Inequality As a Barrier to Growth? Invented Out of Thin Air

The idea that inequality limits a country's economic growth is on the verge of becoming conventional wisdom. But, despite the latest International Monetary Fund report, no one has proved the negative macroeconomic effects of inequality.

Entitled Fiscal Policy and Income Inequality, the IMF report states that "there is growing evidence that high income inequality can be detrimental to achieving macroeconomic stability and growth." New York Times columnist Charles Blow jumped on the bandwagon in last week's column, repeating the IMF's inaccuracies and adding some of his own.

Here are three common errors in the attempt to prove that inequality slows growth.

Error 1: Use of Pre-Tax, Pre-Transfer Income to Measure Inequality. Throughout the report, the IMF uses the concept of "market income" to measure inequality. Market income is defined as income before taxes are paid to the government, and before transfers from the government to low-income individuals.

This concept of income is far removed from reality. The top five percent paid 57 percent of all federal individual income taxes in 2011, the latest year data are available. The top half of earners paid 97 percent of these taxes. The bottom half of earners paid 3 percent. They received back a substantial share of the 97 percent paid by the top half for programs including Medicaid, food stamps, the earned income tax credit, housing vouchers, and unemployment insurance.

The idea that inequality can be measured by income irrespective of taxes and transfers makes little sense.

Yet the IMF report states that "the share of market income captured by the richest 10 percent surged from around 30 percent in 1980 to 48 percent by 2012, while the share of the richest 1 percent increased from 8 percent to 19 percent."

Mismeasurement of income is not the only flaw: many changes occurred between 1980 and 2012. The Tax Reform Act of 1986 lowered tax rates on individuals relative to corporations, and so more businesses filed as individuals. This meant that individuals appeared to earn more after 1986, even though the assets were just transferred from the corporate side to the individual side of the tax code.

Women streamed into the workforce in the 1980s. By 2012, most families in the top fifth of the income distribution had two earners, not one.

Between 1980 and 2012, the share of taxes paid by top earners increased, and the share paid by low-income earners declined. At the same time, transfers to low-income Americans went up.

Cornell University economists Richard Burkhauser and Philip Armour, together with Jeff Larrimore of the Joint Committee on Taxation accounted for these factors in a paper published last year by the National Bureau of Economic Research. Rather than an increase in inequality over time, they concluded that the share of income of the top five percent declined between 1989 and 2007.

Error 2: More Inequality Leads to Lower Mobility. The result that more inequality leads to less economic mobility, cited in the IMF report, comes from a graph by Princeton University professor Alan Krueger, former chair of President Obama's Council of Economic Advisers. The graph, called The "Great Gatsby Curve," purported to show that countries with more inequality had lower intergenerational economic mobility. The logical conclusion of such a graph was that inequality is actually preventing people from getting ahead.

Just one problem: as with Error 1, more sophisticated data leads to different results. In The Collapse of the Great Gatsby Curve, my Manhattan Institute colleague Scott Winship showed that the Great Gatsby curve reversed itself when economists used better measures of inequality, the Luxembourg Income Study inequality estimates. Data from University of Ottawa professor Miles Corak on the United States, Canada, and Sweden suggest that more inequality is associated with higher mobility, not less mobility.

Winship's findings echo those of Harvard University economist Raj Chetty, who found little association between the share of income of the top one percent and mobility, either in the United States or between different countries.

Error 3: Tax Increases Lead to Higher Economic Growth. The IMF report suggests many ways that taxes can be raised on upper-income individuals in order to increase economic growth. The theory is that the poor spend a larger share of their income than the rich, so raising taxes on the rich and redistributing these funds to the poor raises growth.

However, spending by upper-income consumers creates local employment, at least in the United States. Labor Department data show that the top fifth of income earners was responsible for 52 percent of all spending on personal household services, and 56 percent of spending on fees and admission to entertainment. Services and entertainment are local businesses that employ low-wage workers. Taxing top earners will result in lower spending on these categories, and less domestic employment.

In contrast, the lowest fifth of income earners spend more on apparel, footwear, and nondurables, which are more likely to be imported. A substantial percentage of goods purchased at big box stores, where low-income individuals tend to shop, are made overseas.

If transfers of income from one group to another succeeded in creating economic growth, the fastest-growing countries would be those with the highest top tax rates. As Nobel Prize-winning economist Edward Prescott has shown, the reverse is true.

It sounds simple to say about inequality, as does Charles Blow, "We can't grow our way out of this obscenity. It's a barrier to growth." But the real obscenity is inventing evidence to try to prove that inequality harms growth.