Some economic effects of inequality

Dr Anne Holmes, Economics

Key issue
There are a number of reasons why inequality may harm a country’s economic performance. At a microeconomic level, inequality increases ill health and health spending and reduces the educational performance of the poor. These two factors lead to a reduction in the productive potential of the work force. At a macroeconomic level, inequality can be a brake on growth and can lead to instability.

Defining inequality

Economic inequality means unequal access to wealth and income. This brief mostly deals with income. In most developed countries, market income is mainly from wages and salaries, but also from returns on capital such as shares and rents. People's market income is then reduced by taxation and/or increased by government transfers such as pensions and child payments.

Inequality is usually discussed in terms of equivalised household income, which takes account of how many people the income has to support, and (often) whether the household pays rent. Inequality in a society is usually measured as the ratio of high incomes to low; for example, the ratio of the top 20% of equivalised household incomes to the bottom 20%.

It is important to distinguish between inequality and wealth and poverty. A rich country can be relatively unequal, and a poor country can be relatively equal.

Many effects of poverty are well known. For example, children of poor families do not perform as well at school as those of affluent families. Poor people have worse health than rich people.

These are results—or at least correlates—of poverty, and they have been documented in most societies. The relationships are usually fairly easy to demonstrate by correlating two variables; for example, by linking family income of a large number of subjects and the test scores or health status of those subjects.

It is less easy to demonstrate a causal relationship between inequality of itself and other social outcomes, principally because inequality is not a characteristic of an individual. Also, the causal mechanisms may be less obvious.

Is there an economic issue?

Two pressing economic issues today are the need to lift productivity and the need to promote growth while avoiding financial instability of the kind that culminated in the global financial crisis. It is possible that inequality reduces labour productivity. It is also possible that it is a brake on growth and can lead to economic instability.

Health

If people are not healthy they will not work to their full productive capacity.

Ascertaining whether inequality is a direct cause of ill health (as opposed to merely being correlated with it) is difficult. On balance, the research seems to indicate that inequality causes poor health. One possible mechanism for this is through increases in stress, which is a known risk factor for many diseases. Specifically, World Health Organization research shows that in Europe more unequal countries have poorer mental health outcomes.

More simply, in most rich countries there are diminishing marginal returns to an individual’s expenditure on health, so a transfer of funds from treating the rich to treating the poor would both reduce inequality and improve the total health of the population.

Education

If children are less successful at school, they are less likely to become highly skilled workers. Their productive capacity, and therefore the productive capacity of the economy, is diminished. OECD research concludes that policies to improve high school and tertiary education completion rates also improve gross domestic product per capita.

Inequality reduces performance because of its segregating effects. There is a good deal of evidence that children’s school success depends at least partly on the interests and aspirations of their peers. The influence of peers is greater than any school effects, including teacher quality. If schools are segregated, children from socioeconomically disadvantaged households will mix with other disadvantaged children, and thus with children who do not perform well at school. Segregation is more likely in an unequal society. The negative effects of poor children associating with less gifted children are greater than any positive effects of affluent children associating with more gifted children. So inequality may cause a net reduction in educational attainment.

Unlike in health, a simple transfer of resources to poor schools may not be very effective in reducing inequality. The research cited above suggests that unequal outcomes will persist to some extent as long as there is residential segregation or parental choice of schools.

Economic growth

In his book Inequality and Instability, James K Galbraith concludes:

... more egalitarian societies tend to have lower steady-state unemployment. They also tend to have higher rates of technical progress and productivity growth.

A more equal wage distribution encourages specialisation in higher value-adding industries, while low wage, low value-adding industries cannot compete.

Meanwhile, work by International Monetary Fund economists shows that ‘longer growth spells are robustly associated with more equality in the income distribution’.

Thus inequality may have a generally slowing effect on economic growth.

Economic stability

A number of economists have argued that inequality leads to economic instability. One mechanism by which this happens is that the rich consume a smaller proportion of their income than the poor. They save money which people on lower incomes would spend. This leads to a reduction in aggregate demand, which in turn leads to unemployment. In response, governments take measures to stimulate demand, such as lowering interest rates. This feeds into asset bubbles—for example, unsustainably high housing prices.

Meanwhile, as inequality grows, individuals facing low or declining relative incomes maintain their consumption through borrowing (financed by the savings of the rich). A very small rise in unemployment or interest rates can lead to defaults on mortgages or consumer loans and can have catastrophic results.

There is some level of consensus that inequality in advanced countries helped cause the global financial crisis.