Economic Freedom and the Trade-off between Inequality and Growth

Studies | Economy

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


Perhaps the single most important political question of the past century has been how to construct government policy so that the standard of living rises and all income classes benefit from increased prosperity.  This debate remains with us today.  The political parties of the right and left (or center-right and center-left) are separated by their respective emphasis on government programs and policies that promote economic growth or those that redistribute income among citizens.  To a great degree, raising living standards and redistributing income are mutually exclusive goals.

“Economic freedom promotes economic growth.”

Promoting economic growth predominantly entails government getting out of the way of personal decision-making and free market activity and exchange. Yet government can contribute to economic growth by providing infrastructure, expanding educational opportunities, protecting property and contracts, and providing for national defense and public health.  Economic growth requires a fiscal state of some size and perhaps some intervention in market outcomes where market failure occurs.2

Such activities, up to some level, are growth-promoting.  However, beyond a certain size, taxation, transfers and subsidies and other market interventions are about income redistribution.  These political interventions have a price.  As economist Arthur Okun pointed out long ago, transfers are made with a “leaky bucket” — a loss of national output arising from income distribution.3 This trade-off between economic growth and income inequality, and the link to the amount of government intervention in market outcomes is widely understood by both economists and politicians.

A History of Economic Freedom.  Throughout the last two centuries, economists and politicians on both sides of the Atlantic have struggled with the question of how much government intervention is required to balance the trade-off between economic growth and income inequality. In the 19th century, thanks largely to Adam Smith, the English economy was freed of massive state control.  England adopted free trade and a general policy of benign neglect of the economy.  The Industrial Revolution led to the movement of peasants from the countryside to the cities and the Dickensian squalor of factory and urban life.

Before 1850 an Englishman or an American could expect to be dead before age 40, but by the early 1900s he could expect to live past age 50.  The longer life span was in large part due to public measures like conveying potable water to the cities, garbage pickup and sewage disposal.  But the increase in life expectancy was also due to the rising standard of living brought about by economic growth.4

The Introduction of the Progressive Income Tax.  With economic freedom and economic growth, the gap between the rich and poor widened, and was filled by a growing middle class.  Because the middle class became so numerous, it became feasible to do something about the less fortunate.5 In the mid-19th century England introduced the progressive income tax.  Although there had been pressure from populists and progressives in the United States, the first income tax was not introduced until the U.S. Civil War.6

The Socialist Influence.  Concern for income inequality rose with the socialists, who became active in France, Germany and England in the second half of the 19th century.  Ultimately, to one degree or another, the political parties of the left adopted much of the agenda of the socialists.  (For example, the British Labor party is a democratic socialist party, as are most of the leftist parties in Europe.)  Their schemes, which took decades to implement and which remain with us today, included progressive (often punitive) taxation, public welfare plans and subsidies, and state-provided housing, schooling and medical care.  The socialists also promoted protectionism and state ownership of natural monopolies, failing industries, the commanding heights of the economy (for example, steel, automobiles, mining and transportation) and so on.7

“Governments transfer money from rich to poor to reduce inequality.”

Government Intervention at Work.  Most societies, ours included, do not like the distribution of income that occurs in free-market economies.  There are too many poor, and the rich have too much wealth.  The justification for market intervention and income redistribution by the state is that the gap between the haves and have-nots is too wide.  Thus, over the decades, governments in advanced nations have intervened in market outcomes deemed politically and socially unacceptable by imposing high marginal tax rates, estate taxes, minimum wages or incomes policies; instituting worker rights to job security and a variety of job benefits; creating social security, Medicare or state-run health services; and implementing price controls, regulations and a variety of other policies and programs. These interventions in market outcomes adversely affect the efficiency of the economy and lower the rate of economic growth.  They do so by introducing distortions into the economy and altering the incentives that affect individual choice.  Government programs and policies alter prices in the economy, and hence alter the allocation of resources from their distribution to the highest valued use that would occur in a free market to a distribution that is more politically and socially acceptable. This government-induced reallocation of resources lowers the efficiency of the economy, and lowers the rate of economic growth.

Economic Freedom at Work.  In a free market, capital, labor, land, entrepreneurial talent and so forth seek the highest returns possible from employment at their highest valued uses.  These returns are their remunerations.  In equilibrium, these factors of production earn an amount equal to the value of the increment in output that they produce.  When this equilibrium is reached, the economy is producing the maximum amount of output with its scarce resources and existing technology. A free market will produce its output most efficiently, and simultaneously there will be an income distribution associated with that efficient production.  In a free society, people are free to choose.  They can stay in school or drop out. They can take a job that requires hard work and effort, or one that is less taxing and rewarding.  They can save for an emergency or retirement, or they can spend every dime they make. They can insure against risk, or gamble with fate. All of these choices, and others, contribute to where they wind up in the income distribution.

Using data for many advanced countries and for some newly industrializing Asian nations, this paper examines the effect of economic freedom on economic growth and on income distribution, as well as the trade-off between economic growth and income inequality.  [See the Appendix and Appendix Table for model details.]

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