Macro Minute: Inequality and Economic Growth

On a macroeconomic level, inequality can affect economic growth, productivity, and political stability, which in turn has direct implications for corporate profitability.

As with most social science endeavors, there is a healthy debate about the precise impact of inequality on growth. For starters, does it hinder or accelerate economic growth? Economic theory shows that with higher income and wealth come higher savings rates and, therefore, a higher level of investment and gross domestic product. In this case, if marginal productivity is higher for capital than for labor, one can see that more inequality would create higher economic growth. Also, in economies with underdeveloped credit markets, significant investments can only be made if wealth is accumulated. In the presence of imperfect capital markets and indivisibility of investments, an economy with higher levels of inequality may be able to introduce new industries, technologies, and markets and ultimately grow faster than the same economy with lower levels of inequality. Finally, there is an argument that reducing inequality reduces incentives to accumulate wealth through labor, entrepreneurship, and innovation, having, therefore, a negative impact on long-term growth.

However, a healthy debate should not be confused with a balanced debate. The bulk of the literature supports the theory that inequality hurts economic growth. Studies that found a positive relationship between inequality and growth were focused on the short term, and studies that found a negative relationship were focused on the long term. In other words, inequality can produce a small contribution to growth in the short term but will substantially adversely affect growth in the long term. Empirical results have increasingly supported the arguments for impaired economic growth and a negative impact on productivity in the face of rising inequality.

Poor people without access to credit markets often defer health care treatments, cannot procure housing or transportation and lack the means to further their education. This results in missed opportunities and diminished productivity and growth potential. The same applies to poor parents with multiple children compared to wealthy parents with few children. The inability of low-income families to invest in their children’s education, and the inability of poor workers to invest in developing job skills because of either financial constraints or time constraints while working multiple jobs, can result in a reduction in overall skills and knowledge of the potential employee pool. That can have a drag on growth, productivity, and business performance. Finally, there is the problem of the indivisibility of consumption. In the absence of developed credit markets, expensive items can only be acquired by accumulating wealth. If the economy became more equitable, part of the population initially excluded from the acquisition of these goods would enter the market, encouraging the creation of new domestic industries.

Societies with higher levels of inequality also tend to have higher levels of crime, keeping a larger share of the labor force from productive activities and decreasing potential growth. Also, with the increase in social instability, trust and social cohesion can erode, leading to conflict, political crises, and the resulting retraction of investments. One of the potential consequences is the rise of nationalism and the splintering of support for globalization. This scenario has played out in economies around the world over generations. Ray Dalio, the founder of Bridgewater Associates, the world’s largest hedge fund, has warned of the corrosive effects of inequality on faith in capitalism and, therefore, the stability of the institutions and markets in which business operates.*

*This excerpt appeared in the article “Business Risks Stemming from Socio-Economic Inequality” by Todd Cort, Stephen Park, and Decio Nascimento at the Columbia Law School Blue Sky Blog published on April 15, 2022. The article is based on the paper “Disclosure of Corporate Risk from Socio-Economic Inequality” by the same authors published on March 18, 2022. You can find the article here, and the paper here.