What is the relationship between the degree of inequality in a country and the rate of economic growth? The traditional answer is that there is a trade off between the two. Increasing the rewards to those who are more productive or who invest encourages a growth in productivity and capital investment, which, in turn, leads to faster economic growth. Redistribution from the rich to the poor, by contrast, is argued to reduce incentives by reducing the rewards from harder work, education, training and investment. Risk taking, it is claimed, is discouraged.
Recent evidence from the OECD and the IMF, however, suggests that when income inequality rises, economic growth falls. Inequality has grown massively in many countries, with average incomes at the top of the distribution seeing particular gains, while many at the bottom have experienced actual declines in real incomes or, at best, little or no growth. This growth in inequality can be seen in a rise in countries’ Gini coefficients. The OECD average Gini coefficient rose from 0.29 in the mid-1980s to 0.32 in 2011/12. This, claims the OECD, has led to a loss in economic growth of around 0.35 percentage points per year.
But why should a rise in inequality lead to lower economic growth? According to the OECD, the main reason is that inequality reduces the development of skills of the lower income groups and reduces social mobility.
By hindering human capital accumulation, income inequality undermines education opportunities for disadvantaged individuals, lowering social mobility and hampering skills development.
The lower educational attainment applies both to the length and quality of education: people from poorer backgrounds on average leave school or college earlier and with lower qualifications.
But if greater inequality generally results in lower economic growth, will a redistribution from rich to poor necessarily result in faster economic growth? According to the OECD:
Anti-poverty programmes will not be enough. Not only cash transfers but also increasing access to public services, such as high-quality education, training and healthcare, constitute long-term social investment to create greater equality of opportunities in the long run.
Thus redistribution policies need to be well designed and implemented and focus on raising incomes of the poor through increased opportunities to increase their productivity. Simple transfers from rich to poor via the tax and benefits system may, in fact, undermine economic growth. According to the IMF:
That equality seems to drive higher and more sustainable growth 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 that themselves undercut growth. In such a situation, even if inequality is bad for growth, taxes and transfers may be precisely the wrong remedy.
Explain what are meant by a Lorenz curve and a Gini coefficient? What is the relationship between the two?
The Gini coefficient is one way of measuring inequality. What other methods are there? How suitable are they?
Assume that the government raises taxes to finance higher benefits to the poor. Identify the income and substitution effects of the tax increases and whether the effects are to encourage or discourage work (or investment).
Distinguish between (a) progressive, (b) regressive and (c) proportional taxes?
How will the balance of income and substitution effects vary in each of the following cases: (a) a cut in the tax-free allowance; (b) a rise in the basic rate of income tax; (c) a rise in the top rate of income tax? How does the relative size of the two effects depend, in each case, on a person’s current income?
Identify policy measures that would increase both equality and economic growth.
Would a shift from direct to indirect taxes tend to increase or decrease inequality? Explain.
By examining Tables 3, 26 and 27 in The Effects of Taxes and Benefits on Household Income, 2012/13, (a) explain the difference between original income, gross income, disposable income and post-tax income; (b) explain the differences between the Gini coefficients for each of these four categories of income in the UK.
The eurozone is made up of 18 countries (19 in January) and, besides sharing a common currency, they also seem to be sharing the trait of weak economic performance. The key macroeconomic variables across the eurozone nations have all seemingly been moving in the wrong direction and this is causing a lot of concern for policy-makers.
Some of the biggest players in the eurozone have seen economic growth on the down-turn, unemployment rising and consumer and business confidence falling once again. Germany’s economic growth has been revised down and in Italy, unemployment rose to a record of 13.2% in September and around 25% of the workforce remains out of work in Spain and Greece. A significant consequence of the sluggish growth across this 18-nation bloc of countries is the growing risk of deflation.
Whilst low and stable inflation is a macroeconomic objective across nations, there is such a thing as inflation that is too low. When inflation approaches 0%, the spectre of deflation looms large (see the blog post Deflation danger). The problem of deflation is that when people expect prices to fall, they stop spending. As such, consumption falls and this puts downward pressure on aggregate demand. After all, if you think prices will be lower next week, then you are likely to wait until next week. This decision by consumers will cause aggregate demand to shift to the left, thus pushing national income down, creating higher unemployment. If this expectation continues, then so will the inward shifts in AD. This is the problem facing the eurozone. In November, the inflation rate fell to 0.3%. One of the key causes is falling energy prices – normally good news, but not if inflation is already too low.
