Growth-Equity Trade-Offs in Structural Reforms

Lambert here: Now they tell us!

By Jonathan D. Ostry, Deputy Director, Research Department, IMF, Andrew Berg, Deputy Director, IMF Institute for Capacity Development, and Siddharth Kothari, Economist, IMF. Originally published at VoxEU.

While there is consensus that structural reforms can increase growth, and therefore deserve the attention of policymakers in the current environment (IMF 2015), there is also a fear that certain reforms could further exacerbate inequality. Reforms produce winners and losers, and it is perhaps the opposition of the losers that make reforms so difficult to implement politically. As one senior European policymaker recently lamented, “We all know what to do; we just don’t know how to get re-elected after we’ve done it.” Moreover, if the losers are concentrated among those who are already less advantaged, then reforms can indeed increase inequality, which in turn can reduce growth (Ostry et al. 2014) and make it more fragile. More generally, structural reforms aim to allow market forces to play a larger role in the economy, and this may induce greater inequality insofar as those members of society best able to take advantage of market incentives are those with better initial conditions.

To investigate these issues, in a new paper we used cross-country data covering advanced, emerging and developing economies, and undertook both panel (growth and inequality) regressions and event studies, as well as a narrative analysis of select country cases (Ostry et al. 2018). Our dataset on reform indices covers financial (banking and securities markets; external capital market liberalisation), institutional (broad reforms of the legal framework), and real sector reforms (trade reforms, network reforms, and labour market reforms). In undertaking this analysis, we recognise that the effects of reforms on growth and inequality are not homogeneous, and that the reform indices we use summarise complex, multi-faceted phenomena, and indeed that in some cases they may not measure quite what we would want them to. This said, these reform indices have been used to underpin policy advice to countries as well as to investigate the impact of reforms in the academic literature (e.g. Prati et al. 2013, Ostry et al. 2009). Our approach is to transparently report results irrespective of whether they are economically or statistically significant for a particular index and despite the fact that some indices may be more informative than others about the underlying reforms.

Growth–Equity Trade-Offs

Our overall finding is that certain structural reforms indeed give rise to growth–equity trade-offs, with the extent of the trade-off varying across reforms. We find that domestic financial deregulation, external capital market liberalisation, and one of our two measures of current account reform entail trade-offs between equity and efficiency, with both growth and inequality (measured by the Gini) increasing after reforms. We find that basic institutional reforms that strengthen the legal system and popular observance to the law tend to increase growth with no adverse effect on inequality. The results for our index of network reforms (which measures inter alia the degree of competition and liberalization in the networks and telecoms sectors), as well as our measure of decentralisation of collective labour bargaining, are the weakest and least robust, potentially due to data limitations.

The Net Effect of Inequality-Increasing Reforms

For reforms that are found to increase inequality, we combine the results from our panel growth and inequality regressions to ask what the total (net) effect of reforms is on growth. That is, after taking account the higher inequality following reforms, how much lower is the effect of reforms on growth (and is it even positive)? The results suggest that, while the inequality increase does dampen the effect of reforms on growth, there is nevertheless typically still a sizable growth dividend accruing from the reform process. Of course, our results represent average direct (from reforms to growth, holding constant inequality) and indirect (from reforms to inequality, and then from inequality to growth) effects of reforms across the countries in our sample. The effect of any reform on growth and inequality in a particular country will depend on country-specific characteristics and institutions, and reforms that look the same according to our indices may differ in important details. While the average net growth effect of reforms is generally positive, this does not justify a neglect of distributional considerations, since popular support for reform packages will continue to depend on ensuring that benefits are broad-based, which in turn requires attention to distributional effects ex ante, that is, at the reform design phase.

While the reform indicators we use have shortcomings as far as their ability to measure the market orientation of policies, if the goal is to study the broad patterns in the cross-country data, they nevertheless represent the best option available. Moreover, the tenor of the results seems to pass a basic smell test of plausibility. Financial and external capital market liberalisation have been found in previous studies to increase inequality (recent examples include Larrain 2015 and Furceri et al. 2018); growth effects from external financial liberalisation have proved difficult to establish using macro data, unless capital flows are unbundled into more disaggregated components (Ostry et al. 2015, Ghosh et al. 2017). Basic legal reforms are often found to exert important effects on longer-run growth and development with little damage on the equity side. With respect to goods trade liberalisation, there is a growing literature suggesting that the impact on inequality may undo some of the gains from trade (e.g. Antras et al. 2016), and a more general sense that job displacement from trade may be very difficult to remedy in practice (Williams 2016).

Policy Implications

The policy message of our results is twofold.

• First, structural reforms exert effects on both growth and equity.

In a way, this is unsurprising, given that these reforms by their nature give a greater role to market forces in the economy and the market is in no way constrained that gains get equitably shared. To the degree that distributional effects get downplayed, this may be because such effects are seen as small, or because of a view that even large impacts can be easily remedied through appropriate design of complementary policies. However, the evidence we adduce suggests that, on average, distributional effects of certain reforms are significant and are not in fact remedied in practice. This is important not only because equity is often an objective in its own right, but also because of evidence that support for supply-enhancing policies can be undercut by a failure to design policy packages that mitigate distributional effects (Colantone et al. 2015).

• Second, we are not saying of course that distributional consequences should give cover to roll back structural reforms, particularly since our results confirm that, even taking account of distributional effects, net effects on growth remain significantly positive.

But we do call attention nonetheless to distributional effects out of a conviction that ex ante design of reform packages that do a better job of balancing winners and losers is essential to give credibility to claims that gains from supply-enhancing reforms will end up being broadly shared. The need to design reform packages with an eye to their distributional consequences is particularly important where inequality is already high and popular support for (trade and financial) openness, and supply-enhancing policies more generally, has been waning.

Authors’ note: Views expressed are those of the authors and should not be attributed to the IMF.

References available at the original.