Viral Stash Financial News

I’ve been trying to develop my intuitions about how inequality might affect aggregate growth. It’s not like this is a new question. Theoretical arguments have been made both ways, and an empirical literature found a consensus in the 1990s (inequality looked bad for growth), then squinted harder to find little relationship in the 2000s. For some careful theorizing about how inequality might harm growth, take a look at this paper by Philippe Aghion, Eve Caroli, and Cecelia Garcia-Penalosa (”ACG”). They tell three stories, with very careful models: i) when capital markets are imperfect, inequality might reduce the efficiency of investment, as the less productive opportunities of the wealthy are funded in preference to the more productive opportunities of the poor; ii) the borrowing required to fund investment under inequality imposes agency costs, because entrepreneurs expend less effort when the benefits and costs of their labors are shared with financiers; and iii) unequal access to investment opportunities may combine with financial market imperfections to create macroeconomic downcycles during which savings cannot be efficiently invested.

Those are good stories, and there are others. The oldest story has to do with incentives. The traditional notion of a trade-off between efficiency and equity comes from the idea that redistribution blunts incentives to invest and produce. In almost any model, reducing after-tax returns on investment will reduce investment, ceteris paribus. It is worth pointing out that inequality and redistribution are separate questions. Inequality may be harmful (or helpful) to growth regardless of whether redistribution by the state would would be good policy. That lower after-tax investment returns reduce growth doesn’t really tell us all that much about the effect of inequality. Also, incentives swing both ways: see ACG story (ii) above, or models of effort in tournaments (e.g. Freeman & Gelber via Benign Brodowicz and commenter Indy).