Jonathan Loynes, Chief European Economist at Capital Economics said:
“[the inflation and jobless data] gives the ECB yet another nudge to take urgent further action to revive the recovery and tackle the threat of deflation…We now expect the headline inflation rate to drop below zero at least briefly over the next six months and there is a clear danger of a more prolonged bout of falling prices.”
Some may see the lower prices as a positive change, with less household income being needed to buy the same basket of goods. However, the key question will be whether such low prices are seen as a temporary change or an indication of a longer-term trend. The answer to the question will have a significant effect on business decisions about investment and on the next steps to be taken by the ECB. It also has big consequences for other countries, in particular the UK. The data over the coming months across a range of macroeconomic variables may tell us a lot about what is to come throughout 2015. The following articles consider the eurozone data.
The articles linked below look at the dangers of deflation and policies of central banks to counter it.
Deflation in economics has three meanings. The first is falling prices: i.e. negative inflation. The second, more traditional meaning, is a fall in real aggregate demand, resulting in lower output, higher unemployment and lower inflation – and quite possibly an actual fall in the price level. These first two definitions describe what is generally seen as an undesirable situation. The third is a slowing down in the growth of real aggregate demand, perhaps as a result of a deliberate act of fiscal and/or monetary policy. This third meaning could describe a desirable situation, where unsustainable growth is reduced and inflation is reduced from an above-target level.
Here we focus on the first definition. The first two articles look at the dangers of a fall in the price level. The chart below shows falling inflation, although not actually deflation, in China, France, Germany and the UK (click here for a PowerPoint). Several European countries, however, are experiencing actual deflation. These include: Greece, Spain, Hungary, Poland and Sweden. Inflation in the eurozone for 2014 is expected to be a mere 0.5%.
The most obvious danger of deflation (or expected deflation) is that people will delay spending on durable goods, such as cars, furniture and equipment, hoping to buy the items cheaper later. The result could be a fall in aggregate demand and a fall in output and employment.
For retailers, this is all spelling Christmas doom. Already the runup to the most crucial time of the year for shops is being characterised by a game of chicken. Shoppers are wondering how long they can leave their festive buying in the hope of late bargains.
Interest rates may be low, but for people with debts, this is being offset by the fact that inflation is no longer reducing the real value of that debt. For people with credit card debt, personal loans and most mortgages, the interest rate they pay is significantly above the rate of inflation. In other words, the real interest rate on their debt is still significantly positive. This may well discourage people from borrowing and spending, further dampening aggregate demand. And, with a Bank Rate of just 0.5%, there is virtually no scope for lowering the official interest rate further.
In the USA, by contrast, there is little danger of deflation, as the US economy continues to grow strongly. The downside of this, has been a large rise in consumer debt (but not mortgages) – the ingredients of a possible future bubble and even a new financial crisis.
What are (a) the desirable and (b) the undesirable consequences of deflation? Does the answer depend on how deflation is defined?
What is meant by a ‘deflationary gap’? In what sense is ‘deflationary’ being used in this term?
Why have oil prices been falling? How desirable are these falls for the global economy?
Is there an optimal rate of inflation? If so, how would this rate be determined?
The chart shows that inflation in Japan is likely to have risen in 2014. This in large part is the result to a rise in the sales tax earlier this year. If there is no further rise in the sales tax, which there will probably not be if Mr Abe’s party wins the recently called election, what is likely to be the effect of the 2014 tax rise on inflation in 2015?
If the Bank Rate is below the rate of inflation, why are people facing a positive real rate of interest? Does this apply equally to borrowers and savers?
In what sense is there a cultural revolution at the Bank of England?
Since coming to office two years ago, Shinzo Abe’s government has been determined to revive the Japanese economy. The policy has involved ‘three arrows‘: expansionary fiscal policy, expansionary monetary policy and supply-side reforms. But figures just out show that the Japanese economy is back in recession. The economy shrank by 0.4% in quarter 3, having shrunk by 1.9% in quarter 2.
This has come as a huge disappointment for Mr Abe, who has staked his political reputation on escaping from deflation and achieving sustained economic growth. In response, he has called a general election to put a revised economic plan to the electorate.
The main cause of the reversal into recession has been an increase in the sales tax on all goods, which has dampened spending. The tax rise, planned by the previous government, was to help reduce the deficit and start tackling the huge public-sector debt, which, at over 230% of GDP, is by far the highest in the developed world. Another rise in sales tax is due in October 2015 – from 8% to 10%. Mr Abe hopes to cancel the rise and it is this that he may put to the electorate.
So what is the outlook for Japan? Will quarter 4 show economic growth, or will pessimism have set in? Will the Bank of Japan introduce even more quantitative easing, or will it wait for the latest increase in QE to take effect (see the blog post, All eased out: at least for the USA and UK)?
