In our last Blogpost we discussed the question whether a growing inequality in the distribution of income has a positive or a negative impact on economic growth. The answer was not unambiguous. Now we want to study this question by analysing the German economy. Our main argument deals with the effects of growing income inequality on aggregate demand.
Income inequality and domestic demand
If, under a condition of high income inequality, an increasing share of national income goes to high-income households, the savings of the economy will grow, because the consumption ratio (defined as consumption expenditure as a share of disposable income) of households declines with rising disposable net incomes. This relationship is depicted in Fig. 3, using Germany as an example.
Hence, a high degree of income inequality weakens the demand for goods and services. In less developed economies, this situation does not cause severe problems for aggregate demand. These savings are available for investment and a less developed economy needs high investment because the capital stock of the country is low. Therefore, the drop in consumer demand is offset through business investment. In highly developed economies, however, the level of capital stock is already very high. In case of a decline in consumer demand, there is no incentive for additional investment. Consequently, investment does not compensate for the shortfall in consumer demand.
This relationship can also be illustrated using Germany as an example: The downward trend in consumer demand and the resulting decline in net investment have in sum resulted in an excess supply of savings. This has been true of Germany since about 2002, and also applied to the former West Germany in the middle to late 1980s (see Fig. 4). An oversupply of savings of this kind corresponds to weak consumption of domestically produced goods and services. However, if domestic businesses find that not all their produced goods and services are demanded, this reduces the incentive to increase production capabilities through further investment. Consequently, investment declines as a result of the weak domestic demand for goods. In the medium term, this trend leads to stagnation or even economic contraction.
In light of the foregoing analysis, we conclude that the extent of income inequality in Germany has become a brake on growth, because the growth-dampening effects are greater than the growth-promoting effects. The primary indicator for this thesis is the fact that savings have exceeded net investment for a number of years. In this case, there is no fundamental contradiction between a state redistribution of income and economic growth.
Designing any income redistribution policy, however, must bear in mind that the collection of public revenues can also have negative effects on economic growth, by reducing performance incentives for taxpayers (which affects labour and capital supply), and through the welfare and growth losses associated with tax collection. In the specific design of income-redistribution measures, it is therefore important to ensure that the negative growth effects of redistribution are not larger than the positive growth effects of the income redistribution.
In this regard, a reduction in income inequality should not be limited solely to pure redistribution through the tax-transfer system. A realignment of the supply-side policies of the last 30 years is also necessary. In many developed nations, demand-oriented economic policies were replaced in the late 1970s by a supply-side economics policy. At the heart of this economic policy orientation is an improvement in supply-side conditions for businesses through cost and tax reductions, an increase in flexibility within goods and labour markets, and the restriction of government activities to a few core tasks. Within the framework of this economic policy orientation, a redistribution of income to favour income from business activities is not an undesirable side effect, but rather an intended consequence, as an improvement in companies’ income conditions is considered to be a prerequisite for increasing economic growth and creating new jobs.
However, if the wealth-promoting effects of this income redistribution are no longer evident, there is also no longer any economic justification for the resulting differences in income. A modified supply-side policy then becomes necessary, in which a stronger and more capable state strengthens the forces of growth by expanding access to education, health care and other state infrastructural offerings for people with low incomes. This assumes a stable revenue base, in order that the expansion of state offerings does not lead to an increase in public debt.
If you are interested in learning more about the impacts of income inequality on economic growth you can download the full impulse paper on the topic here.