There is a growing body of evidence indicating that high levels of income inequality increase instability, debt and inflation which are damaging for a developed economy in the long term. There is, however, no consensus on the relationship between income inequality and growth. Some key research findings are:
Sustainability, Crisis, Debt and Inflation
- Increased inequality can lead to financial crises1.
- High levels of income inequality are associated with economic instability and crises, whereas more equal societies tend to have longer periods of sustained growth2.
- High levels of income inequality lead to higher levels of personal and institutional debt3.
- There is substantial evidence to suggest that increased inequality was at least partially responsible for the increase in debt that precipitated the US financial crisis4.
- Inequality may have played a role in the UK financial crisis by increasing debt and over-consumption, but these effects could also have been small5.
- Increased inequality may increase rates of inflation6.
The evidence on the relationship between inequality and economic growth is mixed.
- There is no link between inequality and growth when rates are compared between countries7.
- Some studies have found inequality leads to increased growth8.
- Others found no link or a strong link suggesting inequality reduces growth9,10,11.
- Some research has found that economic growth is lower and periods of growth are shorter in countries that have high inequality12.
- Research suggests that small alterations to methodology can change the relationship. This research has suggested that there may not be a straightforward relationship between inequality and growth13.
People at the top of the income spectrum use their position to increase their personal gains beyond the amount needed to sustain their employment. This is called rent seeking; and it creates inefficiency in the economy. For example, due to the composition and structure of the US healthcare system people and insurance companies pay more for medical treatments that would cost much less in other countries. As this increases personal benefit but decreases social benefit, this is a classic example of rent seeking.
This, and other market distortions, occur due to the increased power of those at the top of the income spectrum, and their ability to influence political debate through lobbying and ownership of media outlets. Another effect of this influence is that it leads to deregulation which increases instability14.
Some have suggested that it is not inequality that reduces growth but only the inequality consisting of income concentration at the top of the spectrum which causes rent seeking15.
Research suggests that lowering the wage of a low-paid worker decreases their productivity by a greater amount than increasing the wage of a high paid worker increases theirs16. This would suggest increases in wage inequality decrease productivity.
- Employees’ productivity is also affected by whether they believe their pay to be fair, hence excessive executive pay that workers see as unfair decreases their productivity and makes them less committed17.
- An employee’s productivity is further lowered if their pay is low enough that they are struggling to afford their basic expenses. This happens because people living with scarcity devote a portion of their mental energy on dealing with this, which they could otherwise use to work18.
“Keeping up with the Joneses”19
Income inequality is thought to lead to status competition20, which drives increases in consumption as people across the income spectrum spend more attempting to keep their living standards and respectability level with their peer group. Low-income households feel forced to borrow to maintain high levels of consumption. This results in higher levels of debt21.
Incentives are thought to drive growth
Income inequality is thought to increase growth due to allowing for larger incentives. However the evidence linking income inequality and incentives suggests that the UK is an exception in several ways which suggests this theory may not be applicable to the UK’s situation.
The UK has the lowest levels of incentives for those who are paid between £15,000 and £20,000, whereas other countries have lower incentives for those higher up the income spectrum. Additionally the UK has previously decreased inequality with no change in work incentives. This suggests that the relationship between inequality and incentives may not be as strong as previously thought22.
 (OECD 2012)
 (Panizza 2002)
 (Cingano, 2014)
 (Stiglitz 2009)
 (Benabou 1996)
 (Stiglitz 2009)
 (Stiglitz 2009)