Income inequality has a negative impact on the long-term growth rate of an economy, according to a recently published working paper from the Organisation for Economic Co-operation and Development (OECD).[1] The paper, which looks at trends in income inequality and its subsequent impact on economic growth, found that out of the OECD’s 34 member countries, the gap between rich and poor has widened significantly over the 30 years.

In the UK alone, the proportion of total income going to the richest 10% is noticeably higher than a decade ago: 31% in 2008/09 compared with 28% in 1998/99.[2] Growth of this nature may be met with discontent in the country as an increasing number of reports suggest that food bank usage has reached a record high.[3] Income inequality not only impacts the economic status of a nation, but it can have a significant impact on social factors, creating political instability and class fractionalisation. This feeds back into the economic status of a nation as political instability creates a turbulent investment environment and damages consumer confidence.

The OECD paper finds that a key mechanism in how income inequality impacts economic growth is through human capital accumulation, particularly the skills we gain from education and employment. In societies with increased income disparities, skill development is reduced among individuals with lower parental education.[4]

Needless to say, reduced skill development poses a problem for the governments of OECD nations and the economic policies they pursue. As inequality has increased, the stock of human capital amongst lower income groups of the population has fallen. OECD government attempts to create equality of opportunity, through provision of basic schooling and other policies, has not led to equivalent outcomes, as parental education and their representative income remain the main determinants of an individual’s income.

To understand why a representative OECD country may have not have pursued creating equality of opportunity as a first resort, it may be that the policies pursued followed the reasoning of the ‘trickle-down’ wealth effect of economies. The thesis is that high levels of income inequality is beneficial to the economy. Individuals with high incomes have money to spare and with this money they can then invest in the economy to generate further income, for instance, in R&D and venture capital. The result of this investment is new products, new ideas and new markets. This could lead to growth in the economy.

However, individuals with larger incomes also have a higher marginal propensity to save, relatively speaking. Investing in R&D and venture capital are by nature risky ventures and are not always pursued as individuals are cautious to retain their accumulated income. Value is not always created for society from the use of this income as individuals put their money into savings, or government debt. Savings unused create a theoretical “leakage” from the economy and therefore depresses economic growth.

What does this have to do with human capital? Since the relationship between inequality and a country’s growth are at odds, the OECD paper calls for redistribution measures (i.e. taxing the rich) to transfer income to poorer segments in the population. This redistribution can come in two forms: a) direct transfers through the benefits system and b) through indirect transfers such as specific tuition programmes, suited to building human capital amongst those with lower incomes in the population. Redistribution measures will transfer income from those with higher marginal propensity to save, to those with higher marginal propensity to spend. The effect of which would be to increase economic growth.

Obviously redistribution policies have been going for a long time now, but the OECD’s report demonstrates that there is still a long way to go. Governments in the OECD can often be considered to have acted haphazardly in attempts redistribute and increase human capital accumulation amongst citizens. For instance, the UK government has increased spending towards pre-school education, which ensures that there are at least 570 hours of free early education or childcare a year. However, while this improves the quantity and quality of early education, government policy with respect to higher education effectively denies access of such education to individuals from poorer backgrounds.  After tuition fees for higher education were introduced in the UK in 1998, the fees required per year’s study have increased nine-fold.  As such, a student now engaging in three years of higher education may face student loan debts of around £50,000. This dis-incentivises students from lower income backgrounds from engaging in higher education and as such, limits the forms of human capital they are able to accumulate.

Both early year education and higher education are areas worthy of investment, as education is a merit good and any increase to human capital has positive externalities. However, to put an effective cap on the human capital that individuals from poorer backgrounds from the highest echelons of education not only hurts equality of opportunity, but it also is of detriment to the economy’s growth as well.

Article by Peter O'Flynn

[1] Cingano, F. (2014), “Trends in Income Inequality and its impact of Economic Growth”, OECD Social, Employment and Migration Working Papers, No. 163, OECD Publishing. http://dx.doi.org/10.1787/5jxrjncwxv6j-en

[2] Poverty.org.uk, (2014). UK: income inequalities - The Poverty Site. [online] Available at: http://www.poverty.org.uk/09/index.shtml [Accessed 10 Dec. 2014].

[3] BBC News, (2012). More Britons 'use emergency food'. [online] Available at: http://www.bbc.co.uk/news/business-19953938 [Accessed 10 Dec. 2014].

[4] What is meant by skill development is that individuals will be schooled for fewer years (lowering their “stock” of education) and they will be less proficient in the skills they obtain.