Private and public sectors must adopt policies that promote inclusive growth to reduce inequality and ensure the benefits of prosperity are shared.
Achieving inclusive growth is the pivotal economic policy challenge of our time. Despite significant economic and social progress over the 75 years since the end of the Second World War, too many people still suffer from poverty and lack of opportunity, and too many countries have a long way to go to meet their Sustainable Development Goals. Rapid climate change creates an escalating danger to sustaining growth. Inclusive growth is multidimensional and requires multidimensional policies.
To start with, macroeconomic stability is important. IMF research shows that economic crises and instability have scarring effects on both advanced and developing economies. In fact, the global financial crisis of a decade ago is likely contributing to the backlash against globalization and the declining trust in public institutions, especially in advanced countries. Crises lead to higher inequality and have played a major role in thwarting developing countries from catching up. So macroeconomic stability is a prerequisite to achieving sustained growth and inclusive prosperity.
Improving governance is another important way to ensure inclusive prosperity. This process will take different forms, depending on the country, entailing such things as reducing the opportunities for corruption, increasing its cost and chances of detection. It could require adopting a regulatory framework with fewer discretionary decisions and more transparency in government processes. Cross-border agreements are also important for combating corruption and tax evasion. For example, anti-money laundering measures and agreements to share financial data with home country tax authorities can combat illicit activity, and tax agreements between countries could be needed to reduce legal tax avoidance.
Direct government intervention policies affect the distribution of income and the incidence of poverty. Fiscal policy is a powerful tool to reduce inequality, through redistribution. In advanced economies, direct taxes and transfers reduce income inequality by about one-third, on average. Approximately three-quarters of this fiscal redistribution is achieved on the transfer side of the budget, with public pension benefits accounting for about half of that. Fiscal redistribution has a large impact on inequality in advanced countries, although much less so in developing ones.
Digging deeper, some tax policies require a trade off between reducing inequality and increasing growth. Progressive income taxes can reduce inequality, but high marginal tax rates could discourage work and investment. Value added taxes (VAT) are less damaging to growth, but may be regressive. However, there are tax policies that do not require a trade off. These include broadening the tax base, especially by eliminating non-means-tested loopholes and exemptions; simplifying the tax code, and taking other measures to fight corruption and tax evasion; and taxing profits that arise from excess market power.
There is a range of spending programs that can improve both inclusiveness and growth. They include public infrastructure to crowd-in private investment and improve productivity, education and health spending; measures to improve labour-force participation; and budget support for R&D. Conversely, some types of universal subsidies are bad for growth as well as equity. An important example is energy subsidies, which can be quite large in some countries. Studies show the benefits of energy subsidies tend to go disproportionately to the rich. And, of course, energy subsidies promote overuse of energy, which is detrimental to the environment.
Are there trade offs between inclusion and growth?
Do policies to improve inclusion come at the expense of growth? Actually, causation goes in both directions. Some mechanisms and policies lead to a trade off between growth and inclusion, and others permit both higher growth and more equality. For instance, higher growth can create more job opportunities as well as providing resources for redistribution, lowering poverty and reducing inequality. But the returns to capital and skilled labour might be higher than the returns to unskilled labour, leading to higher inequality.
In the opposite direction of causation, policies that result in moderate inequality based on rewards for saving, investing, studying, innovating and taking risk can generate higher growth. But inequality that is too high may produce poverty traps, crime, and social conflict, which could impair growth. Policy design needs to take account of these complex issues.
Work from the IMF finds that higher levels of inequality are associated with fewer years of continuous strong growth, while a more equal distribution of income is conducive to a higher rate of growth in the subsequent decade. Redistribution has almost no impact on growth unless it is extremely high. So modest levels of redistribution can reduce inequality without undermining growth.
Policies for an inclusive private sector
Most economies are organized such that private firms and individuals generate a substantial share of economic activity, producing goods and services, and earning income on their labour, capital, and innovation. Policies targeted at the private sector and markets can therefore also impact inclusive growth.
Competition and anti-trust policies can help ensure a level playing field for firms and encourage innovation. In some cases, countries could support high-tech clusters to facilitate the growth of start-ups and young firms. As countries integrate into the global economy, policies can aim to mitigate the costs of globalization, while reaping its benefits.
Labour market policies should aim to reallocate workers efficiently between jobs as needed and help the economy adjust to macroeconomic shocks. For example, policy should protect workers, not jobs, especially with unemployment insurance rather than excessive employment protection systems. The minimum wage should be set high enough to prevent exploitation, but low enough to prevent unemployment among unskilled workers. The government can avoid high taxes on labour, which might discourage employment creation. A collective bargaining system that is a combination of firm-level bargaining to provide flexibility for firm-specific conditions and national agreements to help adjust to major macro shocks could be ideal.
Financial inclusion means ensuring that people have access to vehicles for saving, as well as for investing in human capital and business opportunities, which increase growth and provide poor people the chance to get ahead. Financial inclusion can be promoted by providing information that facilitates access to financial services like credit bureaus and collateral registries, enhancing financial literacy, and through new technologies like peer-to-peer lending, mobile banking, and microcredit. But all of this needs to be balanced with maintaining financial stability through appropriate laws and regulation.
Inclusive and sustainable outcomes
Inclusive growth implies sharing the benefits of growth across genders, communities and generations. To improve gender equality, some countries need to change laws that discriminate against women working, owning property or participating in other aspects of economic life. There needs to be sufficient public spending on education, and in some developing countries, there is a need for (literally) concrete measures like providing sanitation facilities (the absence of a bathroom is one reason girls might choose to not go to school). Child care support and flexible working arrangements can encourage women to enter the labour force, as can eliminating discriminatory taxes and higher marginal taxes on second earners. Gender budgeting, in which fiscal measures are assessed based on the impact they have on gender inequality, is being adopted by many countries, including Canada.
Some regional communities are hit harder than others by globalization, technological change or other trends. They might need support from the central government, as local fiscal resources will be under pressure. Active labour market policies and retraining could be part of the policy response.
Climate change is an existential threat to inclusive prosperity. Responses include pricing carbon through taxes or emissions trading schemes, as well as boosting sustainable infrastructure and its financing.
Promoting strong, sustained, and broad-based growth requires an array of policies. Some of these should spur the private sector to create opportunities for all to work, save, learn, and invest, while others are direct government measures to level the playing field and support those most in need. This will help ensure the benefits of growth are shared, now and into the future.
The views expressed here are those of the author and should not be attributed to the IMF, its executive board, or its management.
This article is part of the Ensuring inclusive prosperity when all boats aren’t being lifted special feature.