How Income Inequality May Be Hurting Economic Growth

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The OECD's Stefano Scarpetta and Wharton's Joao Gomes discuss income inequality.

Economic growth is the casualty of a widening gap between the rich and the poor among member countries of the Paris-based Organisation for Economic Co-operation and Development (OECD), according to a report issued last month. The richest 10% of the population in OECD countries earn 9.5 times more than the poorest 10%. In the 1980s, that ratio was 7:1, and the income gap is at its highest level in about 30 years. The report suggests that the growing income inequality has, over the past two decades, cost the U.S. between 6 and 7 percentage points in economic growth, nine points in the U.K., and 10 points in New Zealand and Mexico.

“Income inequality is a source of concern not just from a social point of view, but also from an economic point of view,” said Stefano Scarpetta, director of employment, labor and social affairs at the OECD. He attributed the growing inequality to globalization and technological progress, and called for more access to quality education for people in lower-income households. He also saw a bigger role for private companies in training and retraining workers to bridge gaps in skills.

Wharton finance professor Joao F. Gomes was not as convinced of the connection between income inequality and economic growth, and said that many other factors could be at play. He also noted that “the rich are getting richer in rich countries, but the rich countries are not getting richer — the poor countries are.”  Twitter In any event, he underscored the need to focus on education, especially with targeted programs.

Scarpetta and Gomes discussed the takeaways for policy makers from the OECD report on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

“[People from poor socio-economic backgrounds] contribute less to economic growth because they cannot fully invest in their potential and develop their talents.”–Stefano Scarpetta

Indeed, an OECD survey of people who discontinued their education for a job found that in countries with high income inequality, people from poor socio-economic backgrounds have less access to education, particularly higher education. “They contribute less to economic growth because they cannot fully invest in their potential and develop their talents,” said Scarpetta.

Different Strokes

Gomes said that inequality within countries has undoubtedly increased significantly in the last 20-25 years. However, “inequality across countries has decreased enormously,” he pointed out. “That is something to think about more carefully as we think of policies to reduce inequality.”

He also found it hard to conclude from the report that inequality leads to weaker economic growth. “It is a little hard to disentangle these things,” he said. “For example, [the report says] human capital doesn’t matter for growth; education does matter. Or that investment doesn’t matter for growth. [The] true drivers of inequality and growth are hard to identify. I am hesitant to jump from this to policies to deal with this issue.”

Scarpetta maintained that the OECD’s “results are fairly robust.” However, he agreed with Gomes on the difficulties in comparative analyses across countries to identify the effects of income inequality. “It is not the last word — far from that — but [Gomes] points to an important element for reflection. By no means should we build policies only on that. But it is opening up an avenue for further research.”

“If we are going to liberalize trade, we need a majority of people to benefit from it.”–Joao F. Gomes

Gomes was not convinced that difficulties in accessing education increase income inequality. “The question we have to ask with these kinds of studies is: Is this going to harm growth?” he said. “I am more concerned about increased globalization and the increased skills premium for talent. More and more, people need to share into this success story. If we are going to liberalize trade, we need a majority of people to benefit from it.”

A Preference for Inequality?

The U.S. seems to prefer income inequality, relative to Europe, according to Gomes. Scarpetta agreed with him. “There is an element of social preference — how much tolerance there is for the level of income inequality,” Scarpetta said. Tax and transfer systems to redistribute income explain the differences between countries in their tolerance to income inequality, he added. “Nordic countries have a significant way to compensate for an increase in market income inequality through distribution — much more than in the U.S. or in a number of other countries.”

Both Scarpetta and Gomes expressed concern over the study’s finding of “huge variations in the levels of competence” in the U.S. among working adults. “This is because of the education system, which creates a lot of people with high talent and competence, but also people with very low levels of competence,” said Scarpetta. For the latter group, “it is very difficult to find jobs, or find rewarding and productive jobs, as our economies become more competitive, precisely because they are operating in a global context,” he added.

Scarpetta found it “astonishing” that in the U.S., the top 1% of the population accounted for 20% of the total pre-tax income (in 2012) , up from 8% in the 1980s. However, raising tax rates will not fix that income inequality, he said, though he noted that other measures, like closing loopholes in the tax code and reducing exemptions, would help.

“It’s about repurposing people, [and] training them at later stages in response to shocks that change the things they need to do to be successful 20 years from now.” –Joao F. Gomes

Takeaways for Action

According to Scarpetta, it is imperative that countries invest in early childhood education “when some of the important building blocks are made.” Increased access and improved quality of education for those from low socio-economic backgrounds are equally important, he said. “An even bigger challenge is to skill and re-skill those who are already in the labor markets, because their existing skills may no longer adapt to the way in which economies have evolved,” he added. “This has to be a partnership between public intervention and private sector companies.”

Gomes agreed with that agenda, but called for targeted policies instead of across-the-board investments in education. “It’s about repurposing people, [and] training them at later stages in response to shocks that change the things they need to do to be successful 20 years from now.”

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