Effect of Economic Inequality on Economic Growth

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Measures to Decrease Economic Inequality

Piketty introduced three Measures to decrease economic inequality:

Demographic Growth

One of the measures that decrease economic inequality is strong demographic growth, this is because it decreases the significance of inherited wealth. Inherited wealth, as mentioned earlier makes it much easier to accumulate further wealth due to capital income. It might also dictate opportunity in countries with lower education and social inequality.

Distribution of Knowledge

Another Measures for decreased inequality, the distribution of knowledge and investments in training and skills. This force operates not only within a country, but also between them. This is evident with countries like China, which adopt production modes and skills of the rich countries and gain a huge jump in productivity, boosting their growth.

Demographic growth and the distribution of knowledge may occur more or less naturally as the economy matures, but since economic inequality is not just an emerging market country problems it is evident that the forces of disagreement can be stronger than coming together in even mature economies.

Progressive Global Annual Tax on Capital

Piketty’s suggested a progressive global annual tax on capital for decreasing economic inequality. He himself admits that it is a perfect idea, and actually implementing would require unrealistic levels of international cooperation (Piketty 2014 p. 515). The difference between his idea and existing forms of capital taxation is that this tax would be progressive and would be applied to all forms of assets: real estate, financial assets, and business assets (Piketty 2014 p. 517). The point he underlines is that the purpose of this tax would not be to replace other forms of taxation as a source of revenue, but to stop the different effect of capital income on economic inequality.

The tax would also serve to regulate the financial and banking system in order to protect against financial crises. Additionally significant gain of this would be increased transparency for the financial system, by requiring everyone to report their ownership of capital assets. This in turn would require increased sharing of international banking data between authorities, with the effect of eliminating tax evasion through tax havens. (Piketty 2014 p. 519-521). Prompt global introduction of the progressive annual capital tax is hardly realistic, so Piketty outlined a theoretical case of Europe adopting the tax. The rate would be 0 % for fortunes below 1 million Euros, 1 % between 1 and 5 million Euros, and 2 % for above. This he estimates, if applied to the European Union countries, would generate revenues equivalent to 2 % of Europe’s GDP it’s not an insignificant number. (Piketty 2014 p. 528).

Now that we considered measures to decrease economic inequality, let’s focus on the second research question of this thesis and consider them in conjunction with economic growth.

Measures to Stimulate Economic Growth

The main source of economic growth is aggregate demand and supply. The economy can also be enhanced by an increase in productivity, but since this is mainly done through improving training, equipment, and technology it can be said to be a component of supply. As mentioned earlier, consumption cannot be decreased too far without also hurting investments, but the same is also true in reverse. Too much consumption, will lower funds available for invest. Investments, as mentioned, play a key role in maintaining competitively. This in turn affects the employment rate and wages, which feed consumption.

The issue is thus to pursue measures that don’t improperly burden consumption or investments. Let’s us examine each of the measures used in decreasing economic inequality.

Strong demographic growth can be achieved through either a natural increase of population, more births, or immigration. High immigration can cause social unrest, but if the social policies succeed in facilitation adjustment to local population it can be a great source of economic growth as defined in the chapter about economic growth. So as a measure to decrease economic inequality, not only does this measure not harm consumption or investment, it actually increases them.

Distribution of knowledge too is highly beneficial to economic activity. However this measure is of less use in already developed economies as education already plays a significant role and efficient production is widespread. It however summaries the importance of maintaining high quality education available to all. If higher education becomes too expensive for the lower income households it will lower social mobility and increase inequality. Inheritance would play a larger role in determining opportunity.

The last measure, the proposed progressive global annual tax on capital, is less clear on its effect on economic activity. A very high rate would obviously kill of investments altogether and create an economic suicide. However in many developed economies, the combined effect of the previously mentioned measures is not enough to combat the full economic inequality. One of the only remaining tools left is taxation, and Piketty’s suggestion contains many interesting ideas, such as the decreased effect of tax havens, more transparent financial and banking system, and finally a regulative effect against irresponsible speculation by the investors.

The concern is of course that the tax would lower investment, but to this Piketty suggests that the tax would act as an incentive to invest more efficiently. The logic behind is like this, in order to cover the tax rate of 1 or 2 %, the investor would have to seek out investments with higher yields. Those incapable of this would lose their assets and the assets would pass to more dynamic investors. (Piketty 2014 p. 526). According to Piketty, the average real rate of return on capital is 4-5 %, so it should not be impossible to manage finding higher yield investments than 1 or 2 % (Piketty 2014 p. 572).

The real problem as suggested by Piketty, first on a regional level such as Europe is not effect on investment, but rather that it requires unexpected levels of international cooperation to implement globally. The solution would be attempt for it incrementally, (Piketty 2014 p. 515).


To start our discussion on the effect of economic inequality on economic growth, we first needed to examine the various reasons for which a country can experience economic growth. Growth we will take as an increase in the real GDP per capita, which is GDP adjusted for the effects of population and inflation. The factors that affect GDP can be divided into demand and supply side factors. This is because of the theory that economy is based on aggregate demand and supply. Keynesians will place more importance on aggregate demand. This is because they believe demand will create supply, a preference to focus on consumption over investment. The classical economists on the other hand have faith in Say’s law which is a reverse of what the Keynesians believe. Regardless of which to focus on, both can be said to be important for economic growth.

After growth this study focused on economic inequality and its causes. And found the causes of economic inequality to be divided into short and long run effects. The short run effects are the changes in asset prices and exchange rates. The long run effects are the rapid growth of the economy, demographic trends, savings rate, inheritance arrangements, general macroeconomic trends, and possibly government policies. We then examined two measures for economic inequality, the Lorenz curve, and the Gini coefficient, their advantages and faults. After covering both growth and economic inequality we needed to find significant evidence of a link between Economic inequality and Growth. The regression analyses and models by Cingano and Voitchovsky showed a correlation between inequality and growth, with growth as the dependent variable. Cingano’s regression model did not fully explain the connection, as indicated by the p-values, but as Voitchovsky’s model shows this can at least partly be explained by the lack of the Gini index as a inequality variable.

With both growth and economic inequality covered we could finally focus on the research questions. Economic inequality was found to cause imbalances between consumption and investments, the two primary causes of economic growth. These imbalances could then potentially lead to recession, or even a financial crisis. The resulting crisis, would then have a terrible effect on accumulated capital. The loss in capital would affect capital income, and thus lower economic inequality. With the first research question covered we focused on the measures to reduce economic inequality without hampering economic growth.

The findings indicated that many of the possible measures were tied to the growth of the economy, but were insufficient to stop the increase of inequality developing and new emerging economies like Afghanistan, Pakistan, and India. No naturally existing balancing mechanisms were thus proven to exist, leaving government policies as the only option of decreasing economic inequality. Thomas Piketty suggested the creation of a progressive global annual tax on capital. The benefits of that tax would include the decreased effect of tax havens, more transparent financial and banking system.

Cite this paper

Effect of Economic Inequality on Economic Growth. (2020, Dec 09). Retrieved from https://samploon.com/effect-of-economic-inequality-on-economic-growth/

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