Why income redistribution doesn't hurt growth
Thomas Piketty's book "Capital in the Twenty-First Century" documents the increase in inequality in recent decades, and it has rekindled an old debate about the effects of income redistribution on economic growth. Until recently, most economists believed there's a trade-off between equity and efficiency and that the redistribution of income would lower economic growth.
Several reasons account for this, such as the economic distortions that taxes imposed to redistribute income and wealth can cause. However, the main reason is that taking income away from the wealthy reduces the incentive to implement innovative ideas. In its most extreme form, where redistribution is used to ensure that everyone has the same income, why bother to work hard, or work at all?
But as the recent paper "Redistribution, Inequality, and Growth" by Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides of the International Monetary Fund explains, there are also reasons to believe the redistribution of income can enhance economic growth in some cases.
For example, "think of ... cash transfers aimed at encouraging better attendance at primary schools in developing countries..." Thus, the authors note, in theory income redistribution can have both positive and negative effects on economic growth, so it's ultimately an empirical matter.
Taking advantage of a new data set on before- and after-tax income in a wide variety of countries, their paper's main finding is that "redistribution appears generally benign in terms of its impact on growth; only in extreme cases is there some evidence that it may have direct negative effects on growth."
The bottom line is that "the combined direct and indirect effects of redistribution -- including the growth effects of the resulting lower inequality -- are on average pro-growth."
Another piece of evidence on this question comes from the tax cuts enacted under President George W. Bush. If increasing taxes and redistributing the income lowers growth, then lowering taxes on the wealthy ought to increase growth.
However, the evidence does not support this hypothesis: Economic growth did not increase as a result of the tax cuts. Instead, it was quite lackluster in subsequent years. Perhaps tax cuts that allow people to earn, say, $100 million instead of $80 million for an innovative idea -- or vice versa for a tax increase -- don't change incentives that much after all?
Economics does not tell us what the distribution of income ought to be. That involves a value judgment, and individuals will differ on what is fair and equitable. But economics can tell us about the consequences of redistribution, and the best evidence we have suggests that modest redistribution, if anything, enhances growth.
