Inequality, growth and welfare

This paper examines the relationship between economic inequality, growth and social welfare, challenging the conventional identification of welfare with GDP and the widespread assumption that greater equality necessarily entails lower growth. An Atkinson-type social welfare function is first adopted in which welfare increases with average income and decreases with inequality. Using stylised income distributions broadly reflecting the contemporary United States and the more egalitarian Scandinavian economies of the 1980s and 1990s, it is shown that faster growth in a highly unequal economy may generate less welfare than slower growth in a more equal one. Progressive taxation combined with uniform transfers increases welfare, even when redistribution involves substantial efficiency losses of the kind represented by Okun’s “leaky bucket”. Dynamic simulations further indicate that a more unequal but faster-growing economy may require several decades to reach the welfare level of a more egalitarian, slower-growing economy; progressive taxation significantly shortens this convergence period. Finally, an alternative welfare measure is introduced, which is based on individual aversion to disadvantageous inequality, whereby welfare depends partly on the income gap relative to the richest group. Under this approach, aggregate welfare may rise while the welfare of the bottom 90 % declines, thereby undermining conventional applications of both the Kaldor–Hicks compensation principle and the Pareto criterion.