Redistribution is not bad for economic growth: Evidence from the IMF

For the study that this post is based on, click here.

In a previous post I outlined the main case for redistributing wealth- an extra hundred dollars means a lot more to someone struggling to make ends meet than to a millionaire. We even put some figures on how much inequality ‘costs’ through exactly this effect. As I said in the post though, this is only one side of the ledger, the other is the efficiency costs, or gains, of redistribution.

It’s something of an article of faith that there is a trade-off between growth and inequality. In particular, because participants in a democracy have a natural tendency to seek policies that benefit the many at the expense of the few, a tremendous propagandistic literature has developed warning that aiming to reduce inequality instead of increasing growth threatens to create only ‘an equality of misery’. For example, Mr Tanner of the Cato institute writes:

“We have become obsessed with economic equality at the expense of economic growth. Inequality is said to be the transcendent issue of our time. Yet a society that is rich and unequal still beats one that is poor and equal any day of the week.”

The problem is it’s a false dichotomy. There’s no clear trade-off between growth and reducing inequality under current circumstances. Mind you, even if reducing inequality did mean a somewhat smaller economy in aggregate I’d still be in favour of it, but it’s not even clear that we have to make that choice.

I concede that, given the way incentives are structured in a capitalist economy, at some level of redistribution there must be such a trade-off as long as we remain in a market based economy. However available empirical evidence based on variations in growth and redistribution between countries does not support the notion of a growth/equality trade-off at practical levels of redistribution.

A 2014 working paper by IMF looked at this issue by comparing the Gini index (a measure of inequality) for countries before taxes and transfers and after taxes and transfers. Compare the difference between these and you get the level of redistribution in a country. What’s unique about this research is that prior attempts usually looked at limited proxies for redistribution, such as tax rates or social spending. By considering the statistical interrelations between growth, inequality and redistribution the paper found:

“…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.”

Check the paper out for yourself, but it’s really quite robust. The paper isn’t exactly using fancy-schmancy-blink-and-you’ll-miss-it econometrics, so there honestly aren’t a great many degrees of freedom for cooking the results. The basic model is pretty much just a regression. Obviously controls are then added as appropriate but the result is quite stable. Interestingly, despite their claim that ‘extreme cases’ must be anti-growth (something I will accept or a given value of extreme), nothing in their paper demonstrates this statistically.

Plenty of others have found similar results, for example these two papers.

Indeed Ostry et al. (2014) find not only that redistribution has no direct effect on growth, but its indirect effect (through lowered inequality) is positive. Moving from the median level of redistribution to the 60th percentile of redistribution (a moderate but significant increase in redistribution) increases growth by 0.5%. Although it may not sound like a lot, this actually a great deal of extra growth, especially in a developed nations context, where growth tends to hover between 1 & 4 percent. Although these results are sensitive to statistical specifications, and may not represent the real state of play, it’s very interesting that we’ve moved from worrying about massive negative effects on growth of redistribution to wondering whether it might have a positive effect!

Now it is possible that the truth is that redistribution harms growth, and this study has not detected this relationship because of subtle methodological flaws, or because of limitations in the data-set. This is the kind of question one could spend a lifetime studying, and I’m certainly not arrogant enough to think it can be answered in a blog post. What I would say though is that even if the studies we have reviewed are wrong (and I see no reason to think they are) we have already pushed many far outside their comfort zone. We’ve come a very long way from ‘redistribution is ultimately worse for everyone because it tanks the economy’ to ‘redistribution is ultimately worse for everyone because it tanks the economy but you can only detect this if you use super-refined statistical techniques and exactly the right methodology’.

Remember that from a utilitarian point of view, not redistributing has costs because of the declining marginal value of income- a little extra money means a lot more to the poor than the rich. These costs are obvious, large and form the basis of an ethical case for redistribution. The counter-case, at least from a utilitarian view, has always been efficiency -redistribution harms growth-, yet the evidence for this is pretty hard to find via regression.

The confidence so many people have that ‘economics’ shows that redistribution reduces efficiency, even though actual empirical studies by actual economists don’t necessarily show any such thing, is a form of ideology where ‘economics’ is associated with hostility to state intervention, except to create and sustain property rights. The truth is that what actual economists think, and what economics shows, is far more varied than this rather flat picture of ‘economics’ that various think tanks and propaganda agencies push upon us.