Economic Freedom and the Trade-off between Inequality and Growth

Policy Reports | Economy

No. 309
Monday, March 31, 2008
by Gerald W. Scully

Executive Summary

One of government’s biggest challenges is to develop policies that raise the standard of living in a society without creating large income gaps between the rich and poor.  But to a great extent, raising living standards and redistributing income are mutually exclusive goals.

Up to some level, government can contribute to economic growth by building infrastructure, expanding educational opportunities, and providing for national defense and public health.  Beyond these activities, however, government intervention in market outcomes tends to be about income redistribution. Taxation reduces incentives to work, save and invest. If tax revenue is merely redistributed from some people to others, rather than spent on raising productive potential, the net consequence will be lower national income.

This study examines the effect of economic freedom on economic growth and income inequality.  It also examines the trade-off between income inequality and economic growth.  It includes data for 26 advanced countries, including some newly industrializing Asian nations.
It measures economic freedom by constructing an index based on 10 components of government policy, including the share of government-owned enterprises in the economy and the top marginal tax rates.  Income inequality is measured as market-based income, as represented by a Gini coefficient, which ranges from 0 (meaning everybody has the exactly the same income) to 1 (meaning one person has all the income).  Economic growth is defined as the real growth in per capita gross domestic product (GDP) in U.S. dollars.

All else equal, the central findings are:

  • Freer economies enjoy higher rates of economic growth than less free ones.
  • Freer economies are more equal economies; economic freedom reduces inequality by increasing the share of market income going to the poor and lowering the share going to the rich.
  • Economic growth increases income inequality, but the effect is small.
  • Overall, the increase in inequality from economic growth is outweighed by the reduction in inequality caused by greater economic freedom — creating a net benefit to lower income groups.

Conversely, nations in which the government more aggressively redistributes income have significantly lower rates of economic growth.  In the long run, this income redistribution hurts the poor.  For example, among the countries analyzed in this study:

  • Lowering a country’s Gini coefficient by 0.01 would require reducing the income share of the rich by 0.6 percent and redistributing it to others.
  • However, this would lower the economic growth rate by 1.6 percentage points (from 2.3 percent to 0.7 percent).
  • With the transfer, but a lower growth rate, average household income in the lowest group would reach only $8,050 after 25 years, instead of the $10,320 that would be achieved without the transfer.

This study confirms that a relatively free market with a limited role for government will, over time, produce the greatest economic benefits for the lowest income earners.

The higher income brought about by economic growth ultimately raises the incomes of low-income households more than an increase in the equality of incomes brought about by a redistribution of income.

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