This paper aims to show why policymakers need to focus on the poor and the middle class. Earlier IMF work has shown that income inequality matters for growth and its sustainability. This paper suggests that the income distribution itself matters for growth as well. Specifically, if the income share of the top 20 percent (the rich) increases, then GDP growth actually declines over the medium term, suggesting that the benefits do not trickle down. In contrast, an increase in the income share of the bottom 20 percent (the poor) is associated with higher GDP growth. The poor and the middle class matter the most for growth via a number of interrelated economic, social, and political channels.
Second, the paper investigates what explains the divergent trends in inequality developments across advanced economies and emerging markets and developing countries (EMDCs), with a particular focus on the poor and the middle class. While most existing studies have focused on advanced countries and looked at the drivers of the Gini coefficient and the income of the rich, this study explores a more diverse group of countries and pays particular attention to the income shares of the poor and the middle class—the main engines of growth.
The paper concludes that:
- Technological progress and the resulting rise in the skill premium (positives for growth and productivity) and the decline of some labor market institutions have contributed to inequality in both advanced economies and EMDCs. Globalization has played a smaller but reinforcing role. The authors find that rising skill premium is associated with widening income disparities in advanced countries, while financial deepening is associated with rising inequality in EMDCs, suggesting scope for policies that promote financial inclusion.
- Policies that focus on the poor and the middle class can mitigate inequality. Irrespective of the level of economic development, better access to education and health care and well-targeted social policies, while ensuring that labor market institutions do not excessively penalize the poor, can help raise the income share for the poor and the middle class.
- There is no one-size-fits-all approach to tackling inequality. The nature of appropriate policies depends on the underlying drivers and country-specific policy and institutional settings. In advanced economies, policies should focus on reforms to increase human capital and skills, coupled with making tax systems more progressive. In EMDCs, ensuring financial deepening is accompanied by greater financial inclusion and creating incentives for lowering informality would be important. More generally, complementarities between growth and income equality objectives suggest that policies aimed at raising average living standards can also influence the distribution of income and ensure a more inclusive prosperity.
