How much inequality is acceptable?

Inequality matters. Inequality is also inevitable. So how much of it is acceptable? It’s a question I don’t hear very often, but it’s a pretty important one.

I’m not sure I know anyone who advocates absolute equality, and history suggests its a doomed idea. But even if it was possible, is absolute equality something we really want? People have different levels of ability, motivation and ambition. Some work harder or longer. Branko Milanovic, an economist who specialises in inequality, still recognises that there are positive effects: “Without inequality you lack incentives to do practically anything – to work, to invent new things or to invest. Nobody is going to do things for nothing and we know that monetary rewards are really crucial, so this is the good part of inequality. We should not forget that inequality is indispensible for the development of a society.”

Absolute equality is a false goal. But if too much inequality is corrosive to society, where is the happy medium?

I was interested to see the recent Earth for All report have a go at this question. The Transformational Economics Commission that is part of the process behind the report has wrestled with the matter, and come up with an answer. To do so, they draw on the work of the Chilean economist Jose Gabriel Palma. Rather than look at distribution of wealth across the whole of the economy, he focuses on the two ends of the income spread. This is based in the observation that in most countries half the wealth goes to the 50% of people in the middle.

If half the wealth generally goes to the middle classes, then the big difference in inequality is between the top 10% and the poorest 40%. Divide the wealth of the top 10% by the share of the bottom 40%, and you get a simple measure of inequality called the Palma Ratio.

The UK has a Palma Ratio of 1.47, according to the OECD. The US is 1.63. Several European and Scandinavian countries score around 1. At the other end, South Africa is nearer to 7.

The Earth for All report tracks the effects of inequality along with sustainability measures in its computer model. They reckon that a Palma Ratio of around 1 is sustainable – so the richest 10% would have the same wealth as the poorest 40%. Anything higher than that and you risk social tension that may eventually become ungovernable: “extreme levels of inequality are deeply destructive, even to the wealthy. They create division and resentment. They breed conditions that are dangerous to everyone. They undermine democracies.”

When inequality becomes too extreme, the experience of the richest and the poorest is so different that you no longer have one society. Government can be captured by the wealthy, often depending on the allegiance of the middle classes against the poorest. Rising inequality leads to more extreme politics, but inequality of around 1 on the Palma ratio appears to be stable.

That’s what the computer model says. That doesn’t mean a Palma Ratio of 1 is optimal, and ultimately it’s a moral question. What you consider to be an acceptable level of inequality is likely going to be influenced by where you are on the scale. And of course the question of what you do about it is another matter altogether.

What I do know, and that I describe in The Economics of Arrival, is that we should be aiming for an economy that is more inclusive from the start. One where everyone has what they need, even if they don’t get everything they want.