2 Does income inequality drive or hamper economic growth?

Addressing economic inequality is an important concern for many policy makers, as economic and social inequalities, such as health inequity and gender or racial inequality, oftentimes intersect. For example, health outcomes such as life expectancy or child mortality are worse for people living in less affluent households (Pickett and Wilkinson, 2010). Similarly, in the US, 71.7 percent of White households own their own houses compared to only 41.7 percent of Black households (Hermann, 2023).

Nonetheless, while the correlation between economic inequality and social inequalities is quite well established, the link between economic inequality and economic growth is less clear. Within economics the question of whether or not we need a degree of income inequality to grow our national incomes remains a topic of contestation.

Historically, many economists believed that an unequal distribution of wealth and income was the price to pay for higher economic growth. Most famously, Simon Kuznets, a Belarusian-born US American neoclassical economist suggested that as a country undergoes economic development, income inequality will increase at first and then decrease again over time, as workers could organise themselves and put pressure on policymakers and employers to pay them higher wages (Kuznets, 1955). As illustrated in Figure 3, this relationship between economic growth or development and a country’s income distribution is captured in the Kuznets curve, represented as an inverted U-shape.

Source: Madsen (2010)

Figure 3: Kuznets curve

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This is a figure graphically representing the Kuznets Curve which illustrates the relationship between economic growth and income inequality. The figure is plotted with two axes, which touch in the bottom-left corner labelled with two zeros. The horizontal x-axis is labelled economic growth. The vertical y-axis is labelled income inequality. The figure shows a light-blue curve that has an inverted U-shape. The curve begins low on the left, rises upward to a peak at the middle, and then slopes downward toward the right. The curve reaches a peak, labelled Turning Point, marked by a blue dot and a vertical dashed line, indicating the highest level of inequality. The left side of the curve until the peak in the middle is marked with an upward-pointing black arrow labelled increasing inequality. On the left side of the figure alongside the x-axis the label developing economies is shown. The right side of the curve from the peak in the middle onwards is marked with a downward-pointing black arrow labelled decreasing inequality. On the right side of the figure alongside the x-axis the label developed economies is shown.

Figure 3: Kuznets curve

Since its appearance, the Kuznets curve has oftentimes been used to push-forward the idea that economies grow when firms do well and have spare capital available in the form of savings that they can re-invest into the production process (Galenson and Leibenstein, 1955). This is because the more profit capitalists make, the more savings they have available to re-invest into the production of goods and services, which in turn will foster innovation and technological advancements.

Proponents of ‘trickle-down economics’ draw on this logic to argue in favour of tax cuts for the wealthy (as this will incentivise them to invest more) and a reduction in government regulation (as this will make it easier for entrepreneurs to expand their production). The additional wealth created at the top of the income distribution is then expected to ‘trickle down’ to the rest of the population, based on the assumption that the rich will put their additional wealth to good use and re-invest their extra capital in businesses that will generate new jobs for workers, while also paying a good amount of taxes to the government. However, other economists, such as French economist Thomas Piketty, have challenged the validity of the Kuznets curve (Piketty, 2006).

Activity 3: The Kuznets curve in practice

Timing: 3 minutes

Figure 4 shows the link between economic growth and income inequality estimated by a team around the French economist Thomas Piketty. Describe the relation they found. Does it provide evidence in favour of the Kuznets curve?

Figure 4: U-shaped long run inequality trend Source: World Inequality Database

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The figure shows a line graph showing the before-tax income share of the richest 1% in four countries over time. The x-axis represents the years, and the y-axis represents the percentage of income. The four countries represented are the United Kingdom (dark-blue line), the United States (green line), Canada (yellow line) and Italy (red line). Each country's data is plotted as a separate line. The overall trend for all countries is a U-shape, meaning that inequality initially rose, then fell, and then rose again. The United States saw a significant increase in inequality in the late 20th century, while the other countries experienced a more gradual rise.

Figure 4: U-shaped long run inequality trend Source: World Inequality Database

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Discussion

Piketty and his team found a U-shaped curve rather than an inverted U-shape curve for groups of countries. The empirical observations of him and his team show that inequality across several advanced capitalist societies was high at the beginning of the 20th century, but then slowly decreased to become particularly low during the post-war years. Since the 1980s, income distribution has become more unequal again.

Also other recent studies have come to the conclusion that economic inequality hampers economic growth and is associated with a phenomenon called secular stagnation – slow average economic growth (Shen and Zhao, 2023).This is because economic growth started to ‘stagnate’ from the 1970s onwards across many countries of the Global North, and has been much less stable since then, compared to the period of 1950-1970 (see Figure 5) (Madsen, 2010). Yet, whether or not we can conclude unambiguously that a skewed income distribution has a negative effect on economic growth remains contested.

Figure 5: Smoothed growth rate in per capita GDP Note: The graph is based on the average of the following 17 countries: Canada, the US, Japan, Australia, Austria, Belgium, Denmark, Finland, France, Germany, Italy, the Netherlands, Norway, Spain, Sweden, Switzerland, and the UK.

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The figure illustrates the evolution of GDP per capita growth rates for five advanced capitalist economies from 1950 to 2020. The horizontal s-axis represents the years from 1950 to 2020, divided into decades and the vertical y-axis represents the average compound GDP per capita growth rates, ranging from -1.0% to 7.0% with major tick marks every 1.0%. The figure shows data for five countries: France (light-blue line), United Kingdom (dark-blue line), United States (green line), Australia (yellow line), and Spain (red line). Australia: A yellow line that shows a general decline over time, with peaks in the 1950s-60s and 1960s-70s. Spain: A red line that starts high, declines sharply in the 1970s-80s, and then shows a gradual recovery. France: A light-blue line that shows a similar pattern to Spain, with a peak in the 1960s-70s and a decline in the 1970s-80s. United Kingdom: A dark-blue line that starts high, declines in the 1970s-80s, and then shows a gradual recovery, with a peak in the 1990s-00. United States: A green line that shows a relatively stable growth rate throughout the period, with a slight decline in the 2000s-10 and a more significant decline in the 2010-20.

Figure 5: Smoothed growth rate in per capita GDP Note: The graph is based on the average of the following 17 countries: Canada, the US, ...