The talk about inequality has turned from ethical issues (should the rich be so rich) to economic impacts, such as whether inequality means economic stagnation. A recent report by Standard & Poor's economists highlights this attention. In this series of articles, I first address the differences between inequality and poverty, then discuss four possible impacts of inequality that have economic implications: lower consumer spending, more likely end to growth spells, social friction and political control by the rich.

Inequality or Poverty?

Inequality is not the same as poverty. Inequality is the difference of incomes among different people or households, whatever the levels of incomes. Poverty is having a low income. It’s possible to imagine a society which is uniformly poor, and thus perfectly equal, or a society with wide variation of incomes but nobody in serious need.

Consider possible policies to alleviate inequality. Many who have weighed in on the subject would like to move income from the upper one percent or ten percent and transfer it to the lower ten percent or twenty percent. That would reduce both poverty and inequality, if it really worked that way.

Efforts to equalize incomes among different people may reduce total income, as the economist Arthur Okun noted in his classic book Equality and Efficiency: The Big Tradeoff. Okun says, “The money must be carried from the rich to the poor in a leaky bucket. Some of it will simply disappear in transit, so the poor will not receive all the money that is taken from the rich.” The bucket leaks for two reasons. First, higher tax rates on the rich reduce their incentive to work while increasing their incentive to use tax avoidance schemes. Second, higher support for the poor reduces their incentive to work. For example, a recent Congressional Budget Office report found that for incomes in the range of $5,000 to $20,000 per year, the next effect of earning an extra dollar is only 15 cents, because of the phase-outs of so many safety net programs. As a result, many lower-income families make the rational decision to work less than they otherwise might.

Taxes that have the worst impact on economic growth are those that most impact investment. Yet the rich derive far more of their incomes from investments, so tax-the-rich proposals often shrink the economy more than other methods of raising government revenue.

To better understand the difference between inequality and poverty, consider the chart. Let the blue line show the status quo. Some people have low income, many have middle incomes, and some have high incomes. Now consider different policy proposals. The red lines show one possible proposal in which the poor are a little worse off, the middle class worse off by an even larger fraction of their incomes, and the rich are much worse off. Is reducing inequality so important that we would be willing to make poor people worse off?

Or would we be willing to help the poor and middle class if the “price” is having the rich get even richer (the green line in the chart)? This question is not simply made up. In the 1970s, politicians in Great Britain discussed subsidizing new companies in the semiconductor industry. The lure was thousands of new middle-class jobs, which would help pull some poor people out of poverty. However, the political leaders realized that this dynamic industry would not succeed under government ownership; it would need entrepreneurs who could potentially get rich. The debate among the leftists was simply: is the creation of new middle class jobs worthwhile if it means a society with a few more millionaires? The socialist Fabian Society concluded that reducing inequality was more important than stimulating lower and middle class incomes.

The key takeaway from this discussion is that reducing inequality is not always the same as reducing poverty.