Increasing the income of the wealthy rather than the middle-class or poor has negative effects on a nation's economy, according to a new International Monetary Fund study which deals a blow to the trickle-down economic theory.
If the income share of the richest 20 percent increases by 1 percentage point, "GDP growth is actually 0.08 percentage points lower in the following five years, suggesting that the benefits do not trickle down," wrote five IMF economists in the report released Monday, titled, "Causes and Consequences of Income Inequality: A Global Perspective."
Contrarily, increasing the income of the bottom 20 percent is associated with 0.38 percentage point higher GDP growth, which is why policymakers "need to focus on the poor and middle class," IMF said.
"Our findings suggest that raising the income share of the poor and ensuring that there is no hollowing-out of the middle class is good for growth," the authors wrote.
Income inequality contributes to a number of problems, such as policies detrimental to growth, a higher chance of conflict due to lack trust and social cohesion and lower labor productivity since "poor children grow up in low-quality schools and forgo college."
The group also notes that inequality may worsen financial crises and could have intensified the Great Recession.
"In particular, studies have argued that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation in mortgage-underwriting standards, and allowing lobbyists to push for financial deregulation," it said.
The study refutes the trickle-down economic theory made popular by President Ronald Reagan and often supported by conservative policy makers, which proposes that cutting capital gains taxes and implementing other strategies that benefit the 1 percent will result in a flourishing economy. As the theory goes, the 1 percent will then hire more employees and generally pump more money into the economy.
To fix the inequality problem, the IMF suggested additional investment in health and education policies that reduce poverty, along with more progressive taxation.
"Fiscal policy already plays a significant role in addressing income inequality in many advanced economies, but the redistributive role of fiscal policy could be reinforced by greater reliance on wealth and property taxes, more progressive income taxation, removing opportunities for tax avoidance and evasion, better targeting of social benefits while also minimizing efficiency costs, in terms of incentives to work and save," they wrote.
"In addition, reducing tax expenditures that benefit high-income groups most and removing tax relief-such as reduced taxation of capital gains, stock options, and carried interest-would increase equity and allow a growth-enhancing cut in marginal labor income tax rates in some countries."
