Today's Editorial

24 November 2017

Spreading it out



Source: By Bhaskar Dutta: The Telegraph



Thomas Piketty's unlikely bestseller - Capital in the TwentyFirst Century - generated renewed interest in inequality amongst both academic researchers and policy economists. Distributional issues have, of course, always been at the forefront of economic research, particularly amongst development economists. But, their typical concern has been with issues involving the incidence of poverty in developing countries rather than with inequality per se. But Piketty and others established conclusively that income (and wealth) distribution is a matter of serious concern even in the advanced economies - there is a wealth of evidence that the fruits of economic growth have been captured almost entirely by those at the top of the income ladder. Not surprisingly, rising inequality levels have created a lot of social unrest and political upheavals, Brexit and Donald Trump's victory being leading examples of the latter phenomenon.


An important consequence of the renewed interest in inequality has been the change in the mindset of international agencies which have in the past paid scant attention to distributional issues, focusing (and preaching) on policies that they believed would accelerate growth. Perhaps the best and most dramatic example of this is the International Monetary Fund, hitherto one of the bastions of rightwing economic orthodoxy. Several recent studies by IMF staff economists have re-examined the trade-offs between sustained growth and inequality levels. One study indicates that lower inequality may actually drive faster and more durable growth for a given level of redistribution. Moreover, redistribution appears generally benign in its impact on growth. There is very little evidence suggesting that countries which emphasize redistribution suffer from low rates of growth once other factors have been taken into account. These suggest that the combined direct and indirect effects of redistribution are, on average, pro-growth.


Another IMF study published in its Fiscal Monitor is perhaps more striking. It concludes on the basis of an analysis of tax rates in the countries of the Organisation of Economic Co-operation and Development that there is no strong relationship between the degree of progressivity of tax rates and economic growth. In fact, the study adds that if countries prefer to redistribute wealth and incomes, then "there may well be scope for increasing the progressivity of income taxation without significantly hurting growth". This must come as music to the ears of the sizeable number of people who feel that "right wing" governments are simply not doing enough to promote the interests of those at the bottom end of the income ladder.


The received doctrine in much of the neoclassical literature on growth and development has been that implementation of equality-inducing policies must also retard economic growth. This was, for instance, the central theme in Arthur Okun's influential book written in 1975. Much earlier, Nicholas Kaldor described a theoretical model with just two income classes - the rich and poor. Kaldor made the quite plausible assumption that the rich save a larger fraction of their gross income. This immediately implied that the higher the fraction of total income accruing to the rich, the greater would be the overall volume of savings and investible resources in the economy. To the extent that the availability of capital is the only constraint on growth, this may be one channel through which efforts to reduce inequality may slow down the growth process.


While there may be a grain of truth in the Kaldorian paradigm, it is rather naïve to assume that the growth tap will be turned on as soon as capital is made available. In particular, the major constraint on growth may be an inadequacy of aggregate demand. Entrepreneurs may cut back on production and meet low levels of demand by drawing down inventories. A more equal distribution of incomes can generate additional demand precisely because low income earners spend virtually all their incomes. This may well be a principal cause of the recent slowdown in India and many other economies.


A more 'modern' or recent approach is to bring in the negative incentive effects of redistribution through higher tax rates. A first impression must be that any increase in income tax rates will reduce the marginal return of work. This tends to make work less rewarding and correspondingly leisure more attractive. However, there is a countervailing effect. The increase in tax rates also reduces incomes and reduces demand for all goods and services. Since leisure can be treated like other goods, this effect will make people demand less leisure - that is work more. So, there is no unambiguous effect of income on the incentive to work. Of course, what is crucial is the level of taxation. There is no doubt that the exorbitant marginal tax rates that we had at one time - over 90 per cent - must have left the top income earners either with no incentive to work or promoted large-scale tax evasion.


The report in the IMF's Fiscal Monitor alluded to earlier also has interesting policy implications for India. The IMF's analysis reveals that if governments intend to maximize revenue, then the optimal tax rate on higher incomes should be 44 per cent. While such a precise quantitative estimate must be taken with a pinch of salt - the optimal rate must surely depend on specific country circumstances such as the level of indirect taxes - it does suggest that the super-rich in India are getting off rather lightly with marginal tax rates in the mid-thirties. A common argument against raising income tax rates is that this may encourage a greater degree of tax evasion. However, increased computerization and streamlining of operations of the tax authorities has forced greater tax compliance. It is that much harder to evade taxes and so an increase in marginal tax rates of, say, 3-4 per cent is unlikely to result in more people evading taxes.

It is fair to claim that the recent debate on distribution versus growth shows that that the equality-growth trade-off is nonexistent. That is, there is little reason to believe that efforts to achieve a more equitable distribution of incomes must come at the expense of lower rates of growth. In fact, redistribution may even result in higher rates of growth. Of course, our concern with rising or even static but high levels of inequality should not be based purely on instrumental grounds. A better distribution of the national cake is a legitimate objective of development policy. But, it helps that instrumental reasons reinforce welfare-theoretic arguments in favour of a more equitable distribution of national incomes. This should surely ensure that there is less opposition to future efforts at redistribution.


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