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November 28, 2000
Why We Don't Have to Choose between Social Justice and Economic Growth: The myth of the equity/efficiency trade-off
by Andrew Jackson
Director of Research
Canadian Council on Social Development
Section I: Introduction
The Big Trade-off in Theory and Contemporary Debate
The idea that society faces a fundamental trade-off between equity and efficiency, between social justice and economic growth, is a staple of both economics textbooks and contemporary political debate. The basic premise is that too much social effort to promote an equal distribution of income or wealth distorts the necessary functioning of (inequality generating) incentives and disincentives in a market economy and thus, carries a cost in terms of lost income and future economic growth. The classic formulation of this idea was put forward a quarter of a century ago by U.S. economist, Arthur Okun, who wrote that inequality reflects "a system of rewards and penalties that is designed to encourage effort ...The pursuit of efficiency necessarily creates inequalities. And hence society faces a trade-off between equality and efficiency."1
The typical economics textbook presentation of the issues concedes that, from the point of view of maximizing economic welfare at a given moment in time, there is little question that income equality achieved through redistribution is optimal. (The "utility" of more income for the poor is greater than the loss of "utility" on the part of the rich.) However, the central issue is posed as the relationship between equity and economic growth. Do measures to promote greater equality of income such as redistributive taxes and transfers diminish total output and income? In other words, does "sharing the pie" result in a smaller pie, and thus smaller slices even for those who benefit from redistribution in a simple static analysis?
The textbook presentation of the issues argues that the key mechanisms of redistribution to achieve social equity - that is, taxes and the income transfers they finance - carry significant costs for efficiency. In this view, taxes and transfers are said to reduce incentives to work, savings and investment, thus resulting in labour market "rigidities," unproductive dependency, foregone work effort in the present, and reduced investment in the future. Key mechanisms to achieve greater equality of market income - such as collective bargaining and legislated employment standards - are also said to be economically inefficient because of the resulting "distortion" of wages.
The question of a trade-off is critically important to advocates of progressive economic and social policy who want to achieve a more equal distribution of income and opportunities than would arise under pure "free market" mechanisms. Those who want to redistribute income to achieve social justice, or to promote an initially more equal distribution of market income, will face an uphill fight if their opponents can successfully demonstrate that this would result in a large overall income loss, and particularly if their opponents can show that low-income households are actually better off in absolute terms in a high inequality but high income society.
The question of who benefits from trading-off equity for efficiency is often not explicitly considered. For example, in the recent U.S. experience, a pertinent question to ask is: Boom for Whom? The U.S. may be a rich society in dollar terms compared to many others, but income is distributed profoundly unequally. As a result, many Americans are excluded from the "average" level of prosperity and they fare worse than ordinary citizens in other, "poorer" societies. Canadians, on average, currently have incomes at about 80% of the U.S. level (GDP per capita in 1997 adjusted to equalize purchasing power), but analysis shows that it is only the top layer of U.S. citizens who are significantly better off than Canadians at a comparable point in the earnings distribution. The median Canadian household - one at the precise mid-point of the national income distribution - is almost as well off in terms of their purchasing power as the median American household, and the income privilege of being American only becomes significant for about the top 20%.2 (Calculation is for real after-tax household income, adjusted for differences of purchasing power and household composition.) Low-income Canadians (the bottom 25%) are significantly better off than low-income Americans in terms of their absolute purchasing power. This result reflects the combined workings of a larger and more redistributive tax/transfer system operating on top of a modestly more equal initial distribution of market incomes in Canada.
At some point, however, income gains from faster economic growth can be expected to eventually make even lower income households better off than similar households in lower income but more equal countries. Lower income households in the U.S. have indeed finally benefited from very low unemployment rates, even if a lot of the employment growth has been in low-wage jobs. And there has been some real income growth for low-income households in the U.S. since 1997 as the benefits of the economic expansion have finally started to percolate downwards.3
It is generally recognized that the U.S. and other "liberal" countries such as the United Kingdom have both relatively high levels of earnings inequality and high levels of after-tax household income inequality, and that income inequality in these countries has increased throughout the 1990s despite sustained growth. But strong economic and job growth are often cited as results that make this a good trade-off for society. Strong economic growth in the U.S. in the 1990s supposedly demonstrates the virtues of the "liberal free market" model, while weaker growth in Canada and in much of Europe is said to reflect the costs of a "kinder, gentler" form of capitalism that is associated with higher taxes and transfers and more labour market regulation.
A key theme in the influential 1995 OECD Jobs Study was that "flexible," U.S.-style labour markets deliver strong employment growth compared to the regulated labour markets of "sclerotic" continental Europe. In this view, overly generous welfare states are thought to discourage the growth of lower wage jobs and to encourage costly
"dependency," while relatively equal wage structures impede the necessary reallocation of workers between jobs by "distorting" market signals. Low taxes, as in the U.S., are seen as necessary to reward effort and stimulate savings and investment. The market delivery of services, as in the U.S., is also seen as inherently more efficient than the public provision of services.
The concept of a fundamental equity/efficiency trade-off has been a very prominent feature of recent policy debate in Canada. It is frequently argued that a downward harmonization of Canadian taxes to, or even below, the U.S. levels for corporations and mobile high-income earners is needed in order to boost growth and productivity in an ever more closely integrated continental economy. But such an agenda would erode the capacity of the tax and transfer system to reduce market income inequality, since the progressivity of the personal income tax system would be reduced, and growing fiscal resources would be directed to tax cuts, rather than to additional spending on income transfers such as Employment Insurance and social assistance, or to other equality enhancing public programs and social investments.
