A world where a few people have most of the wealth motivates others who are poor to strive to earn more. And when they do, they’ll invest in businesses and other areas of the economy. That’s the argument for inequality. But it’s wrong.
A study of 21 OECD countries over more than a 100 years shows income inequality actually restricts people from earning more, educating themselves and becoming entrepreneurs. That flows on to businesses who in turn invest less in things like plant and equipment.
Inequality makes it harder for economies to benefit from innovation. However, if people have access to credit or the money to move up, it can offset this effect.
It measured the impact of this by looking at the number of patents for new inventions and then also looking at the Gini coefficient and the income share of the top 10%. The Gini coefficient is a measure of the distribution of income or wealth within a nation.
How inequality reduces innovation
From 1870 to 1977, inequality measured by the Gini coefficient fell by about 40%. During this time people actually got more innovative and productivity increased, incomes also increased.
But inequality has increased in recent decades and it’s having the opposite effect.
Inequality is preventing people with less income and wealth from reaching their potential in terms of education and invention. There’s also less entrepreneurship.
Inequality also means the market for new goods shrinks. One study shows that if incomes are more equal among people, people who are less well off, buy more. Having this larger market for new products, incentivises companies to create new things to sell.
If wealth is concentrated among only a small group of people, it actually increases demand for imported luxuries and handmade products. In contrast to this, distributed incomes means more mass produced goods are manufactured.
What’s been driving inequality since the 1980s is changes to economies – countries trading more with each other and advances in technology. As this happens old products and industries fade while new ones take their place.
These changes have delivered significant net benefits to society. Reducing trade and innovation will only make everyone poorer.
The declining number of people in unions has also contributed to inequality, as workers lose collective bargaining power and some rights. At the same time, unions can adversely affect innovation within firms.
Unions discourage innovation when they resist the adoption of new technology in the workplace. Also if innovation creates profits for firms but some of these are taken up by higher wages (lobbied for by unions), these reduced profits provide less incentive for firms to innovate.
Where workers’ jobs are protected, for example with union membership, there’s often less resistance to innovation and technological change.
Giving people access to credit could change this
Most countries have much higher levels of inequality than the OECD average. This combination of high inequality and low financial development is a major obstacle to economic prosperity.
When financial markets work well, everyone gets access to the amount of credit they can afford and can invest as much as they need. It is found that for a nation with a credit-to-GDP ratio of more than 108%, low income earners are less discouraged by not having a share of the wealth. There’s less of a dampening affect on innovation.
Unfortunately, most countries (including many in the OECD) are far from this threshold. In 2016, the credit-to-GDP ratio averaged 56% across all countries, and only 28% for the least developed. Until 2005, Australia was also below this threshold.
This means governments should look at providing more people with more access to credit, especially to the poor, to stimulate growth.
For financially developed nations like Australia, increased inequality actually has less of an effect on innovation and growth. So tackling inequality might not be as easy as increasing access to credit.
Spending and taxing are already historically high and growing inequality makes it harder to further raise taxes. Countries like Australia are not unequal societies in the sense of having significant barriers to people improving their income.
Australia is a relatively egalitarian nation. In 2016, the top 1% owned 22% of the wealth in Australia, compared to 42% in the USA, and 74% in Russia.
Governments in more developed nations can instead try to maintain a stable financial sector to improve growth or by training and education.
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Steve Ovett, the famous British middle-distance athlete, won the 800-metres gold medal at the Moscow Olympics of 1980. Just a few days later, he was about to win a 5,000-metres race at London’s Crystal Palace. Known for his burst of acceleration on the home stretch, he had supreme confidence in his ability to out-sprint rivals. With the final 100 metres remaining,
[wptelegram-join-channel link=”https://t.me/s/upsctree” text=”Join @upsctree on Telegram”]Ovett waved to the crowd and raised a hand in triumph. But he had celebrated a bit too early. At the finishing line, Ireland’s John Treacy edged past Ovett. For those few moments, Ovett had lost his sense of reality and ignored the possibility of a negative event.
