When income inequality slows economy

It’s an astounding statistic, but according to a report earlier this year, the top one per cent of income earners in Canada captured 37 per cent of the growth in Canadian incomes over the three decades 1975 to 2007.

It’s an astounding statistic, but according to a report earlier this year, the top one per cent of income earners in Canada captured 37 per cent of the growth in Canadian incomes over the three decades 1975 to 2007.

This is not as much as in the U.S., where the top one per cent captured 47 per cent of the growth in incomes.

The report, from the Organization for Economic Co-operation and Development, explained as well that “highly disposable incomes makes it easier for the one per cent to save and accumulate capital, which eventually increases incomes further.” So this income inequality can become self-sustaining.

But there is rising concern that high levels of income inequality are actually bad for the economy, a point that has been made by the International Monetary Fund, because high levels of inequality lead to slower economic growth.

Now, a Wall Street rating agency, Standard & Poor’s, has added to the debate. As it says in a new report, “a degree of inequality is to be expected in any market economy. It can keep the economy functioning effectively, incentivizing investment and expansion.” But too much inequality can undermine growth, it warns, adding that “the current level of income inequality in the U.S. is dampening growth.”

As Standard & Poor’s argues, “higher levels of income inequality increase political pressures, discouraging trade, investment and hiring.” If a large part of the population feels the economic system is unfair, then support for political populism, which encourages protectionism, antagonism towards immigrants and hostility to those on social welfare, not to mention to high-profile wealth, increases.

High levels of income inequality can also dampen social mobility and produce a less-educated workforce which, it warns, “diminishes future growth prospects and potential long-term growth.” So inequality may be reinforced since slower growth means fewer new jobs.

The rating agency cites John Maynard Keynes, who argued that income inequality can lead affluent households to increase savings and decrease consumption while those with lower incomes increase borrowing to sustain their standard of living. Indeed, a significant part of the Canadian ‘recovery’ from the Great Recession can be explained by an explosion of consumer debt based on ultra-low interest rates. This high level of household debt is now seen as a serious risk to the Canadian economy.

In an earlier report this year, economists from the IMF found that “inequality is a robust and powerful determinant both of the pace of medium-term growth and of the duration of growth spells, even controlling for the size of redistributive transfers.” So, the three economists — Andrew Berg, Jonathan Ostry and Charalambos Tsangarides — argue that it would be “a mistake to focus on growth and let inequality take care of itself, if only because the resulting growth may be low and unsustainable. Inequality and unsustainable growth may be the two sides of the same coin.”

Moreover, they say, “the average redistribution, and the associated reduction in inequality, seem to be robustly associated with higher and more durable growth.” So “while positive incentives are surely needed to reward work and innovation, excessive inequality is likely to undercut growth.”

This is clearly an issue Canada needs to address. Much of the change in tax policy in recent years has favoured top income earners while worthy initiatives to benefit lower-income families are underfunded.

The OECD’s economic survey of Canada, published this summer, noted that while Canadians enjoy high levels of well-being, “disposable income inequality has increased by considerably more in Canada since 1995 (11 per cent) that in other countries with data (two per cent) to a level that is now 12th highest in the OECD.”

But this cannot be simply blamed on Prime Minister Stephen Harper’s Conservative government, the OECD says, because the jump occurred in the late 1990s, when the Liberals were in power.

All too often we are presented with false choices. For example, when governments propose increasing the minimum wage to reduce inequality, they are typically met with a storm of business-led protests, aided by academic economists, claiming this will lead to a massive increase in unemployment when, in fact, the benefits of a minimum wage increase are positive for the economy.

Fortunately, there is growing economic analysis which shows that acting on inequality is good for the economy. So why is there such a wide gap between what we know and what we do?

Economist David Crane is a syndicated Toronto Star columnist. He can be reached at crane@interlog.com.

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