POLICY INSIGHT. Inequality The hidden headwind for economic growth. How inequality slows growth

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1 POLICY INSIGHT Inequality The hidden headwind for economic growth Economists often talk of headwinds the swirling oppositions and uncertainties that may hamper economic growth. We hear of the slowdown in China, muted business confidence, changes in interest rates abroad and demographic changes at home. But there is a hidden headwind: inequality. In this short paper, we argue that inequality poses an increasing challenge to Australia s economic growth prospects. Economic growth has led to substantial gains in living standards for most Australians. We did better than most to distribute the gains of a once in a lifetime commodities boom. Yet, despite this experience, there is growing evidence that our economic system is perpetuating inequalities rather than reducing them - and that this could start to cost us dearly. Over the last 30 years, the Gini coefficient of inequality in Australia has risen from 0.27 to The coefficient rose by one point in just two years to The traditional assumption that inequality is an unavoidable byproduct of economic growth, while fairness can only be achieved at the expense of growth, is increasingly being challenged. The evidence for the growth versus fairness assumption is rather weak. In fact, an increasing body of work is demonstrating the exact opposite we are learning that increased income inequality subtracts from economic growth 2. This is because economic policies that promote inequality leave low and middle-income households behind, sacrificing consumption, investment and output key drivers of growth. How inequality slows growth Inequality can dampen economic growth through two key mechanisms. Firstly, overall household consumption is reduced. Lower and middle-income earners have a much higher marginal propensity to consume. In other words, they spend more of their income. By giving them a lower share of income they have less money to consume in the economy. Second, investment opportunities in poorer segments of the population are reduced. In particular, high income inequality restricts the ability of lower-income people to improve their knowledge and skills by investing in their own education. At a macro-economic level this restricts the productive capacity of the nation; it also further reduces their individual incomes over time. 1 A Gini coefficient of 0 represents perfect equality (every person has the same income), while a coefficient of 1 implies perfect inequality (one person has all income). The closer to zero, the more equal the income distribution, the closer to 1, the more unequal figure of 0.27 taken from Johnson, D, Wilkins, R (2006) The Causes of Changes in the Distribution of Family Income in Australia, 1982 to , Australian Government Department of Families, Social Policy Research Paper No. 27; figure of 0.33 taken from ABS Household Income and Wealth. 2 Ostry, J et al (2014) Redistribution, Inequality and Growth, IMF Staff Discussion Note 14/02; Dabla- Norris et al (2015) Causes and Consequences of Income Inequality; IMF Staff Discussion Note 15/13; OECD (2015) In it Together: Why Less Inequality Benefits Us All.

2 The consequences for the Australian economy By way of illustration, we can apply modeling undertaken by the OECD to the recent Australian experience. With this approach, we find that the increase of 1 Gini point between and could cost the Australian economy $13.1 billion in foregone output (GDP) by That is, the level of GDP in five years time is 0.7 percent lower than it otherwise would have been. For an individual this means they will be earning around $500 less per person in because of the cost of rising inequality. Over the long term (25 years), the OECD estimates that a 1 Gini point increase in inequality can reduce GDP by 3 percent 3. The rise in inequality experienced in just two years could wipe billions off the national economy every year in a generation. To put that into context, this is almost equivalent to wiping out the gains of national competition policy reforms, which were estimated to have delivered a permanent boost to GDP by 2.5 percent 4. And, despite all the fanfare associated with Free Trade Agreements (FTAs), the potential cost of increased inequality is much greater than the benefit of three recent FTAs with Japan, Korea and China. Collectively, these FTAs are expected to raise GDP by only 0.1 percent over the long-term 5. As summarised by macroeconomist, Peter Dixon and public policy Professor Maureen Rimmer, trade policies are approximately zero-sum games. There are domestic winners and losers, and although the national welfare gain is not zero, it is usually small 6. In contrast, ensuring middle- and low-income people have a greater share of income, leading to improved education and better health, can make everyone a winner. 3 Based on modeling by the OECD. The model shows a 1 Gini point reduction increases GDP by at least 3 percent (up to 5.7%). The conservative assumption of 3% has been applied here. 4 Productivity Commission (2005) Review of National Competition Policy Reforms 5 Centre for International Economics (2015) Economic Benefits of Australia s North Asian FTAs 6 Dixon, P and Rimmer, M (2015) What s Really At Stake if the China FTA Falls Through? The Conversation, 8 September 2015

