The evidence is clear that inequality in America is rising. There are those who see this as a grave threat. Others see is as a sign of a healthy and vigorous capitalist economy. Some inequality is essential in producing opportunities and incentives for individuals to create new products, to invest in innovative ideas, and to work hard.
Accepting a life of grinding penury for large portions of the populace is offensive to empathetic and humane sensibilities, and has been throughout human history. But the acceleration of inequality trends in recent years is provoking important questions about the effect on growth itself. Is economic growth threatened by inequality? Does high inequality cause the economy as a whole to produce less for all?
We support the view that income inequality has crossed a threshold that threatens overall growth and that it is an issue of great importance.
Perceived, Actual and Desired Inequality
In a 2011 study, economists Michael Norton and Dan Ariely asked a random sample of Americans to rank three alternative distributions of wealth for a society. The first is the actual distribution of the wealth of the US, with the richest 20% holding 84% of the wealth and the poorest 20% holding 0.1%. The second is a hypothetical intermediate distribution, with the richest 20% holding 36% of the wealth and the poorest 20% holding 11%. The third is a hypothetical distribution in which each fifth of the population has the same level of wealth. Respondents were asked which society they would rather inhabit. The top choice was the intermediate distribution, with the equal distribution being next, and the actual distribution last.
Respondents were then asked what distribution actually exists in the US and which they would like it to be. Two main lessons may be drawn from these results. The first is that people appear to underestimate dramatically the level of wealth inequality in the US economy. The average person believes that the richest quintile holds about 57% of the wealth when the actual share is 84%. Second, people wish that wealth inequality were even lower than they believe it to be. The average person feels that the richest quintile should hold about 32% of the wealth.
Norton and Ariely confirm our belief that most favor some inequality. Most would prefer less inequality than they think exists and would prefer far less than actually exists. Overall, most Americans think current inequality is excessive and likely would feel stronger about it if they knew the actual facts.
Inequality and Growth
A certain amount of inequality is inevitable, and most economists would agree that some is essential for health and vigorous economic growth. As inequality increases, though, the marginal benefit to output from additional inequality logically declines. Has inequality risen to a point where the marginal effects on output are actually negative? Is inequality now so high that recent widening has caused lower GDP than we would have had with the lower levels of inequality of the middle of the last century?
In his 2010 PhD dissertation, Poverty, Income Inequality and Economic Growth, Ramaprasad Rajaram considers the effects of income inequality and poverty on economic growth. He relates per capita income growth to poverty rates and overall income inequality in 3,072 US counties using data from the 1980 and 2000 US Census. He assesses the relationship of poverty in 1979 to growth from 1979 to 1999 and finds that counties with lower poverty rates in 1979 grew significantly more quickly during the next 20 years. Similarly the counties with less inequality in 1979 grew significantly more quickly than those with higher income inequality in 1979. He then looked at actual growth from 1979 to 1999 as a predictor of 1999 poverty and inequality measures. He found that counties that grew more quickly from 1979 through 1999 had lower poverty rates and overall inequality at the end of the period.
His results tell a compelling story. Those areas with less inequality and poverty today can expect higher future growth in future per capita income. In the future, those that actually experienced the highest growth are likely to have lower poverty and overall inequality. Those that grow quickly are likely to be the ones that start with lower inequality. The resulting high growth in turn has a dampening effect on future increases in inequality.
Inequality and Demand for Goods and Services
As household income increases, consumption increases along with it. This has an effect of increasing the demand for the goods and services that give rise to the additional income. Poor households spend nearly all their increases in income, while middle households spend most of the increases. Those at the top spend a smaller proportion of additional income. When incomes at the top are growing much more quickly than those in the middle and the bottom of the distribution, consumption naturally declines as a share of GDP. Growth is constrained as inequality increases beyond a level that encourages growth.