard work. The bigger the state, the greater the distortion of private incentives.

In China and India it has been freedom and better incentives that have been integral to economic growth, however some of the inequality that is apparent today is inefficient rather that growth promoting. The Economist came up with various reasons:

1. Countries with the biggest income gaps, increasing inequality is partly a function of rigidities and rent-seeking—be it labour laws in India, the hukou system and state monopolies in China or too-big-to-fail finance in America. Such distortions reduce economies’ efficiency.

2. Rising inequality has not, by and large, been accompanied by a smaller (and hence less distortive) state. In many rich countries government spending has risen since the 1970s. The composition has changed, with more money spent on the health care of older, richer folk, and relatively less invested in poorer kids. Modern transfers are both less progressive and less growth-promoting.

3. Recent experience from China to America suggests that high and growing levels of income inequality can translate into growing inequality of opportunity for the next generation and hence declining social mobility. That link seems strongest in countries with low levels of public services and decentralised funding of education. Bigger gaps in opportunity, in turn, mean fewer people with skills and hence slower growth in the future.

The area of inequality and social mobility showed that the USA’s GDP growth was inversely correlated with their inequality of opportunity, but not with overall inequality. Known as the “Great Gatsby Curve” (see below) this suggests that countries with higher Gini coefficients tend to have lower inter-generational social mobility.

Great Gat Curve

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  1. Simon
    January 28, 2013 at 8:07 pm

    The trickle down theory of the 1980’s was a huge fraud. Money trickles UP not down that should be pretty clear by now. And yes, as stated above the rich are the greatest savers. Unsurprisingly they can save a much larger proportion of their income than the poor. Of course they then also have to decide how to invest and this is not a simple matter.

    If the objective is to accumulate more wealth this may or may not improve overall economic conditions. Generally higher wealth favors increased wealth through the generations provided the following generation are not complete flakes. That it is easier for the rich to get richer should be pretty clear. And that unless some intervention occurs in general wealth and income inequality tend to rise over time should be obvious by now.

    Pretty much the only way to slow down the rate of inequality acceleration is for governments to tax and spend. Effective taxation and effective spending serve to stabilize and stimulate the economy, increase the velocity of money and in an efficient economy improve the diversity and quality of services that a larger proportion, ideally the largest possible proportion, of the population can afford.

    Financial stability and a vigorous economy within a stable democracy are a very desirable objective. In my opinion this can be achieved much more easily within a fair society that recognizes that “success” is not really success unless it can be shared in a fair and reasonable way by all the economic participants.

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