3 Conclusion Our order of magnitude estimate shows that rising inequality, left unchecked, poses a serious economic risk for Australia. Rising inequality will reduce the pace at which the economy can grow, damaging long-term growth prospects and even worse, negating hard won gains of successful economic policy in the past. Rising inequality means that efforts to transition Australia from the mining boom to a modern economy - innovation, competition and investment policies - need to work even harder in the face of unequal opportunities. And the economic cost of higher inequality now will grow for future generations. They will pay the price. But, it does not have to be this way. There are measures to increase equity that also underpin economic growth. Applying the OECD research to the Australian context, they include: Access to quality education to increase economic and social mobility starting with early childhood education, right through to needs-based student funding and affordable higher education. Increasing labour outcomes for women flexibility in childcare options, paid parental leave and reducing the gender pay gap so that return to work is a financially viable. Basic standards for all workers in a modern economy ensuring safe and secure work with access to entitlements including for contract or temporary workers, such as superannuation, penalty rates and paid leave. Affordable health care for all a healthy population is critical to a healthy workforce. Access to universal healthcare remains critical to supporting workforce participation and productivity. Changing the tax mix for example, reforms to negative gearing on property, capital gains, superannuation and international tax that create the space for a reduction in effective tax rates on middle- and low-income workers - increasing take-home pay and preserving incentives to work and invest in the real economy. Many of these options are already being debated, but they must become a common sense economic agenda that transcends policy prejudice. A new level of inequality is emerging in Australia. Armed with the insight that rising inequality can and ultimately will constrain economic growth we must consider measures that will unlock opportunities for enterprise and prosperity of all Australians, not just a fortunate few.

4 Summary of findings Between 2012 and 2014 Australia s income Gini index grew by 1 percentage point from 32 to Over the next five years, this is projected to reduce the level of GDP by $13.1 billion or 0.7% lower than it would otherwise have been in This approximately translates to a reduction of around $500 per person. Over the long-term, a 1 Gini point increase in inequality is estimated to reduce the level of GDP by 3 percent. As a comparison, this is equivalent to wiping out the gains of the national competition policy reforms, which were estimated to have boosted GDP by 2.5 percent. Another comparison is with the stated impact of the three North-Asia FTAs (Japan, Korea, China), which are expected to raise GDP by only 0.1 percent over the long-term. Technical Note The projection in this paper is based on estimates contained in an OECD Working Paper by Federico Cingano: Trends in Income Inequality and its Impact on Economic Growth 8. The OECD team use the Generalised Method of Moments econometric technique to estimate the Solow growth model (augmented to include human capital). The results of this research form the centrepiece of the OECD s latest report on inequality: In It Together 9. Cingano (2014) refers to a 1 Gini point reduction in inequality increasing the steady state of per capita GDP by 5.7 percent, or 3 percent increase after 25 years 10. We have taken 3 percent as a conservative estimate. Over to , Australia s Gini coefficient increased from to This can also be described as moving from 32 to 33 Gini points. By using the OECD regression coefficients to make a projection, we are conducting partial equilibrium analysis (assuming all other factors constant). By contrast, General Equilibrium (GE) modelling of Free Trade Agreements (FTAs) and competition reforms aim to take inter-dependencies into account. Importantly, GE models still do not allow for all dynamic and behavioural interactions. This exercise is intended to be illustrative only, to isolate and demonstrate the order of magnitude of the impact of increasing inequality, rather than to generate a precise forecast which includes the outcome of other factors. 7 A Gini coefficient of 0 represents perfect equality (every person has the same income), while a coefficient of 1 implies perfect inequality (one person has all income). The closer to zero, the more equal the income distribution, the closer to 1, the more unequal. 8 Cingano, F (2014), Trends in Income Inequality and its Impact on Economic Growth, OECD Social, Employment and Migration Working Papers, No. 163, 9 OECD (2015), In It Together: Why Less Inequality Benefits All- 10 Cingano, F (2014), Trends in Income Inequality and its Impact on Economic Growth, OECD Social, Employment and Migration Working Papers, No. 163, p44 11 ABS Household Income and Wealth,

5 The comparison with claimed contributions to GDP from the North Asia Free Trade Agreements (Japan, Korea and China) is based on modelling commissioned by the Department of Foreign Affairs and Trade from the Centre for International Economics (CIE), which finds GDP will be 0.1 percent higher in The comparison with competition reforms is based on the Productivity Commission s estimates that productivity and price changes resulting from reforms to utilities and infrastructure sectors in the 1990s generated a permanent increase in Australia s GDP of 2.5 percent 13. The OECD results are for an average country. Where Australia sits in the inequality-growth nexus at any point in time depends on specific country context. That is, depending on a country s inequality starting point and phase in its growth trajectory, an increase in inequality may have lesser or greater impact than the OECD average. Consequently, this analysis effectively assumes the impact of a 1 point Gini change is linear. That is, the impact is the same whether moving from very unequal to 1 point more unequal or -moving from very equal to slightly less equal. Again, the projections are a simplification and designed to illustrate the potential size of the impact of rising inequality. The OECD finds the gap between low-income households and other households is the most damaging aspect of inequality. That is, a key channel through which inequality negatively affects economic performance is through lowering investment opportunities (particularly in education) of the poorer segments of the population. Equity Economics and Development Partners Pty. Ltd. ABN: Centre for International Economics, Economic Modelling of the Australia s North Asia FTAs, 17 June 2015, page Productivity Commission (2005) Review of National Competition Policy Reforms