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Income inequality undermines economic growth

Income inequality is a major barrier to economic growth, according to a new 200-page report from the United Nations Conference on Trade and Development (UNCTAD). The 2012 UNCTAD Trade & Development Report concludes that “reducing inequality through fiscal and incomes policies is key for growth and development.”

Unfortunately, Latvia “is one of the least equal societies in Europe,” according to the Latvian Economics Ministry’s June 2002 Economic Development Report. In its otherwise glowing account of Latvian economic performance under its tutelage, even the IMF concurs. According to Eurostat data, Latvia is tied with Spain as the second most unequal country in the European Union (Lithuania is first).

The problem with inequality, in UNCTAD’s view, is that high inequality encourages employers to profit from forcing wages down rather than from pushing productivity up. When inequality is low and wages are relatively uniform across the whole economy, the most profitable firms are those with the best products and services.

On the other hand, when wages differ dramatically across firms and sectors, the most profitable firms are those that are best at finding ways to employ workers at the lowest possible wages. Companies that are successful at finding low-wage formulas can outcompete companies that focus on product and service innovation. The result is a race to the bottom in wages.

The UNCTAD report recommends that “as far as possible … the wage level for similar qualifications [should be] similar throughout the economy, and … not left to the discretion of individual firms.”

Low wages and high wage inequality are also found to be associated with high levels of unemployment and underemployment. Latvia is a case in point. Latvia has low wages compared to the rest of the European Union, yet unemployment continues at high levels despite extraordinarily high levels of labor emigration.

The UNCTAD report, subtitled “Policies for Inclusive and Balanced Growth,” finds that “policies that preserve the share of workers in national income and redistribute income through progressive taxation and public spending would improve equality as well as economic efficiency and growth.”

These recommendations are almost completely at odds with Latvia’s national development priorities. Latvia’s priorities are based on European Union policies that favor “flexible” (i.e., low-wage) labor markets, regressive taxes based on consumption, and the promotion of exports through subsidies and incentives for foreign investors.

Why would the European Union advise the Latvian government to pursue policies that — according to the evidence-based conclusions of the United Nations Conference on Trade and Development — would drive down wages, harm Latvia’s economy, and exacerbate Latvia’s problem of mass unemployment?

Whether through coincidence or not, the policies recommended by the European Union are exactly those that would benefit major western European corporations.

First, low wages benefit foreign corporations by reducing their labor costs. If those corporations operate in Latvia, they benefit directly from Latvia’s low wages. Even if they don’t, they still benefit indirectly by using low Latvian wages to bully their own workers into accepting lower wages. In many ways the single market in goods, sold to Europeans on the basis of economies of scale, is in reality just a mechanism for European companies to play workers in different countries against each other.

Second, consumption taxes are a foreign investor’s dream. Foreign corporations operating in Latvia consume very little in Latvia. They hate investment income taxes (obviously), don’t like wage taxes (which drive up hiring costs), and love consumption taxes (which shift the burden of taxation to the domestic — i.e., Latvian — sector of the economy). They don’t really care that consumption taxes fall most heavily on the (Latvian) poor.

Third, investment incentives are the gravy on the goose, the icing on the cake, a free prize for doing nothing. Why should the Latvian government offer subsidies to non-Latvian businesses in order to help them out-compete Latvian businesses? Put that way, the whole idea is crazy. Yet it is official Latvian government policy to provide tax incentives, subsidize power infrastructure, and provide credit guarantees, despite the fact that foreign investment collapsed by more than 80% after the economic crisis hit in 2008.

That final fact highlights the lunacy of relying on foreign investment to develop a country: foreign investors are always the first to fly. Absent the massive withdrawal of foreign investment from Latvia in 2008-2010, Latvia would have experienced a recession, not a national crisis. Admittedly, national income would have been lower from the beginning. But the cycle of boom-and-bust would have been far more mild.

Latvians need hardly be reminded that Latvia is a small country. A small country may succeed for a time by riding the coattails of its larger neighbors. For Latvia, that means either kow-towing to the whims of Russian oligarchs or sheltering as a neocolonial appendage of western Europe, as I have argued previously.

Big countries don’t have these options simply because they’re too big: no matter how much Turkey rolls out the red carpet for European companies, European investment will never have a major impact on Turkish growth rates. For a small country like Latvia, the subordination strategy can work — for a while.

Sustained economic well-being, however, depends on the success of the domestic sector, not on subsidized foreign investment or undercutting wages in other countries. For a small country, this is even more true than it is for a big country. The reason is that small countries by their very nature tend to have “leaky” economies.

Policies that reduce inequality bring down the incomes of the rich while increasing the incomes of the poor. In a small country, the rich are much more likely than the poor to spend their incomes overseas. A shift in incomes from rich to poor tends to increase spending inside the borders of the country, further multiplying the effect of the original income.

Progressive income taxes that focus on the richest segment of society have a similar effect. They take money out of the hands of people who are likely to spend or invest it overseas and put it instead in the hands of the government, which is almost certain to spend it at home.

Consumption taxes on money spent inside a country by definition have no multiplier effect, since the funds being taxed were already being spent inside the country. Progressive income taxes, however, have very large multiplier effects.

When high incomes are taxed to pay for government services, the total impact on national income is typically 3-5 times the amount of the original income taxed, due to the low multiplier for high incomes combined with the high multiplier for government spending.

When it comes to money, it’s best not to trust the advice of people who have a vested interest. The European Union and International Monetary Fund have strong interests in making Latvia and other developing countries profitable for multinational corporations. The United Nations Conference on Trade and Development has no such interest. Nor do I.

Latvians must make up their own minds about their economy and their society. But if Latvia decides on a high-inequality model that caters to foreign investors, Latvians might want to look carefully at where that model came from. The answer might help them decide where it is likely to lead.

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Sydney-based globalization expert Salvatore Babones is available to speak on the Chinese economy (demographics, growth, technology), the Belt & Road Initiative, global trade networks, and Australia-China relations. Contact: