Published on Duncan Green’s From Poverty to Power blog

In a new report, the IMF effectively drives the final nail into the coffin of trickle-down economics. The top finding, in their words, is that “if the income share of the top 20 percent (the rich) increases, then GDP growth actually declines over the medium term, suggesting that the benefits do not trickle down.”

In contrast, an income bump to the poorest 20 percent is associated with higher GDP growth. The report concludes, “The poor and the middle class matter the most for growth.”

These findings build on previous work from the IMF demonstrating that high inequality negatively affects growth. While the previous work suggested overall inequality is bad for growth, the current paper contributes by dissecting the income distribution to show what happens to growth when the poor do better compared to the rich.

What does this mean for policymakers?

The big take-away from this research is that sound macroeconomics prioritizes gains to poor and middle income groups. This is significantly different to what many advanced and emerging country governments have pursued in recent decades. Instead of policy strategies aimed at increasing low and middle incomes, they have pursued agendas that enhanced and reflected the economic interests of the wealthiest.

Trickle down had two things going for it. First, for many years the theory enjoyed support from economists and experts. Therefore, it had some semblance of legitimacy. Hopefully, this report puts an end to that. Second, since it implicitly benefits the wealthiest, it wields significant political and ideational power. This second point likely explains its longevity.

As a result, the last few decades have witnessed governments removing important economic regulations, steadily decreasing taxes on the wealthiest, privatizing services like water and health, and weakening workers’ wages and power to organize.

It’s no wonder that 7 out of 10 people in the world live in countries where inequality has increased since the late 1980s. These policies ensured that low and middle income groups grew much slower than the richest 10 percent across countries.

What are the keys to poor and middle income growth?

If growing the incomes of the poor and middle classes is key to shared prosperity and growth, what should governments be doing? According to the authors, the answers are not surprising. In countries at all levels of development, better access to education, redistributive social policies, and better healthcare are associated with higher incomes accruing to low and middle income groups.

Access to credit (“financial deepening”) seems to be an important, and often overlooked, inequality reducer. In advanced economies, more accessible credit has played an important role in reducing inequality. Conversely, lack of access has boosted inequality in emerging economies, where credit is largely limited to the wealthy and the biggest private sector firms.

According to the report, closing the gap in access to education has been one of the most important inequality reducers. However, the report notes that while there’s been overall improvement, access is still skewed toward privileged groups.

These findings, and the impact they have on inequality levels, are shown in the chart below.

What does the report miss?

The report is heavy on good-sounding policy recommendations that governments should take up. For instance, the authors point to the ways in which fiscal policy can be a sharp tool for reducing inequality; governments must curb the tax breaks and handouts given to the rich.

Yet, for me, the influence the wealthy exercise over government policy-making represents the biggest barrier to reducing inequality. In too many countries, our political systems resemble oligarchies instead of democracies. Across the world, collusion among economic and political elites drives pro-rich policies at the expense of greater shared prosperity.

Alas, the world’s economic inequality problem has little to do with economics. Rather, it’s a symptom of entrenched political inequality that underpins the drivers of inequality identified by the IMF: rising labor market flexibility, unequal access to credit, healthcare and education.

This isn’t conspiracy theory, either. Recent research from leading American political scientists show there’s a total disconnect between the preferences of average Americans and how Congress votes. Conversely, Congress overwhelmingly votes in favor of the preferences held by the richest Americans.

This is a great report from the IMF. It’s always helpful when large financial institutions generate solid evidence about the many scourges of extreme inequality. However, real progress may remain elusive until we can address the massive power inequities between the super wealthy and the rest of us.

The IMF has set off the alarm for governments to wake up and start actively closing the inequality gap, not just between the rich and poor, but for the middle class too. The paper’s  message is pretty clear: If you want growth, you need to invest in the poor, invest in essential services and promote redistributive tax policies.