INEQUALITY AND REDISTRIBUTION: THE POLITICALLY DECISIVE ROLE OF MIDDLE CLASS INVESTORS

Societies in which a large proportion of output is produced in small and medium-sized enterprises are more unequal. That is one of the findings of research by Professors Hans Peter Grüner and Rüdiger Schils, published in the October 2007 issue of the Economic Journal. Their study of the relationship between inequality and political pressures for redistribution examines the politically decisive role of the middle class investors who finance entrepreneurs’ investments.

Many democracies are characterised by an unequal distribution of wealth. In 2001, the richest 1% of all US households owned 33% of the domestic wealth and roughly 40% of net financial wealth. 67% of net financial wealth was concentrated in the hands of the top 5% of the households while the bottom 60% owned about 1%. The figures are similar for other industrialised countries.

The ownership of physical capital is particularly highly concentrated although politically the redistribution of capital is an option available to voters. So why don't the poor take a rich man's wealth? And why do very unequal societies such as the United States redistribute less than the more equal European ones?

This study presents a unified explanation for both empirical observations: the limits to wealth redistribution and the missing link between inequality and redistribution.

At the core of the authors’ reasoning lies the connection between the wealth distribution and the economy's interest rate. When capital markets are imperfect, a firm's ability and willingness to borrow depends on its owner's wealth. When wealth is distributed more equally, relatively rich entrepreneurs can only produce efficiently if their interest burden declines. Hence, equilibrium interest payments have to decrease.

This adverse interest rate effect of equality would harm the politically decisive middle class investors who finance entrepreneurs’ investments. Consequently, they vote against redistribution. More inequality may reduce redistribution because a larger wealth gap between the entrepreneurial classes and the lower classes makes the interest rate effect more pronounced. This is why inequality may be politically self-sustaining.

Grüner and Schils find that the initial distribution of the capital stock and the available technology play a crucial role in determining whether the middle class's political preferences are aligned with those of either the upper or lower class. Technological change may induce dramatic changes in political outcomes.

According to their analysis, the importance of capital income for the middle class should play a role in shaping individuals' preferences for political redistribution. Moreover, voters should have fewer incentives to redistribute income or wealth in economies with a larger entrepreneurial sector.

This should in particular be the case when small or medium-sized enterprises play a major role in the economy. The authors relate OECD and European data on the importance of small and medium-sized enterprises with a measure of income inequality. In deed, most of the very unequal OECD societies produce more than half of their output in small and medium-sized enterprises. The positive relationship is significant for the European countries.

Professor Grüner concludes:

‘The message of the paper is a simple one: the middle class benefits from wealthy entrepreneurs when this alleviates incentive problems and generates higher returns on their investments.’

ENDS

Notes for editors: ‘The Political Economy of Wealth and Interest’ by Hans Peter Grüner and Rüdiger Schils is published in the October 2007 issue of the Economic Journal.

Hans Peter Grüner is at the University of Mannheim. Rüdiger Schils is at RWE AG, Essen.

For further information: contact Hans Peter Grüner on +49 621 181 1886 (email: hgruener@rumms.uni-mannheim.de); or Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com).