Economic Freedom and the Trade-off between Inequality and Growth

Policy Reports | Economy

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

The Trade-off between Economic Growth and Income Inequality

It is widely believed that nations with high rates of economic growth pay for this progress with more income inequality among their citizens.  This is true for the advanced countries studied here.  The relationship is shown in Figure III.Relationship Between Income Inequality and Economic Growth

  • For the countries in the sample, the dispersion in the growth rates is from -1.8 to 6.3 percent, a difference of 8.1; over this range in growth rates, the predicted difference in the Gini coefficient is 0.05 (say, from 0.325 to 0.375).
  • Estimation of the trade-off rate indicates that a one percentage point increase in the growth rate is associated with an increase in the Gini coefficient of about 0.006 (say, from 0.350 to 0.356).
  • Another way of looking at this issue is to ask what a reduction in income inequality costs; an improvement in the Gini of 0.01 costs 1.6 percent per year in per capita economic growth.

Thus, higher rates of economic growth are paid for with small increases in income inequality.  But the increases are more than offset by the greater effect of economic freedom on reducing inequality.  Put differently, economic freedom’s effect on increasing economic efficiency — allowing for greater distribution of income — outweighs its effect on increasing inequality through economic growth.

"Economic growth slightly increases income inequality."

Economic Freedom and the Trade-off among Income Classes.  A disadvantage of the Gini measure is that there is no unique correspondence between changes in the measure and the underlying income distribution.  That is, redistribution from the top to the middle or the middle to the bottom may yield the same value of the Gini coefficient.  Partly for this reason, but also because there is more information in the quintiles, the relationships using quintile income shares as the dependent variable are examined.11

What is of particular interest is the opposite effect of economic freedom and economic growth on the income shares of the high- and low-income groups.

  • Increases in economic freedom raise the income share of the poor relative to that of the rich.
  • Changes in economic freedom have no apparent effect on the income share of the middle class.
  • Increases in economic freedom lower the share of the highest income quintile.12

For the advanced nations, an increase in economic freedom positively affects the poorest income class and negatively affects the richest income class, but has no effect on the middle class.

The effect of economic growth on income shares is just the opposite. The poor experience a negative effect on their share of income from economic growth, while the highest income quintile experiences a positive effect.  The effect of economic growth on the income share of the middle class is negative, but it is not a very large effect.

These results are consistent with the finding of its effect on the Gini coefficient, previously discussed.  A one percentage-point change in the growth rate was associated with an increase in the Gini coefficient of 0.006.  A one-point increase in the growth rate raises the share of income going to the highest income quintile by 0.64 percentage points and, of course, lowers the share of income going to the other income quintiles by an equivalent percentage.

"The net effect of increases in economic freedom is less inequality."

Measuring Economic Progress. Given the trade-offs, what matters more for a family’s economic progress — more equality in the distribution of income or the higher income brought about by economic growth?  While all sorts of changes in the income distribution will alter the Gini measure, consider the simple case of taking money from the rich (those in the highest income quintile, or 20 percent) and giving it to the poor (those in the lowest income quintile, or 20 percent).  How much would the income share of the rich have to decline, with that income given to the poor, to lower the Gini income inequality measure one point?  The answer is roughly 0.6 percentage points (say, from a share of 46.0 to 45.4 percent).  In dollar terms:

  • Using U.S. income data for 1987, a reduction of 0.6 percentage points in the income share of the highest income quintile would transfer $920 to each household in the lowest income quintile.13
  • This would raise the average annual income of those in the lowest quintile from $5,842 to $6,762, but the price paid for this transfer would be a lowering of the growth rate from 2.3 percent to 0.7 percent per annum.

In the long run, this reduction in growth would hurt the poor.

  • Without the transfer, the real annual income in the lowest quintile would grow to $10,320 after a generation.
  • With the transfer and the lower growth rate, average yearly household income for the poor would only reach $8,050 after 25 years.

In other words, poor households would be better off with a higher rate of economic growth, even at the cost of a little more income inequality.

Read Article as PDF