Tuesday, 8 April 2014

The latest from the IMF: income redistribution is good for growth

Carlos Fortin photo
In previous blogs I commented on two studies from the International Monetary Fund that appeared to depart from orthodox tenets with respect to: (i) the distributional impact of fiscal consolidation (where the IMF study argued that consolidation through reductions of spending increases inequality); and (ii) alternative ways to address fiscal imbalances (where the study recommended increasing the taxation of the top income earners and introducing taxes on wealth). A recent paper(1) signals a further move away from orthodoxy, this time in connection with the question of the relationship between income redistribution and growth.

The paper reviews the economic literature that tests the conventional hypothesis that inequality is good for growth because it provides incentives for innovation and entrepreneurship, raises saving and investment, and allows individuals to accumulate the minimum needed to start businesses. What it finds is decidedly counterorthodox; “the statistical evidence”, the paper states, “generally supports the view that inequality impedes growth, at least over the medium term.” This backs up what the paper calls a “tentative consensus” in the growth literature that inequality can undermine progress in health and education, cause investment-reducing political and economic instability, and undercut the social consensus required to adjust in the face of major shocks, and thus that it tends to reduce the pace and durability of growth.

The paper then goes on to examine redistribution and its impact on growth. The starting hypothesis is, again, orthodox, as presented by Arthur Okun in an influential 1975 book on the trade-off between efficiency and equity.(2) “That equality seems to drive higher and more sustainable growth” the paper states, “does not, in itself, support efforts to redistribute. In particular, inequality may impede growth at least in part because it calls forth efforts to redistribute through the fiscal system, efforts that themselves may undermine growth. In such a situation, even if inequality is bad for growth, taxes and transfers may be precisely the wrong remedy.”

The IMF paper’s findings, however, run contrary to the orthodox hypothesis. Applying a multiple regression model to the Standardized World Income Inequality Database(3) that includes data on 153 countries for the period from 1960 to date, the paper concludes that “redistribution appears generally benign in terms of its impact on growth; only in extreme cases is there some evidence that it may have direct negative effects on growth. Thus the combined direct and indirect effects of redistribution—including the growth effects of the resulting lower inequality—are on average pro-growth”(italics in the original).

The authors of the paper are cautious about over-interpreting these results for policy purposes, not least because of the limitations inherent in the use of regression analysis. But their overall conclusion is clear: “Extreme caution about redistribution—and thus inaction—is unlikely to be appropriate in many cases. On average, across countries and over time, the things that governments have typically done to redistribute do not seem to have led to bad growth outcomes, unless they were extreme. And the resulting narrowing of inequality helped support faster and more durable growth, apart from ethical, political, or broader social considerations.”

And that is music to the ears of those who, like myself, believe that reducing inequality is one of the most crucial challenges of development policy today.

(1) Ostry, Jonathan D., Andrew Berg, and Charalambos G. Tsangarides, “Redistribution, Inequality, and Growth”, IMF Discussion Note SDN/14/02, February 2014. As with all Discussion Notes, the paper carries the disclaimer that it does not necessarily represent IMF views or policy.
(2) Okun, A.M., Equality and Efficiency: the Big Trade-Off, Washington: Brookings Institution Press, 1975.
(3) Described in Solt, Frederick, “Standardizing the World Income Inequality Database”, Social Science Quarterly, Vol. 90, No. 2, June 2009, pp.231-242.

By Carlos Fortin, Research Associate, Institute of Development Studies