"Children who are otherwise identical will start their lives with vast differences in resources and opportunities, depending on which country and which family they are born in. How much consumption and economic growth would a newborn child be willing to give up in order to avoid these birth lotteries? Lucas (2004) suggests that this child would give up very little, because even if the child is born poor, economic growth would help him or her overcome poverty.
Our findings in this paper show that, on the contrary, the child may be willing to give up all growth, in order to avoid birthplace risk, and a large fraction of growth, if not all, in order to avoid family risk. The critical elements for our results are time discounting and risk aversion. Both factors downplay the role of growth for welfare, while risk aversion enhances the benefits of more equal outcomes. A third key factor is the size of the risk involved at birth, which is enormous.
The contribution of this paper is to quantify the social cost of inequality under the most standard assumptions made in macroeconomic theory. Our results suggest that societies could greatly benefit from reducing inequality. They also suggest the existence of a “big tradeoff” between inequality and efficiency, as described by Okun (1975), and help to explain why societies may not always find it best to adopt growth-enhancing institutions, particularly when inequality is large and those institutions may foster further inequality.
Societies commonly face major choices between equality on one hand and efficiency and growth on the other. The degree of progressivity of the tax system, for example, reveals a society’s willingness to trade equality for efficiency. Other examples are trade liberalization and labor market reforms, which are often regarded as beneficial for economic efficiency but detrimental to equality. Similarly, the extent of law enforcement, illustrated for example in efforts to crack down on tax evasion or informal markets, is influenced by distributional concerns at the expense of efficiency and growth. Migration policies are also strongly influenced by this tradeoff. Any correct evaluation of the institutional and policy choices made by different societies requires a proper assessment of the welfare implications of these choices, and in particular, a careful weighing of the welfare gains from efficiency and growth against the welfare costs of more inequality. Our results suggest that inequality concerns are of the utmost importance and should be explicitly considered in any aggregate evaluation of institutions.
Public discussions of the costs of inequality and the value of redistributive policies are often framed in political rather than academic terms and can lead to mistaken impressions of their effects on social welfare.16 We believe that our work provides an important first step in objectively evaluating the costs of inequality in a well-understood welfare framework.
A necessary caveat in interpreting our results is that we have not fully specified the microfoundations of the technological restrictions for inequality, growth, and consumption levels.
We postulate a reduced-form technology, and calibrate it using natural experiments rather than cross-country regressions. Some estimates of the inequality-growth tradeoff appear in the empirical literature on inequality and growth, but there is still no consensus on this relationship. Since most countries seem to share the same long-run growth rate, we suspect that the main tradeoff is not between inequality and growth, but between inequality and consumption levels. In future research, we hope to improve our measurement of these technological constraints using panel data for inequality and consumption levels.
Finally, our exercise suggests that the following is the proper ranking of issues in macroeconomics from the point of view of their potential social welfare impact: crosscountry inequality, within-country inequality, economic growth, and business cycles."
Related;
Inequality (June 2005) Edward L. Glaeser
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