There's a major problem with trickle-down economics: it not only doesn't work, but it ends up backfiring by actually shrinking a country's GDP, according to a report from the International Monetary Fund.
With the gap between the rich and poor growing wider each year, the situation has become dire in many countries, according to the IMF, which found if the top 20 percent of earners increase their income share by 1 percentage point, GDP actually shrinks in the following five years. When income rises for the poorest 20 percent, however, the GDP rises by about one-third of a percentage point.
Inequality leads to a number of problems, including policies that hurt growth and a higher chance of conflicts, thanks to the resulting damage to social cohesion and trust. Prolonged periods of inequality may also worsen financial crises -- similar to the Great Recession -- because such imbalances are connected with higher amounts of leverage and a push from lobbyists to deregulate the financial system.
"Widening income inequality is the defining challenge of our time," the report noted. "In advanced economies, the gap between the rich and poor is at its highest level in decades."
While the growing fortunes of America's top 1 percent of earners has been well documented, the IMF report cites the reasons why policy makers need to pay attention to the waning fortunes of the middle-class and low earners. The bottom line: income distribution matters for economic growth. If the rich alone are profiting, a country's overall economy will end up withering.
The study's findings refute a popular notion among some conservative policy makers, or that of trickle-down economics. Made popular by President Ronald Reagan, the idea holds that the U.S. economy will flourish if the coffers of corporations and top earners are fattened through capital gains tax cuts and other strategies that benefit the top 1 percent. Those "job creators" will then hire more workers at their factories, provide raises, spend more in stores, and generally share their wealth.
In reality, however, that doesn't quite happen, the IMF said.
There is an "inverse relationship between the income share accruing to the rich (top 20 percent) and economic growth," the study noted. The lower GDP suggests "that the benefits do not trickle down."
That should sound alarm bells to policy makers and economists in the U.S., where the share of middle-class families has shriveled in each of the 50 states from 2000 to 2013. With stagnant and even shrinking wages, the middle class simply can't keep up with inflation and higher housing costs, leading to an erosion in the bedrock of the American economy.
Policies that help the poor and middle-class can help reduce inequality, such as providing better access to education and health care, the study noted, while adding that there's "no one-size-fits-all approach to tackling inequality."
Why does widening inequality lead to lower economic growth? A top-heavy distribution of wealth concentrates decision-making and political power with a small group of elites, while also leading to "suboptimal" use of human resources and instability that leads to less investment. While some inequality can be a useful tool -- encouraging people to compete and excel in the labor market -- too much inequality leads to huge social costs, such as undermining the opportunities for the poor and middle class.
In some countries with extreme inequality, "individuals have an incentive to divert their efforts toward securing favored treatment and protection, resulting in resource misallocation, corruption, and nepotism, with attendant adverse social and economic consequences," the report noted. "In particular, citizens can lose confidence in institutions, eroding social cohesion and confidence in the future."
It's not only that the rich are getting richer, but the ranks of the poor are growing. In advanced countries, poverty has risen since the 1990s, with the ratio of the earnings of the 90th percentile to those of the 10th percentile growing in most advanced counties, but especially in the U.S. and the U.K., the report noted.
The IMF isn't the first organization to sound the alarm about the widening wealth gap. Ratings agency Standard & Poor's warned last year that the income gap in the U.S. was approaching an "extreme" threshold that would, if not checked, hamper long-term economic growth. In that case, S&P recommended policies such as helping more Americans earn college degrees, as well as a higher minimum wage.
Given that some of the income gap can be linked to technological changes, which have driven up the wage premium for those with technological skills while eliminating other jobs through automation, focusing on educational policies makes sense, the IMF noted. "Raising skill levels is critical for reducing the dispersion of earnings," the report said.
Redesigning labor market policies and enacting fiscal policies that help raise the income of the poor may also help ameliorate the world's growing inequality gap, the IMF noted.
While the growing inequality gap has become a hot topic in the U.S., it's unclear whether large-scale policy changes will be made to help address the problem. The federal minimum wage remains mired at $7.25 an hour (although many states and municipalities are raising their baseline wage, creating a patchwork quilt of higher hourly rates across the country), while the rich continue to pay a smaller share of their income in taxes than the average American.
Breaking away from trickle-down theories may prove a tough habit to break.
As David Madland of the Center for American Progress writes in Salon in an excerpt from his book, "Hollowed Out: Why the Economy Doesn't Work without a Strong Middle Class," the logic not only pervades conservative thinking, but remains popular with many liberals as well. "Not only is trickle-down still lodged firmly in place, but since the Great Recession, adherents of supply side have doubled down on their policies," he noted.