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Income Gap: An Evil In Disguise

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Economists have been trying to establish a clear link between the income gap and economic growth for decades. Income gap is the difference between the incomes of the rich and the poor in a society. It’s been an old debate. In Plato’s Republic, written around 2500 years ago, one finds a strange proposition. It taunts that the bourgeois and proletariat, living together, ought to have two cities, i.e. a city for the poor and a city for the rich. Lest dwelling together shall be a tale of machinations against each other.

Essential to the debate are opposing views. One side opines that it is an opportunity for entrepreneurs and investors. This, for them, is an imperative incentive for investing. Those who oppose the idea believe that it only results in an ever-shrinking size of the economic pie for the poor. Simply put, the lesser the income, the slower the buying activity.

The poor do not seem able to invest in their very own human capital and are bound to languish in poverty for generations to come. The GDP growth which is explained by an increase in production of goods and services shall remain stunted due to low demand. A society with low income may not be able to increase the demand to match the commercial interests of the investors. Therefore, the question is pertinent; can a link be established between income gap and economic growth?

Simon Kuznets, a 20th-century Russian-American economist, delved deep into the phenomenon of the transition of economies from agricultural to industrial. He opines that there happens to be a corresponding rise in inequality as the transition intensifies. It also explained the increasing concentration of wealth in the hands of a few. However, to the surprise of many, the gap narrowed with the advent of the imposition of taxes, excise sin taxes and levies. Now the graph was U-shaped. The taxation was the game-changer as it binned the proposition tabled by Kuznets.

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In this post-industrialization era, where various schools of thought wrestle to explain the dilemma of income gap and growth, two major opinions have taken the center-stage. One contender is the International Monetary Fund (IMF) and the other is Organization for Economic Cooperation and Development (OECD). The former sides with the perspective which favors the idea of non-interventionist regimes letting the business be done in a fair environment. On the other hand, the OECD earnestly advocates netting, taxation, profit-shifting and base-erosion aspects of an economy.

US economists favoring the income gap, like Greg Mankiw, argue that the transactions are personal choices. The demand for a product marketed by a commercial entity helps the business to attain more wealth and subsequently the investment. The inequality is natural and taxing it unnecessarily, to narrow the income gap, will reduce the incentive to innovate. Light taxation will certainly help the entrepreneur to spare wealth for another investment in the economy. Similarly, Arthur Okun has even called the heavy taxation for the sake of leaky bucket of the poor as wasteful. This idea, advocated by the IMF, can be called as an attempt to explain the link between growth and income gap as a trade-off theory.

Recent research conducted by the OECD indicates that as the income gap increases, the demand for goods and services is compromised within an economy. There is less incentive for the poor to venture out with buying and investing. They are overly cautious about spending on skills, knowledge, health, and livelihood.

This causes a less lucrative environment for the commercial entities, which in turn withdraw their investments. Another fallout is the abundance of low-skilled and less knowledgeable human capital. It is because the income gap has widened to the extent that the poor are unable to spare money to invest in the essentials of quality life.

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Thus, the inequality holds people down. The Great-Gatsby-Curve explains that rich people are likely to remain rich for at least a millennium and the status of the poor is also unlikely to change. The example of Normans of England in the 11th Century and Baskervilles and Mandevilles of today is one such instance that corroborates the Great-Gatsby-Curve. Rising up the ladder shall remain a daunting task for the poor and will require a quantum leap in skills and knowledge for which they cannot invest. Joseph Rowntree Foundation (JRF) in the UK has established that the inequality is highly correlated to social problems like health, education, standard of life, which in turn put significant pressure on the economic growth.


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