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Economic Research: How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide

Meanwhile, the experiences of developing and emerging economies suggest that igniting growth is less difficult than sustaining it (52). Even the poorest of countries have managed to expand their economies for several years--only for growth to falter.

Berg and Ostry found that income inequality is the single most important factor in determining which countries can sustain economic growth. Using the GINI coefficient--which ranges from 0 to 1.0--they measured the extent to which economic growth falls as inequality rises. A country in which everyone earns exactly the same would have a score of 0, while a society in which one person owned everything would have a score of 1.0. Berg and Ostry saw that a GINI coefficient of higher than 0.45 could weigh on growth. Although correlation is not causation, we note that, based on after-tax income, the U.S. economy scored 0.434 on the GINI scale in 2010, according to the CBO, placing it near that threshold (53).

To be sure, it seems counterintuitive that inequality is associated with less-sustainable growth, since some inequality, by providing incentives to effort and entrepreneurship, may be essential to a functioning market economy. But beyond the risk that inequality may heighten the susceptibility of an economy to booms and busts, it may also spur political instability--thus discouraging investment. Inequality may make it harder for governments to enact policies to prevent--or soften--shocks, such as raising taxes or cutting public spending to avoid a debt crisis. The affluent may exercise disproportionate influence on the political process, or the needs of the less affluent may grow so severe as to make additional cuts to fiscal stabilizers that operate automatically in a downturn politically unviable.

Striking A Palatable Balance

The discussion about income inequality is hardly new, and contrary opinions abound. In his influential 1975 book "Equality and Efficiency: The Big Tradeoff," economist Arthur Okun argued that pursuing equality can reduce efficiency. He claimed that not only would more equal income distribution reduce work and investment incentives, but the efforts to redistribute wealth--through, for example, taxes and minimum wages--can themselves be costly (54).

Of course, income inequality in the U.S. was much less 40 years ago. Kristin Forbes found that, in the short- and medium-terms over a few years, an increase in income inequality has a significant positive relationship with economic expansion (55). But Forbes also found that the relationship was weakened (or could turn negative) when she increased the length of the growth spells. And a World Bank study later found that the positive effect on growth was almost exclusively reserved for the top end of the income distribution (56).

Income inequality can contribute to economic growth, and a degree of inequality is a necessary part of what keeps any market economic engine operating on all cylinders. Indeed, a degree of inequality is to be expected in any market economy, given differences in "initial endowments" (of wealth and ability), the differential market returns to investments in human capital and entrepreneurial activities, and the effect of luck.

However, too much of the focus in the debate about inequality has been on the top earners, rather than on how to lift a significant portion of the population out of poverty--which would be a good thing for the economy. And though extreme inequality can impair economic growth, badly designed and implemented efforts to reverse this trend could also undermine growth, hurting the very people such policies are meant to help (57).

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