The total tax share of GDP is significantly higher in Canada than in the United States - 42.8% vs. 31.0% of GDP in 1999 - mainly because upper-middle and high-income earners incur a significantly higher income tax burden. Canada remains a modestly more equal society than the U.S. because of the greater relative size of the tax/transfer system and higher levels of provision of public services.
These differences have, however, been eroded as total public expenditures on programs fell from 41.4% to 36.4% of GDP between 1990 and 1999. Cuts in transfers, combined with increased inequality in the distribution of market income, have increased income polarization and inequality. After years of relative stability in after-tax income shares, the share of the bottom 20% of families fell from 7.7% to 7.1% between 1995 and 1998, while the share of the top 20% rose from 37.3% to 38.8%. Over this period, the share of the top quintile increased at the expense of all other quintiles, and the Gini coefficient of after-tax income inequality increased significantly from .297 to .315.4
Growing after-tax income inequality likely reflects still weak labour market conditions in a period of economic recovery, continued high unemployment and levels of precarious work at the bottom to middle of the income distribution, unequal wage and salary growth across income groups, and, as importantly, the impacts of transfer cuts, particularly cuts to Employment Insurance and social assistance that impact younger households.5
Given this growing gap between the rich and poor, and the badly stretched public services as a result of the recent cuts, the current difference between
Canadian and U.S. tax shares is probably insufficient to meet equity goals and maintain our social distinctiveness, even if growth and unemployment rates were to converge with those of the U.S.
The 2000-01 federal budget attempted to maintain some balance between the "growth agenda" of tax cuts and the "social agenda" of reinvestment in programs such as the Canada Child Tax Benefit, but most observers agreed that the emphasis was tilted to the former. Growth is indeed the only morally defensible case for a regressive strategy of reducing taxes for high-income earners while foregoing major social re-investments,
and the Business Council on National Issues explicitly argued the case for "growing the pie" in its 1999 pre-budget submission to the House of Commons' Finance Committee.
The argument in favour of growth through tax cuts and continued restraint in social spending at a time of growing inequality and social exclusion understandably draws fire from social advocacy groups. Far too conveniently, it equates the self-interest of the relatively privileged with the national interest. And social advocates rightly stress the need to maintain a larger and more progressive fiscal base than the U.S. and a stronger set of social programs if we are to achieve lower rates of poverty, insecurity and income inequality. But social advocates also should - and largely do - recognize the need for stronger economic growth to get more and better jobs, to drive market income growth, and to produce a stronger fiscal base in order to finance transfers and public services. The argument that growth could enhance equality by reducing unemployment and by boosting tax revenues is powerful because it is basically true.
The linkages between economic growth and income inequality are complex, but few people would disagree that growth can potentially promote greater equality through two key channels.
First, economic growth (in excess of trend labour productivity growth) is needed to create jobs. More hours of work for the unemployed and underemployed will increase the incomes of low-income groups. This is particularly true in countries which have relatively ungenerous income support programs for the unemployed.
Second, growth increases social wealth and with it, the capacity to finance more generous income support programs for those who are excluded from the labour market or who, for other reasons, have low market incomes. It is entirely possible for growth to produce more inequality of incomes, particularly when full employment is reached, if the distribution of market incomes is highly unequal. But it is more likely for inequality to increase in a slow growth economy that has high unemployment and a high level of "dependence" on income transfers.
Put another way, the optimal conditions for shared progress are high levels of employment in a job market which provides relatively equal wages, combined with a tax/transfer system large enough to provide a decent income to those who are excluded from the labour market because of old age, infirmity, disability, and so on.
Changes in the job market have led most analysts to agree that modern welfare states must also be prepared to supplement employment income for groups at high risk of low income, such as young working families, single parents with children, and very low skilled workers, although there is no clear consensus on the respective roles of labour market regulation and government-financed income supplements to raise low wages.
The more controversial and unexplored linkage is from equality and inequality of incomes to growth. As noted, the dominant argument is that measures to blunt inequality - such as regulated labour markets which produce relatively equal wages, and progressive tax/transfer systems - will carry a price in terms of lost growth. Fortunately, however, there is growing evidence that we do not have to choose between efficiency and equity, between growth and equality, but can, in fact, get both at the same time.
Economic theory is increasingly critical of the simple trade-off story and increasingly stresses the positive rather than negative linkages between low levels of income inequality and growth. Moreover, empirical studies have undermined the notion of a consistent negative trade-off in favour of the view that equality itself is growth-enhancing and that initially more-equal societies grow faster.
A major survey of the literature made the following observation:
"Recently, the view that inequality is growth-enhancing has been further challenged by a number of empirical studies, often based on cross-country regressions of GDP growth on income inequality. They all find a negative correlation between the average rate of growth and a number of measures of inequality."6
The survey noted that the results of empirical studies were "impressively unambiguous, since they all suggest that inequality reduces the rate of growth." These studies covered a very broad range of both developed and developing countries from the 1960s through the 1980s, but the empirical evidence for North American and European countries in the 1990s also bears out this general conclusion: the idea of a fundamental trade-off between growth and equality is not warranted.
Section II of this paper surveys the evidence, while Section III explores some positive linkages between relatively low levels of inequality and economic growth. Finally, Section IV takes up the issue of whether "globalization" has broken the possibility of pursuing policies which reconcile efficiency with equity goals.
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