The following articles look at the implications of the latest news, both for Japan and globally, and at the options for the government and central bank.
Give details of the Japanese government’s three arrows.
Discuss the pros and cons of the rise in the sales tax. Is it possible for the rise in the sales tax to increase the size of the public-sector deficit?
What have been the effects of Japanese government policies on (a) prices of goods and services; (b) living standards; (c) asset prices?
Who have been the gainers and losers of the policies?
How is the Japanese situation likely to effect the value of the yen? How is this, in turn, likely to affect its trading partners? Could this set off a chain reaction?
How much does the UK spend on welfare? This is a highly charged political question, with some arguing that benefit claimants are putting great demands on ‘hard-working tax payers’. According to information being sent by the government to all 24 million income tax payers in the UK, the figure of £168bn being spent on welfare is around 24.5% of public spending. But what is included in the total? Before you read on, try writing down the categories of government expenditure included under the heading ‘welfare’.
The heading does not include spending on certain parts of the ‘welfare state’, such as health and education. These are services, the production of which contributes to GDP. The category ‘welfare’ does not include expenditure on produced services, but rather transfer payments. The way the government is using the term, it does not include state pensions either, which account for 11.6% of public expenditure. So does the 24.5% largely consist of payments to the unemployed? The answer is no.
The category ‘welfare’ as used by the government includes the following elements. The percentages are of total managed expenditure (i.e. government spending).
•
Public service pensions, paid to retired public-sector employees, such as teachers, police officers, doctors and nurses
(2.6%)
•
Other support for the elderly, including pension credit, winter fuel allowance, bus passes, etc.
(1.5%)
•
Sickness and disability benefits, including long-term care for the elderly, sick and disabled
(6.6%)
•
Support for families and children, such as child benefit and child tax credits
(3.4%)
•
Social exclusion, including income support and housing benefit
(7.8%)
•
Unemployment benefits, including Job Seekers Allowance
(0.7%)
•
Other
(1.9%)
Lumping all these together under a single heading ‘welfare’ can be highly misleading, as many people have strongly held preconceptions about who gets welfare. In fact the term is used pejoratively by many who resent their taxes being given to those who do not work.
But, as you can see from the figures, only a small proportion goes to the unemployed, the majority of whom (around 65%) are unemployed for less than a year as they move between jobs (see). The bulk of benefits goes to children, the retired and the working poor.
Another preconception is that much of welfare spending goes to fraudulent claimants. But, as the article by Professor Hills states:
Just 0.7% of all benefits was over-paid as the result of fraud, less than the amount underpaid as a result of official error. For the main benefit for unemployed people, Jobseeker’s Allowance, estimated fraud was 2.9%, or an annual total of £150million.
It is also important to consider people’s life cycle. The same people receive benefits (via their parents or guardians) as children, pay taxes when they work and receive benefits when they retire or fall sick. Thus you might be a net contributor to public finances at one time and a net beneficiary at another. For example, the majority of pensioners were net contributors when they were younger and are now mainly net beneficiaries. Many unemployed people who rely on benefits now were net contributors when they had a job.
The message is that you should be careful when interpreting statistics, even if these statistics are factually accurate. How figures are grouped together and the labels put on them can give a totally misleading impression. And politicians are always keen to ‘spin’ statistics to their advantage – whether in government or opposition.
What benefits do you receive? How would you expect this to change over your lifetime?
What are the arguments for (a) reducing and (b) increasing welfare payments. In each case, under which categories of welfare would you decrease or increase the level of benefits?
Referring to Table 5.2 in the PESA data below (the table used for the government’s calculations), which of the categories would be classified as expenditure on goods and services and which as transfer payments?
Assess the arguments of the IFS for the reclassification of the categories of ‘welfare’ payments.
Referring to the pie chart above, also in the BBC video and articles and Table 5.2 in the PESA data, assess the arguments about the size of the UK’s contributions to the EU budget.
What is the relationship between the degree of inequality in a country and the rate of economic growth? The traditional answer is that there is a trade off between the two. Increasing the rewards to those who are more productive or who invest encourages a growth in productivity and capital investment, which, in turn, leads to faster economic growth. Redistribution from the rich to the poor, by contrast, is argued to reduce incentives by reducing the rewards from harder work, education, training and investment. Risk taking, it is claimed, is discouraged.
This growth in inequality can be seen in a rise in countries’ Gini coefficients. The OECD average Gini coefficient rose from 0.29 in the mid-1980s to 0.32 in 2011/12. This, claims the OECD, has led to a loss in economic growth of around 0.35 percentage points per year.
