Louis-Philippe Rochon: Why inequality is bad for growth

Income and wealth inequality have increasingly been in the news these past few years. While there are important social and political reasons for opposing our widening income gaps, the economic benefits of reducing them have not always been made clear. Yet, high levels of income disparity are an impediment to economic growth, and one of the main reasons Canada's economy is stuck in this state of secular stagnation.

There are a few occasions in history when social activism, economic events and theoretical essays merge together to become a defining and unstoppable force.  

The 1930s are an example of such an occasion. The economic downturn and Great Depression coalesced in the U.S. with the Bonus Army March.

In the summer of 1932 more than 40,000 Americans, including close to 17,000 WWI veterans, marched on Washington, D.C., demanding financial assistance. This protest largely contributed to the defeat of Herbert Hoover and the subsequent election of Franklin Roosevelt as president.

Meanwhile, in Great Britain, the publication of John Maynard Keynes's General Theory of Employment, Interest and Money forced a complete rethinking of economic policy on a grand scale.  Keynes himself thought he was writing a book that would "largely revolutionize … the way the world thinks about its economic problems."

Recently, another confluence of events took place. The financial crisis that began in 2007 was accompanied by protests in 2011 known as Occupy Wall Street.  A few years later, French economist Thomas Piketty published his bestselling book, Capital in the 21st Century (2013), which focused attention on the disparaging consequences of inequality.

These three events were all predicated on one same phenomenon: the massive growth in income and wealth inequality.

Important implications for growth

Many similarities can be drawn between the 1930s and today, but one stands out — the historically high levels of income and wealth inequalities. And it is this inequality that carries important implications for growth.

It is no coincidence that at the start of both the Great Depression (1929) and the Great Recession (2007), the disparities were eerily similar and our economies collapsed. In both periods, the top 10 per cent owned about 50 per cent of all incomes; in both periods, economic calamity ensued. The causal link between inequality and growth is clear.

After the Depression, inequality collapsed due to specific government policies, and our economies prospered for three decades.

The problem today, however, is that governments are not willing to implement meaningful policies to deal with the unequal distribution of income, and herein lies one of the reasons why our economies are floundering.

So how does inequality slow down economic prosperity? Quite simply, when income is concentrated within the hands of a very few (one per cent or the 10 per cent), there is simply less consumption overall.

The more we redistribute income and wealth, the more consumption increases, which then increases demand. In turn, this should encourage the private sector to invest, thereby accelerating the growth process.

So reducing inequality, in addition to social and health benefits, has important economic implications: our economies grow, and growth itself becomes less volatile. In short, inequality is bad economics.

Not out of the woods yet

This lesson has yet to be learned by governments. Sadly, the opposite has been happening. Not only has inequality increased, but consumers have been increasingly getting into debt, which must eventually be reimbursed. This will inevitably cause a further slowdown in our economies.

In other words, we ain't out of the woods yet.

There is in all this, a silver lining. The current level of inequality is a policy decision made by governments; it reflects their reluctance to address the issue. But this means that governments can do something about it, and the policy options are plentiful.

Eventually, governments will be forced to deal with our stagnating economies, which is further proof that the policies of the last three decades are simply not working. The evidence is now overwhelming.

To restart economic growth, a major preoccupation of many Canadians, there are a number of policies that can be adopted. For instance, higher incomes can be taxed at a much higher marginal rate, including capital gains and income earned from dividends; wealth can also be taxed more.

In light of the Panama Papers, government can close tax loopholes; we can also prevent the private-sector practice of buying back their own shares, which unnecessarily inflates the dividends of shareholders, which in turn favours short-term financial gains to the detriment of long-term economic growth.

Finally, we can adopt a full employment policy.

There are a number of good policies, but regardless of the policies that are adopted, we should also systemically evaluate the impact of these policies on income inequality.

In my opinion, if inequality is not addressed soon, governments won't have much choice but to act as our economies will continue to underperform and stagnate.

Sooner or later, there will be this realization that something must be done, and these policies will become inevitable. Until that time, however, great economic harm will be done in the name of ignorance.

Louis-Philippe Rochon is a professor of economics at Laurentian University and a founding co-editor of the Review of Keynesian Economics. Follow him on Twitter: @LPROCHON.