Too much inequality hurts growth

President Donald Trump’s proposed tax reform is supposed to be the largest tax cut in history. It reduces the highest marginal income tax rate as also the corporate tax rate. It eliminates estate taxes. However, the benefits will flow disproportionately more to the rich. The Tax Policy Centre of America estimates that the tax cuts will mostly benefit the rich, with the wealthiest one per cent families earning more than 700,000 dollars receiving an average tax cut of more than 129,000 dollars annually. President Trump believes such tax cuts will lead to higher job creation.

This week the International Monetary Fund seems to have directly contradicted the Trump proposals. At the annual meetings of the IMF and World Bank, the Managing Director of IMF, Christine Lagarde urged countries to find ways to redistribute wealth. Her speech and the IMF report is in effect asking for higher taxation of the top one per cent income earners, especially in rich countries. The IMF projects higher GDP growth next year for most countries, but many workers will not see significant improvement in their wages, as technology and machines will replace much of their work.  

America has seen wage stagnation for a long time, despite the economy having expanded substantially. Even as the jobless rate has dropped to lower than 2007, the pre-crisis year, most of the jobs added to the economy are low paying. This means most of the benefits of aggregate income growth are going to the top one or even top 0.1 per cent income earners. This is not a recent trend. This trend is leading to a widening of the rich-poor gap, which is what has been flagged in the IMF’s report called the Fiscal Monitor.  Curiously, it is that same widening inequality which has led to political tensions and polarisation, which in turn led to the ultimate election of President Trump.

The IMF is very clearly advocating increasing taxes on the very rich, which it claims will not sacrifice economic growth. This is the opposite of the Trump plan, which is also aiming to promote growth and job creation.  Clearly, one of these two has to be incorrect. Which one? Both can be right at appropriate levels of inequality in society. Here we have to talk about the concept of “too much inequality”.  Inequality, whether of income or wealth, is somewhat like industrial pollution. You can never have it as zero, since you do need to have economic activity. Inequality is a consequence of economic activity, and is inevitable. Indeed in early stages of development an economy may find that with faster economic growth, the inequality may be worsening. This happens because the fast growth sectors race ahead, while others lag behind.

But when inequality becomes excessive, it needs to be corrected. How much is excessive is for each society to decide. When it reaches that danger level (measured by say the Gini coefficient), you need to introduce redistributive taxes, and increase support for lower income groups. Too much inequality can lead to political instability, flight of capital, social immobility, corruption and charges of crony capitalism and drying up of new investment. This is how too much inequality hurts growth. Of course, these extreme levels are seen only in a few countries, but in a majority of the countries we are already at worrying levels. The IMF is effectively saying that in many countries we are past that critical level of inequality and hence need to increase taxes progressively.

There is an apparent anomaly here. The fact is that global inequality has actually reduced. This is mainly because of the rise of countries like India and China, so that the gap between per-capita incomes of various countries has actually trended down in recent decades. But intra-country inequality has increased. That is, within each country, the various income groups have grown very unevenly. The IMF report documents this and says that in roughly half of all the 189 countries, inequality has gone up, and is the highest in the past three decades. This is especially true in USA, China and India. Not only have gaps in income and wealth widened, but even inequality in opportunity is greater. Access to quality health and education is becoming very skewed and unequal.

For India, this was pointed out recently in a research paper of Thomas Piketty and Lucas Chancel.  Their paper shows that for the period 1980 to 2014, the gap between the share of income going to the top one per cent income earners versus the entire economy, was the highest in India in comparison to most other countries. In particular, of the cumulative gain over these 35 years, the share that went to the top one per cent was 29 per cent. The top 0.1 per cent earned 12 per cent, a lion’s share, more than the entire bottom 50 per cent. Their report uses tax data all the way from 1922 onward. They also admit to data inadequacy and the need for further refinement.

Indeed Swaminathan Aiyar has strongly rebutted and said that Piketty and Chancel overestimate India’s inequality. Aiyar of course is more concerned about the implication, fearing that India should not go to the overly statist and socialist policies of the past. But whatever the state of this debate, we cannot escape the conclusion of “too much inequality” in India.

The latest Forbes billionaire report says that the top 100 added 26 per cent to their wealth, much higher than the GDP growth rate, and even higher than the growth in the Sensex. This is just a small corroboration that the spoils of economic growth are very uneven. That is why in our lexicon we use the word “inclusive economic growth” as the goal of fiscal policy. This needs progressive taxation, widening the tax net, vastly increased expenditures on human capital formation and reducing the gaps in opportunities.

For instance, one of the ways to reduce inequality is to increase the share of women in the workforce, and reduce wage disparity between men and women. Surely that is a low hanging fruit? Can we focus on eliminating the loophole of tax shelters in direct taxes? Can we reduce the burden of indirect taxes, which hurt the poor more than the rich?

The list of doable ideas is long, but the first step is too acknowledge that we are at a point of “too much and an unacceptable level of inequality”. That would be a start.

(The author is an economist and Senior Fellow, Takshashila Institution)