Economic growth more likely when wealth distributed to poor instead of rich

June 4, 2015

by Stephen Koukoulas

4 June 2015

Having money from economic growth flow to poor people rather than the rich feeds into a lift in the rate of economic growth and lower unemployment. Conversely, as income inequality increases, the potential for economic growth is constrained.

The economic case for maintaining a progressive income tax structure and targeting welfare payments to those most in need is overwhelming.

The issue can be illustrated through a simple stylised example which outlines how a higher cash flow to the poorest is growth enhancing while a higher cash flow to the rich boosts savings, but keeps economic growth lower.

Take a situation where there is a $1bn addition to the economy via growth. That $1bn can be distributed in many different ways but let’s initially assume the 10 richest people in Australia each receive all of that gain, with $100m going to each person.

According to the BRW Rich list, the tenth richest person in Australia has wealth of $2.65bn while the richest, Gina Rinehart, has more than $14bn. Economic theory and research suggests that the extra $100m to each of these uber wealthy people would be almost totally be absorbed into their wealth and there would be only a very small increase in economic activity as a result.

According to research from the Brookings Institution and the Reserve Bank of Australia, the marginal propensity to consume of high-income earners is substantially less than for low-income earners. In other words, poorer people are likely to spend the bulk of any extra income while the wealthy are more likely to save it.

Looked at another way, would Gina Rinehart, Anthony Pratt or Harry Triguboff increase their spending over and above their current consumption patterns if their income had a one off boost of $100m? The answer is an overwhelming no. More likely the extra $100m would merely find its way into their assets and wealth. Any impact on the macro-economy as a result would be small.

An alternative is distributing the $1bn by allocating $1,000 to each of the poorest one million people via a $20 a week tax cut or benefit increase. In this scenario, there is a strong probability the vast bulk of the $1bn would be spent to improve their living standards. Low-income earners are unlikely to save or invest the extra income.

Now think of how the different distribution of the $1bn will affect the economy and jobs.

If the money finds its way to those on low incomes, there will inevitably be higher aggregate spending, more jobs and quite simply a stronger economy. And if the income distribution continues to be skewed to those on low incomes, there will be a lift in the growth potential of the economy. Unemployment would be structurally lower and there would be a self-supporting cycle of stronger activity as a result.

In most sober analyses of income distribution, no one is suggesting governments have a policy framework to crunch the rich and blindly give the money to the poor. Rather, the idea of greater income equality and a more even distribution of wealth reiterates the importance of a progressive income tax structure. It also highlights the economically sensible nature of targeted welfare assistance to those on lower incomes and a tightening of payments away from high income earners.

This is where the current tax breaks to very wealthy Australian superannuants and the business sector need to be radically overhauled.

Not only will changing policies in these areas enhance economic growth and see a structural lowering in the unemployment rate, they have the other benefit of being fair, decent and compassionate.

Let’s hope the next election covers the issues of income inequality and how redistribution is such a vital element for growth.