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Monday, March 17, 2014

IMF: Redistribution, Inequality, and Growth

In Occupy the Tax Code: Using the Estate Tax to Reduce Inequality and Spur Economic Growth, 40 Pepp. L Rev. 1255 (2013), Jim Repetti and I reviewed the economic literature that presents significant empirical evidence that inequality hurts economic growth. We argued that this literature supports our argument that achieving progressivity in our tax system is an appropriate goal and that the estate tax should be used to advance this goal. For our thoughts on some estate tax reform ideas, see Revitalizing the Estate Tax: Five Easy Pieces, 142 Tax Notes 1231 (Mar. 17, 2014).  For an expanded discussion of the economic literature on the impact of inequality on economic growth, see Jim's earlier articles, Democracy, Taxes, and Wealth, 76 N.Y.U. L. Rev. 825 (2001); and Democracy and Opportunity: A New Paradigm in Tax Equity, 61 Vand. L. Rev. 1130 (2008).

IMFWe are pleased that the IMF staff has confirmed our analysis in a new Discussion Draft, Redistribution, Inequality, and Growth, which uses a new data set and concludes that using the tax system and redistributive policies in a responsible and moderate manner enhances economic growth:

Economists are increasingly focusing on the links between rising inequality and the fragility of growth. Narratives include the relationship between inequality, leverage and the financial cycle, which sowed the seeds for crisis; and the role of political-economy factors (especially the influence of the rich) in allowing financial excess to balloon ahead of the crisis. In earlier work, we documented a multi-decade cross-country relationship between inequality and the fragility of economic growth. Our work built on the tentative consensus in the literature that inequality can undermine progress in health and education, cause investment-reducing political and economic instability, and undercut the social consensus required to adjust in the face of shocks, and thus that it tends to reduce the pace and durability of growth.

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.

While considerable controversy surrounds these issues, we should not jump to the conclusion that the treatment for inequality may be worse for growth than the disease itself. Equality-enhancing interventions could actually help growth: think of taxes on activities with negative externalities paid mostly by the rich (perhaps excessive risk-taking in the financial sector) or cash transfers aimed at encouraging better attendance at primary schools in developing countries, as examples. The macroeconomic effects of redistributive policies will reflect a balance between the components of the fiscal package, and it is an empirical question whether redistribution in practice is pro- or anti-growth.

So what does the historical evidence say? This paper is the first to take advantage of a recentlycompiled cross-country dataset that distinguishes market (before taxes and transfers) inequality from net (after taxes and transfers) inequality and allows us to calculate redistributive transfers for a large number of country-year observations. Our main findings are: 

First, more unequal societies tend to redistribute more. It is thus important in understanding the growth-inequality relationship to distinguish between market and net inequality.

Second, lower net inequality is robustly correlated with faster and more durable growth, for a given level of redistribution. These results are highly supportive of our earlier work.

And third, 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.

While we should be cognizant of the inherent limitations of the data set and of cross-country regression analysis more generally, we should be careful not to assume that there is a big tradeoff between redistribution and growth. The best available macroeconomic data do not support that conclusion.

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