Optimum inequality?

It’s undeniable in the modern world that some countries are too unequal. Take the seeming inability of South Africa to escape its past – it remains an outlier in terms of its Gini coefficient (economists’ usual measure of unfairness) as it hasn’t yet managed to share the benefits of social and political change with the bulk of the population. But are some other countries too equal, to the detriment of their economic growth? That’s a recent argument from Martin Moryson, chief economist Europe at DWS Research Institute, a thoughtful organisation attached to Germany’s largest fund manager.

Moryson posits that there must be a growth-optimising level of inequality from basic principles: in a totally equal society, no one would have any incentive to work as all would have the same and earn the same whatever they did; similarly, in a wholly unequal one, with all value accruing to a single individual, others would have little reason to do anything other than what they were forced to do. Both theoretical wholly equal and wholly unequal societies would thus struggle to grow at all; somewhere between these two extremes must lie an optimum level of inequality that would lead to the greatest possible growth for that society. As an aside, note that the perfectly equal society Moryson theorises from is just as wholly unfair as the perfectly unequal one – as ever, this blog argues that fairness is a much more useful, and human, lens for looking at the world than mere inequality.

Some will recognise in this a shadow of the argument that drives the more than somewhat discredited Laffer curve, which has been used as an argument that lowering taxation will lead to an increase in tax receipts. That theory has not tended to be reflected in the reality of countries that have attempted so-called trickle-down reforms. Let’s not allow that to be counted against Moryson’s work.

He bolsters his theory with a regression analysis based on data from the last 40 years. This suggests that there is indeed a level of inequality that is optimum for economic growth. This is represented by a Gini coefficient of 30 or just above (based on household income after taxes and transfers):

Wisely, Moryson in discussion makes clear that he does not hold to this number with absolute precision and that the cluster of countries with post-redistribution Gini coefficients of just below to a little above 30, are all likely to be in a sweet-spot for their economic growth. That sweet-spot would in the language of this blog be the point of fairness, where in contrast to the perfectly equal and unequal societies all citizens feel that they have sufficient participation in the economic life of their nation that they are able and willing to contribute.

Outside that fair sweet-spot, it is those countries placed at the greater extremes that perhaps have something to consider and to learn from this analysis. Those with such opportunities may perhaps be best revealed by this chart from a different recent paper on inequality (whose focus is Germany, hence the red shading in this chart, which is not relevant for our purposes):

So, by Moryson’s argument, Slovenia (see also Fairness is a Choice II) is seeking excess equality through its taxes and transfers, proportionally one of the largest in the world. It could enhance its annual growth rate by around 0.1% if it reduced its redistributive policies. Actually, Moryson is wiser than this. He rightly says that Slovenia and its small group of fellow countries whose redistributions take their Gini coefficients down to the lowest levels globally are making a political choice – implicitly rather than explicitly – to favour equality over economic growth. The evidence from Slovenia is certainly suggestive that its population favours that political choice.

There are many more countries that have post-redistribution Gini coefficients well above Moryson’s posited optimum level – including the UK and US, together with South Africa and several other emerging economies. In a sense this must be a political choice too – though giving up economic growth to be more unequal feels more like a failure to make political choices. Redistribution may be part of the steps these countries might take to enhance their growth prospects, Moryson argues. But he also notes – especially for the emerging economies – the vital importance of investment in human capital to build growth capacity, and the central role of social mobility to unlock greater equality (and fairness) in societies.

In a final element of his paper, Moryson constructs an index of inequality, assessing the largest 20 economies across 5 different measures. Even though India benefits from being a democracy (one of the 5 elements of the index, because Moryson argues that it makes any inevitable inequality more tolerable), it is by far the most unequal in the ranking, well beyond Indonesia and China, the next worst performers.

At the upper end are the Netherlands, closely followed by Switzerland, Germany and Canada. Moryson notes that all his 5 measures are correlated but by far the dominant factor, and the one with the highest correlations across the piece, is social mobility.

Countries with sclerotic levels of social mobility will struggle to generate the equality, and fairness, that will help generate greater growth. They are certainly not optimising either inequality or fairness.

ESG Special – Inequality: Inequality – An Investors’ Perspective, Martin Moryson, DWS Research Institute, November 2022

Inequality revisited: An international comparison with a special focus on the case of Germany, Maximilian Stockhausen, Judith Niehues, Institut der deutschen Wirtschaft, May 2021

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