Income Inequality and Lost Economic Growth

Income inequality is a common topic in the economic and political arenas.  Most discourse focuses on the causes and the possible cures.  Here we will be concerned with the economic consequences of a system in which wages for the majority of workers have stagnated in real terms (accounting for inflation) while the top few percent of earners have seen their share of net income increase significantly. 

One obvious consequence of this evolution in the distribution of income is that those who spend most of their income on consumer products have relatively less to spend, while those who spend the least share of their income on consumer products have lot more income to dispose of.  If one chooses to think of economic growth in terms of gains in Gross Domestic Product (GDP), this growth of inequality should show up as a decrease in the growth of GDP.  This is not a controversial claim.  The question is how large is the effect?  Josh Bivens produced a study for the Economic Policy Institute that provides estimates of the effect.  His article was published in 2017 and is titled Inequality is slowing US economic growth.  He provides this lede.

“Faster wage growth for low- and middle-wage workers is the solution”

Bivens provided these estimates of saving rates by various income groups.

The bottom 80% by income save almost nothing, pouring essentially their entire incomes back into consumption.  The top 1% only returns about 50% of their income into the economy in the form of consumption.  That does not mean that the other 50% is economically useless.  Much of the savings will appear as investments that might or might not have any general economic value, but it will not contribute directly to the creation of demand for products.

If one has these saving rates and the amount of net income going to each income group, one can calculate the lost consumption every time a dollar of income goes to a high-income person rather than to a low-income person.  The indicated transaction will show up as a decrease in the GDP because a fraction of that dollar is removed from the aggregate demand for products in the economy.  This calculation can be made for the entire economy by knowing the income distribution at a point in time and how it has changed over time.  Since these numbers vary over time and the level of economic prosperity can have a significant effect on them, Bivens calculates how changes in income distribution have affected aggregate demand (GDP) over time.  He finds that over the period 1979 to 2007 aggregate demand fell by 4.2%, from 1989 to 2007 it fell by 3.1%, and from 1989 to 2012 it fell by 2.0%.

“By 2007, the implied inequality-induced drag on aggregate demand that began in 1979 amounted to more than 4 percentage points of GDP every year. Even if we measure from 1989, and we take as given the large (but almost surely temporary) decline in top 1 percent income shares from 2007 to 2012, by 2012 inequality was imposing a drag of over 2 percentage points on aggregate demand growth. It is worth restating that this hit to the level of aggregate demand generated by rising inequality is cumulative: this demand drag is occurring each year by 2007 or 2012.”

These results lead to Bivens’ major conclusion.

“The rise in inequality has contributed significantly to the downward pressure on demand growth that is labeled secular stagnation. Inequality has transferred income from low- and middle-income households with relatively low savings rates towards higher-income households with higher savings rates. All else equal, this transfer drags on demand growth as consumption grows more slowly. This transfer will likely slow growth in aggregate demand by an estimated 2 to 4 percentage points of gross domestic product (GDP) every year going forward from today.”

Since GDP growth at the 2% level has come to be viewed as rather robust, the claim that the growth rate could be at least doubled if there existed a more efficient income distribution is remarkable.

One expects there is room for quibbling over the exact size of the effect, but the logic behind concluding excessive income inequality is harmful to the general economy seems incontrovertible.