Does income inequality hurt economic growth?

Increases in income inequality have raised concerns about their potential effect on society and economies. New OECD research shows that when income inequality rises, economic growth falls. One reason is that poorer members of society are less able to invest in their education. Tackling inequality can make society fairer and economies stronger.

A long-term rise of income inequality

The gap between rich and poor is at its highest level in most OECD countries in 30 years. Nowadays, the richest 10% of the population in the OECD area earn 9.5 times more than the poorest 10%. By contrast, in the 1980s, the ratio stood at 7:1.

The average incomes at the top of the distribution have seen particular gains. However, there have also been significant changes at the other end of the scale. In many countries, incomes of the bottom 10% of earners grew much more slowly during the prosperous years and fell during downturns, putting relative (and in some countries, absolute) income poverty on the radar of policy concerns.

The increase in income inequality is evident not only in a widening gap between the top and bottom income deciles, but also in the Gini coefficient, a broader measure of inequality (which ranges from 0, where everybody has identical incomes, to 1, where all income goes to only one person). In OECD countries in the mid-1980s, the Gini measure stood at 0.29; by 2011-12, it had increased by 3 points to 0.32.

The Gini coefficient increased in 16 out of the 21 OECD countries for which long time series are available, rising by more than 5 points in Finland, Israel, New Zealand, Sweden and the US and falling slightly only in Greece and Turkey.

How is inequality linked to growth?

New OECD analysis suggests that income inequality has a negative and significant effect on medium-term growth. Rising inequality by 3 Gini points, that is the average increase recorded in the OECD in the past two decades, would drag down economic growth by 0.35 percentage point per year for 25 years: a cumulated loss in GDP at the end of the period of 8.5%.

Rising inequality is estimated to have knocked more than 10 percentage points off growth in Mexico and New Zealand, almost 9 points in the UK, Finland and Norway and between 6 and 7 points in the US, Italy and Sweden. On the other hand, greater equality prior to the crisis helped increase GDP per capita in Spain, France and Ireland.

The biggest factor for the effect of inequality on growth is the gap between lower income households and the remainder of the population. The negative effect is not only for the poorest income decile, but all of those in the bottom four deciles of the income distribution. These findings imply that policy must not (only) be concerned with tackling poverty, it also needs to be about addressing lower incomes more generally.

The most direct policy tool to reduce inequality is redistribution through taxes and benefits. The analysis shows that redistribution per se does not lower economic growth. Of course, this does not mean that all redistribution measures are equally good for growth. Redistribution policies that are poorly targeted and do not focus on the most effective tools can lead to a waste of resources and generate inefficiencies.

Why does inequality reduce growth?

By hindering human capital accumulation income inequality undermines education opportunities for disadvantaged individuals, lowering social mobility and hampering skills development.

Analysis drawing from education data and the recent OECD Adult Skills Survey shows that the human capital of people whose parents have low levels of education deteriorate, as income inequality rises. By contrast, there is little or no effect for the human capital of people with middle or high levels of parental educational background. These patterns hold for both the quantity of education (for example, schooling years) and its quality (for example, skills proficiency).

How can policy respond?

Income inequality has dragged down growth in many OECD countries has significant policy consequences. In particular, it challenges the view that policymakers necessarily have to address the trade-off between promoting growth and addressing inequality. Although the benefits of growth do not automatically trickle down across society, inequality also matters for growth. Policies that help to limit or reverse inequality may not only make societies less unfair, but also wealthier.

It is not only poverty or the incomes of the lowest 10% of the population that inhibits growth. Instead, policymakers need to be concerned about how the bottom 40% fare more generally. This includes the vulnerable lower-middle classes who are at risk of failing to benefit from and contribute to the recovery and future growth. Anti-poverty programmes will not be enough. Not only cash transfers but also increasing access to public services, such as high-quality education, training and healthcare, constitute long-term social investment to create greater equality of opportunities in the long run.

Policy also needs to confront the historical legacy of underinvestment by low income groups in formal education. Strategies to foster skills development must include improved job related training and education for the low skilled, over the whole working live.