This analogy works well for the India story and our policy failures , including during the ongoing covid pandemic. While we have never been as well prepared or had significant successes in terms of growth stability as Ovett did in his illustrious running career, we tend to celebrate too early. Indeed, we have done so many times before.
It is as if we’re convinced that India is destined for greater heights, come what may, and so we never run through the finish line. Do we and our policymakers suffer from a collective optimism bias, which, as the Nobel Prize winner Daniel Kahneman once wrote, “may well be the most significant of the cognitive biases”? The optimism bias arises from mistaken beliefs which form expectations that are better than the reality. It makes us underestimate chances of a negative outcome and ignore warnings repeatedly.
The Indian economy had a dream run for five years from 2003-04 to 2007-08, with an average annual growth rate of around 9%. Many believed that India was on its way to clocking consistent double-digit growth and comparisons with China were rife. It was conveniently overlooked that this output expansion had come mainly came from a few sectors: automobiles, telecom and business services.
Indians were made to believe that we could sprint without high-quality education, healthcare, infrastructure or banking sectors, which form the backbone of any stable economy. The plan was to build them as we went along, but then in the euphoria of short-term success, it got lost.
India’s exports of goods grew from $20 billion in 1990-91 to over $310 billion in 2019-20. Looking at these absolute figures it would seem as if India has arrived on the world stage. However, India’s share of global trade has moved up only marginally. Even now, the country accounts for less than 2% of the world’s goods exports.
More importantly, hidden behind this performance was the role played by one sector that should have never made it to India’s list of exports—refined petroleum. The share of refined petroleum exports in India’s goods exports increased from 1.4% in 1996-97 to over 18% in 2011-12.
An import-intensive sector with low labour intensity, exports of refined petroleum zoomed because of the then policy regime of a retail price ceiling on petroleum products in the domestic market. While we have done well in the export of services, our share is still less than 4% of world exports.
India seemed to emerge from the 2008 global financial crisis relatively unscathed. But, a temporary demand push had played a role in the revival—the incomes of many households, both rural and urban, had shot up. Fiscal stimulus to the rural economy and implementation of the Sixth Pay Commission scales had led to the salaries of around 20% of organized-sector employees jumping up. We celebrated, but once again, neither did we resolve the crisis brewing elsewhere in India’s banking sector, nor did we improve our capacity for healthcare or quality education.
Employment saw little economy-wide growth in our boom years. Manufacturing jobs, if anything, shrank. But we continued to celebrate. Youth flocked to low-productivity service-sector jobs, such as those in hotels and restaurants, security and other services. The dependence on such jobs on one hand and high-skilled services on the other was bound to make Indian society more unequal.
And then, there is agriculture, an elephant in the room. If and when farm-sector reforms get implemented, celebrations would once again be premature. The vast majority of India’s farmers have small plots of land, and though these farms are at least as productive as larger ones, net absolute incomes from small plots can only be meagre.
A further rise in farm productivity and consequent increase in supply, if not matched by a demand rise, especially with access to export markets, would result in downward pressure on market prices for farm produce and a further decline in the net incomes of small farmers.
We should learn from what John Treacy did right. He didn’t give up, and pushed for the finish line like it was his only chance at winning. Treacy had years of long-distance practice. The same goes for our economy. A long grind is required to build up its base before we can win and celebrate. And Ovett did not blame anyone for his loss. We play the blame game. Everyone else, right from China and the US to ‘greedy corporates’, seems to be responsible for our failures.
We have lowered absolute poverty levels and had technology-based successes like Aadhaar and digital access to public services. But there are no short cuts to good quality and adequate healthcare and education services. We must remain optimistic but stay firmly away from the optimism bias.
In the end, it is not about how we start, but how we finish. The disastrous second wave of covid and our inability to manage it is a ghastly reminder of this fact.