Warning bells ring for policy makers? IMF 'critical of' trickle down theory, labour reforms

By Rajiv Shah
In an important research paper having major policy implications for India, International Monetary Organization (IMF) has declared that the “trickledown theory” -- which believes that economic growth would take care of poverty alleviation – is proving to be counter-productive. Top pro-Narendra Modi economist Arvind Panagariya, new vice-chairman of Planning Commission’s fresh avatar Niti Ayog (Policy Commission), and his Columbia University mentor, Prof Jagdish Bhagwati, are well known advocates of trickledown.
The IMF admits in its study, which encompasses both developed and developing countries, including India, that earlier IMF work had shown how income inequality “matters for growth and its sustainability”. But the top bankers now say, “Our analysis suggests that the income distribution itself matters for growth.”
The paper is titled “Causes and Consequences of Income Inequality: A Global Perspective”, and authored by Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, and Evridiki Tsounta.
The scholars say, their calculations show that “if the income share of the top 20 percent increases by 1 percentage point, gross domestic product (GDP) growth is actually 0.08 percentage point lower in the following five years”. Pointing out that this “suggests “the benefits do not trickle”, the scholars insist, “A similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth.”
Also challenging the view about the need for labour “reforms” by adopting exit policy as the corner stone for industry to operate smoothly, the IMF says, the “reforms” can only “pose challenges for workers, especially those with low skills, and hence play an important role in explaining inequality developments.” It adds, “A decline in trade union membership (union rate) could reduce the relative bargaining power of laboir, exacerbating wage inequality.”

Income levels of the poor under various scenarios

The observation is significant, as it comes close on the heels of Government of India (GoI) strongly advocating exit policy as the cornerstone of labour “reforms” by allowing free hire and fire of workers a norm for industry. Already, several state governments, including Rajasthan and Gujarat, have changed labour laws, making them more industry-friendly, and the GoI is seriously thinking of going in that direction.
The IMF says, in several of the emerging markets and developing countries (EMDCs), “rigid hiring and firing” and “weak income protection systems” have encouraged informality, fueling wage inequality”, adding, “Evidence from a large sample of countries suggests that de facto labour market regulations (such as minimum wages, unionization, and social security contributions), on average, tend to improve the income distribution.”
The IMF further says, its study shows, “Easing of labor market regulations is associated with higher market inequality and income share of the top 10 percent. In particular, a decline in organized labor institutions and the resultant easing of labor markets measured by an increase in labor market flexibilities index by 8½ percent is associated with rising market inequality by 1.1 percent.”
Seen in this context, the IMF warns, “Extreme inequality may damage trust and social cohesion and thus is also associated with conflicts, which discourage investment. Conflicts are particularly prevalent in the management of common resources where, for example, inequality makes resolving disputes more difficult.”
It adds, “Inequality could result in poor public policy choices. It can lead to a backlash against growth-enhancing economic liberalization and fuel protectionist pressures against globalization and market-oriented reforms. At the same time, enhanced power by the elite could result in a more limited provision of public goods that boost productivity and growth, and which disproportionately benefit the poor.”