Why income inequality matters for the economy, in one sentence

Getty/Spencer Platt

Last November Thomas Piketty’s Capital in the Twenty-First Century was named the Financial Times and McKinsey’s 2014 Business Book of the Year.

The FT described it as “an epic analysis of the roots and consequences of inequality.” It was a controversial book largely because it basically argues that the modern capitalist system is causing rising inequality.

But, in an IMF report released overnight Pikketty gets all the support he needs from one sentence which gives the clearest reason why politicians, policy makers and central banks should be acutely focussed on circumventing the negative feedback loop of inequality.

The IMF says:

we find an inverse relationship between the income share accruing to the rich (top 20 percent) and economic growth. If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth.

What makes this finding so powerful is that the authors undertook their analysis based on a sample of “159 advanced, emerging, and developing economies for the period 1980–2012.”

Their methodology looks robust and they say their findings about the negative impact of inequality and positive impact of a more even distribution of gains “survives a variety of robustness checks, and is in line with recent findings for a smaller sample of advanced economies (OECD 2014).”

That means that “pretax incomes of middle-class households in the United States, the United Kingdom, and Japan have experienced declining or stagnant growth rates in recent years.”

But for Australia there is good news because while “a shift in the allocation of labor income towards the higher and lower ends of the distribution has resulted in a shrinkage of the income share accruing to the middle 20 percent in many advanced economies (Australia, Canada, and Sweden are important exceptions).”

So for all the many headwinds the economy faces this isn’t one of them.

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