Trickledown economics rides on the presumption that eventually the benefits of high economic growth will percolate to those at the bottom of the pyramid. That has been the mantra in India since 1991, influenced in no small part by International Monetary Fund (IMF) policymakers. But now the IMF has had a—gasp!—rethink. In a recent paper, a five-expert group has debunked the trickle-down effect. “By lifting the ‘small boats’ of the poor and the middle class, we can build both a fairer society and a stronger economy,” Christine Lagarde, MD of the IMF, has said.
The call for a bottom-up approach should serve as a wake-up call for India. Remember the heated debate on growth-versus-development last year between Nobel laureate Amartya Sen, Prof Jagdish Bhagwati and Prof Arvind Panagariya (currently part of the Modi government)? The Bhagwati camp argued that high growth—via infrastructure development with larger private sector participation—would help a country bridge the widening divide between haves and have-nots.
But it is increasingly clear that key development goals have been been missed by almost all the countries, including India, which is home to 33 per cent of the global poor. New IMF research shows that if the income share of the poor and middle class is raised by one percentage point, then GDP growth increases by as much as 0.38 percentage points over five years. In contrast, if you lift the income share of the rich by one percentage point, GDP growth decreases by 0.08 percentage points.
The new IMF wisdom follows what several other global think-tanks like Organisation of Economic Cooperation and Development (OECD) have lately been pointing out—the growing inequality between the ultra-rich and the poor is untenable as it would fail to create jobs and economic well-being.
Suffocated By Inequality
Ajit Ranade chief economist, Aditya Birla Group
“When India clocks a growth rate of 7.5 per cent, that’s a national average. The rate across states or sectors can vary from four to 14 per cent. Similarly, growth also varies across income classes, averaging 7.5 per cent. Now what if backward states or lower income classes are consistent laggards while high growth ones accelerate year after year? We then have high growth and widening (regional or income) inequality. Following the 1950s work of Nobel laureate Simon Kuznets, the gospel was that growth always trickles down. Laggards catch up, those racing ahead slow down, income inequality reduces. But the recent work of economist Thomas Piketty and others and research by the IMF cast serious doubt upon the trickledown theory.
The conclusions go both ways: growth can make inequality worse (Piketty); inequality can hurt growth (IMF). The former is easier to describe: if capitalists have a higher rate of return on capital than the overall GDP growth rate, their share of national income keeps expanding, wealth ownership becomes concentrated, inequality worsens. Conversely, inequality also hurts growth. If the poor have considerably fewer opportunities, no good schools or healthcare, their human capital and productivity suffer. Their stagnation can persist for generations. Aggregate growth suffers, consumer spending falls. In such cases, pro-poor policies and reservation can reduce inequality and enhance growth. High inequality might also lead to social and political instability (such as the Arab Spring), more illiberal and protectionist policies that encourage crony capitalism, high indebtedness and civil conflict.
“Income inequality is a bit like industrial pollution. You can never have zero.”
All this hurts growth, which is what the IMF research documents. On the other hand, policies that enhance the income of the poor through redistribution can contribute to growth since the poor spend almost all their incremental income, unlike the rich. It is important to not confuse the issue of poverty and inequality. Poverty removal is almost impossible without adequate economic growth. But the very same growth can make society unequal. Think of Cuba versus the US. The former is poor, the latter is unequal. The question then is: how much inequality is acceptable? That depends on social context. India is already stratified by caste, religion and other social categories. Income and wealth inequality is an overlay.
Devoting resources to the poor, giving them access to education and healthcare makes society more productive. This does not imply wholesale redistribution. Ultimately, inequality is like industrial pollution. You can never have zero. Indeed, some inequality is desirable as it spurs hard work, innovation and entrepreneurship. But there is such a thing as too much inequality. It suffocates. That’s when we need a corrective."
Take The Middle Path
Chetan Ghate associate professor, Indian Statistical Institute, Delhi
“I think there is definitely a change in recognition by the IMF about the importance of inequality in driving sustained growth. Compared to 10-20 years ago, IMF’s research now gives a lot of importance to inequality. The inequality-aversion of society has also increased.
What we learn from recent IMF work is that inequality creates a hazard that growth spells will end. This suggests that ‘equality’ leads to a sustainability of growth spells. The main conclusion is however about net inequality: lower ‘net inequality’—that is, inequality after taxes and transfers—drives faster and more durable growth. What we learn from other work in this field is that growth is more pro-poor if inequality is lower.
I generally support the conclusions of this work. One source of scepticism about redistribution is that it leads to what is called a Meltzer-Richard effect, or a ‘leaky-bucket’ effect. Simply put, this says that redistribution may directly affect incentives and therefore growth. However, there is little evidence of a harmful effect of fiscal redistribution at a macro level in cross-country data. For instance, if distributive policies raise capabilities, then this can boost growth. Bolsa Familia in Brazil—which is well targeted and 0.5 per cent of the GDP—reaches 25 per cent of the population. In Brazil, roughly half of the poverty fall is explained by higher growth, the other half is explained by reductions in inequality. This is a middle path.
“We should have fewer anti-poverty schemes, but they should constitute a larger percentage of GDP”
In India, we have myriad small centre-state anti-poverty sponsored schemes. I think our anti-poverty strategy should be recalibrated so that there are far fewer schemes, but those that are there constitute a much larger percentage of the GDP. Why don’t we have a large-scale Bolsa Familia style conditional cash transfer programme in India? Has the right to food campaign hijacked the debate on conditional cash transfers? Welfare state policies also have to have the right mix between redistributive policies and social insurance policies.
Trickledown works imperfectly. However, we forget that the real wage is always increasing in the capital-labour ratio. So increasing the capital stock, because of higher investment in the economy, will increase real wages which will lead to a fall in poverty. So our growth strategy has to have some top-down elements.
There are other questions the Lagarde speech did not address: what is the role of taxation in reducing inequality and poverty? Should countries try to reduce poverty or reduce inequality? My own view is that the object of policy should be to reduce absolute poverty and think about inequality as a secondary objective. We also think of the progressivity of taxes as one of the tools to address inquality. But then this is not directly useful in reducing poverty.”