From the TUC

Inequality and prosperity

14 Jul 2011, by Guest in Economics

The UK is a very unequal country, and this extreme inequality is the result of major changes in the income distribution over the last thirty-five years, in particular large increases in inequality under the Thatcher government in the 1980s At the same time, according to recent data from the British Social Attitudes survey, three-quarters of people in the UK believe that the gap between rich and poor in the UK is too high.

But would a more equal distribution of income reduce the level of efficiency in the economy and hence make us worse off overall? Conventional economists have often argued that it would, because of the effects of progressive taxation on reducing the rewards for work and entrepreneurship, and reduced returns to investments.

Next week the TUC publishes a new Touchstone Extra report, Fairness and Prosperity, which addresses precisely this question; I’ll be launching the report at an online seminar on Monday together with Richard Wilkinson of Spirit Level fame (you can register here). In the report,  I ask whether a more equal distribution of income would joepardise the UK’s economic prospects. Or rather, is more equality just what we need to improve our prosperity and well-being?

The report first looks at the relationship between inequality and economic performance using a sample of developed countries in recent years. I find no relationship at all between the level of inequality in each country and economic growth between the mid-1990s and the mid-2000s. Meanwhile, more complex academic research using regression models which control for other factors which might affect growth in different countries also fails to establish any consensus view on the relationship between inequality and prosperity. In short, the conventional view that there is a trade-off between equaility and efficiency is simply not borne out by empirical evidence at the cross-country level.

By contrast, recent research by the epidemiologists Richard Wilkinson and Kate Pickett (in their book The Spirit Level), and the OECD (in its Society at a Glance publication), suggests that there is a clear relationship between income inequality and a range of health and social outcomes, when looking at two-way correlations. For example:

  • Countries with more inequality have worse outcomes for women on indicators like political participation, employment and earnings, and social and economic autonomy;
  • Maths and literacy scores for schoolchildren are lower in countries that are more unequal;
  • Countries with greater inequality have higher rates of homicides relative to population size.

Why does the intuition from conventional economics on these matters turn out to be so flawed? The report examines several reasons why greater equality might be associated with better, not worse, economic performance.  For example:

  • It may well be that rewards for high earners in the labour market are completely out of kilter with the value of what those high earners actually produce – this certainly seems to be the case in banking, for example. Thus, high earnings inequality could be a symptom of a malfunctioning labour market rather than a well-functioning labour market;
  • Countries with greater inequality of incomes tend to be less socially mobile – children from poor backgrounds are more likely to stay poor in later life and vice-versa for children from rich backgrounds, which can mean that people are less well matched to suitable openings in the labour market (as ‘good jobs’ are allocated on an ‘old school tie’ rather than a meritocratic basis);
  • In countries like the UK and US where there are relatively few restrictions on the amounts individuals, corporations or other organisations can donate to political parties, increases in wealth and income inequality are likely to have a knock-on impact on inequalities in political campaign financing. This may cause policies to be followed which are not in the interests of the majority of voters but a small segment of the super-rich instead, which can lead to policies being enacted which have adverse impacts on prosperity for the country as a whole. In the light of the recent revelations about phone hacking at News International – a company itself based on the consolidation of power into the hands of the Murdoch dynasty – it is also worth asking whether the concentrations of power that go hand-in-hand with high inequalities impair the ability of the media to function in a fit and proper manner.

It is likely that these negative effects of inequality on economic performance cancel out the positive correlation suggested by conventional economics, leading to there being no overall relationship between inequality and economic growth. At the same time, there are several theories in the academic literature which may explain the fact that inequality seems to be bad for health and social outcomes. The two most important of these are the possibility of an “evolutionary instinct for fairness” and the idea that it is income growth relative to other people in society, rather than in absolute terms, which affects health and social outcomes. Both of these theories are discussed in some depth in the report.

The conclusion of this research is that we do not have to tolerate greater inequality to ensure enhanced economic performance. Quite the reverse in fact: there is good evidence that the high level of inequality in the UK is responsible for lower life expectancy, increased infant mortality, higher homicide rates, lower degrees of trust between citizens, and a range of other negative outcomes in the nation’s economic and social cohesion.

Reducing inequality should be a priority for government policy. In particular, policymakers should look at limiting the extent to which the super-rich are allowed to continue ‘racing away’ from those on average incomes in the United Kingdom, as there is considerable evidence that this particular feature of the last thirty years of British economic history is particularly damaging, leading to a range of problems including greater inequality of life chances, inequalities in political influence and quite possibly lower growth and innovation than if we were a more equal society.

Specifically, policymakers should look at high pay in the private sector, close loopholes in the tax system that allow certain highly paid workers to pay much lower effective rates of tax than other people on the same gross earnings (e.g. the Capital Gains Tax system as it now stands), and assess the impact of tax and spending decisions with regard to income and gender inequalities in a much more systematic way than the government manages to do at the moment.

EVENT: A free online seminar to mark the launch of ‘Fairness and Prosperity’ will be held from 10am to 12 noon on Monday 18th July, here on Touchstone blog. As well as Howard, we’ll be hearing from Richard Wilkinson and Kate Green MP. Just visit us on Monday morning to watch the live feed and add your own questions and comments (more info).
GUEST POST: Howard Reed is Director of the economic research consultancy Landman Economics, which specialises in complex econometric modelling work and policy analysis. He is also a research associate for both ippr and Demos. Previously, Howard has worked at the Institute for Fiscal Studies (where he was responsible for the TAXBEN microsimulation model) and IPPR (where he led a project on the impact of immigration on wages and employment in the UK).