TAKE HIM AT HIS WORD:

Inequality and Growth: Challenges to the Old Orthodoxy (Erwan Quintin and Jason L. Saving, January 2008, Economic Letter—Insights from the Federal Reserve Bank of Dallas)

Until recently, a broad set of ideas led much of the economic profession to opine that inequality was, if anything, favorable to—or at least a necessary by-product of—economic growth.

In classical models, economic growth depends chiefly on the rate at which nations accumulate productive resources, a factor that traces to aggregate savings rates. In this context, distributional considerations matter for growth only if households’ propensity to save varies systematically with wealth. If the rich save at a high rate, a view closely associated with prominent economist Nicholas Kaldor, unequal societies can actually build up their productive infrastructure faster than equal ones, achieving higher growth rates.

Inequality could also foster growth because new industries typically require large initial investments. If credit markets function poorly, a society’s savings may not be efficiently transferred to investments. In this environment, a high concentration of wealth may allow some investors to overcome these impediments and stimulate growth by bringing capital-intensive industries into being.

In the early work, income or wealth redistribution policies are overwhelmingly viewed as detrimental to growth based on at least two arguments. First, redistribution via such instruments as progressive taxation distorts incentives to save, which reduces resource accumulation. Second, some variation in economic rewards helps provide incentives to invest and work.

The classical view long dominated economic thought and emphasized that policies designed to reduce inequality would entail adverse consequences for economic growth.

Recent Challenges

Over the past two decades, these conventional notions have been challenged both on empirical and theoretical grounds. In cross-country comparisons, for example, researchers have generally found a negative relationship between income inequality and subsequent economic growth. These empirical findings, taken at face value, suggest that more equality could, in fact, foster growth.[3]

We illustrate the empirical argument by plotting income inequality in 1960 against average growth rates over the next four decades for all countries with available data. The results suggest, albeit weakly, that nations with more initial income inequality have tended to fare worse in the long run than countries with greater equality (Chart 1). In this example, inequality alone accounts for a fairly small fraction of the variance in growth across countries.

Even so, a growing body of empirical work finds that inequality remains significantly correlated with future growth even after controlling for other important factors, such as nations’ initial level of development. Furthermore, the correlation between inequality and growth seems particularly strong among certain subgroups of nations—for example, those in which private credit is scarce.

The question isn't whether to redistribute wealth--we decided that in the affirmative a long time ago. The question is how to do so. Mr. Obama has in the past expressed his support for a universal 401k, which the GOP should help him pass, Universal 401(k) Accounts Would Bring the Poor Into the Ownership Society (TYLER COWEN, 12/28/08, NY Times)

Of the current proposals to address income inequality, the universal 401(k) is the most likely to bring general prosperity.

The core idea is simple. The federal government creates tax-free retirement accounts for lower-income Americans, supplementing private accounts where they already exist, and matching personal contributions to those accounts. The amount of the match would depend on the income of the family and how much they save.

Gene B. Sperling, senior fellow at the Center for American Progress and the best-known proponent of this idea (americanprogress.org/issues/2004/01/b289151.html), calls for a mix of 2-to-1 and 1-to-1 matches, but of course the exact ratios depend on what we are willing to spend.

Just as the earned-income tax credit pays poor people to work, the universal 401(k) would pay poor people to save. The idea is to bring the benefits of markets and investing to the poor. An H&R Block study (“Saving Incentives for Low- and Middle-Income Families: Evidence From a Field Experiment With H&R Block,” by Esther C. Duflo, William G. Gale, Jeffrey Liebman, Peter R. Orszag and Emmanuel Saez, published in The Quarterly Journal of Economics in November) indicated that lower-income Americans have a strong demand for easy-to-use matching retirement accounts.

But currently only 55 percent of Americans working full time hold a job with a retirement savings plan; the rate is even lower for part-time workers and the poor. Thus the bottom 60 percent of taxpayers receives only 10 percent of the tax incentives for savings.

A universal 401(k) plan would spread these tax benefits more evenly and induce more Americans to save. As in current 401(k) plans, the assets would be protected from creditors, the account would be attached to the individual and thus be portable, and penalties would discourage early withdrawal.

By directing the benefits toward the neediest, the universal 401(k) savings plan tries to increase economic security in a cost-effective manner.

MORE:
Still a Good Idea (Andrew G. Biggs, October 28, 2008, AEI Online)

Consider a simple personal account plan similar to those introduced in Congress. Workers could voluntarily invest four percentage points of the 12.4 percent Social Security payroll tax in a "life-cycle portfolio," which would shift from holding 85 percent stocks through age twenty-nine to only 15 percent stocks by age fifty-five. At retirement, the account balance would be converted to pay a monthly annuity benefit.

Workers who chose to divert a portion of their payroll taxes to a personal account, however, would also receive a reduced traditional benefit. Traditional Social Security benefits for account holders would be reduced by the amount they contributed to the account, plus interest at the rate earned by government bonds held in the Social Security trust fund. This would keep the current system's finances roughly neutral.

Account holders' total Social Security benefits would increase if their account returned more than the interest rate on government bonds. This makes analyzing how account holders would have fared a relatively simple task.

Using historical stock and bond returns since 1965, I simulated an individual who held a personal account his entire career and retired in September 2008. A typical retiree in 2008 would be entitled to a traditional Social Security benefit of roughly $15,700 per year. For workers who chose personal accounts, this traditional benefit would be reduced by around $7,800. But if the worker had a personal account, the balance of $161,500 would pay an annual annuity benefit of around $10,100. This $2,300 net benefit increase would raise total Social Security benefits by around 15 percent.

While today's retiree would have faced the subprime crisis and the tech bubble earlier in the decade, he also would have benefited from the bull markets of the 1980s and 1990s. The average return on his account--4.9 percent above inflation--would more than compensate for a reduced traditional benefit.

While this is an isolated case, it is telling that the very example Senator Obama uses to illustrate the dangers of personal accounts in fact refutes the point he is attempting to make. Even workers retiring today would have increased their Social Security benefits by choosing a personal account.

But we can go further. Using stock and bond data from 1871 through 2008, I simulated ninety-five separate cohorts of account holders retiring from 1915 through 2008, as shown in figure 1. Despite the ups and downs of the stock market, every single group of retirees would have increased their benefits by investing in personal accounts. Total benefits would have increased by between 6 and 23 percent, with an average increase of 15 percent.

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