Question

One of the objectives of great income equality is to encourage economic growth.

a) In light of this, what is the relationship between income (in)equality and growth?

b) Can this be achieved by raising taxes on the wealthy?

Answer 1

a) Economic inequality implies a small portion of the population receives larger portion of national income and large population receives minor share of national income. This inequality can be justifies on the ground that it promotes economic growth.

How far economic inequality promotes economic growth is a matter of economic incentives. In a state of inequality the larger share of population deprived of access to GDP and income earning capacity. If we reduce the inequality, it will promotes social welfare. In a state of equitable distribution the welfare of all citizens are equally preserved. In the context of equitable distribution social justice can be achieved. But as far as economic growth is concerned an equitable distribution of wealth hampers economic growth.

As the income is equally distributed by taking away more from rich, the incentive to work and invest will be reduced. In a state of inequality people will have higher incentive to work and will have more incentive to invest in as they get higher reward for their effort. Then the productive capacity of the economy increase which foster economic growth.

The inequality further can be justified on the ground that a wider inequality promotes saving and capital formation. The wants of the rich people are satisfied so with every addition of income they will save more and this money is invested. Thus higher rate of inequality promote higher saving and capital formation. This further enhances economic growth. An equitable distribution of income reduces the level of saving and falls in the rate of capital formation.

b) Modern countries resort to progressive taxation on income as a measure of reducing income inequality. The progressive taxation minimizes the economic inequality which will reduce the growth of the GDP. Rich save more poor save less. If more is taken away from rich and distribute to the poor, the income given to the people will go on consumption rather than saving. This naturally reduces the capital formation and employment opportunities in the economy. A tax on wealthy is no way recommended in the interest of economic growth but only in the context of social welfare optimality.