Growing the Economy by Reducing Inequality
In my view, the overriding goal of reducing inequality is simply to make poor people better off, not grow the economy. Even if reducing inequality shrinks the economy, it's still worth doing up to a point. With that said, there are actually quite a number of reasons to think reducing inequality may help grow the economy.
Before going into the reasons, it is important to distinguish between an economy operating at capacity and one operating below capacity. When an economy is operating below capacity — as ours is right now — moving money downward in the income distribution can increase total demand because poorer people have a higher marginal propensity to consume. This increase in demand can grow the economy by activating idle resources. This is the standard Keynesian line. However, when the economy is operating at capacity and there are no idle resources, reducing inequality should not have any demand-side stimulative effects, despite what some suggest.
The interesting question is not whether inequality reduction can grow the economy in the short-term as demand-side stimulus, but whether it can grow the economy in the long-term on the supply-side. There is good reason to think that it can.
The most obvious way reducing inequality can have supply-side effects is via human capital deepening. Being poor is a terrible way to be if you are trying to learn things, gain more skills, and improve your own productive potential. Making people less poor should make it easier for them to increase their own human capital through education and training, and thereby improve the overall productive capacity of the labor force. All else equal, a more productive labor force should mean more growth.
A less obvious way reducing inequality can have supply-side effects is suggested by Robert Frank's latest book The Darwin Economy. In the book, Frank argues that people are driven in signifcant part by what amounts to a status competition with one another. You don't just want to do well, you want to do as well or better than those around you. When income is distributed very unequally, the only way for less well off people to have the same material possessions as more well off people is to spend all of their income and even to go into debt. So, in a world with high inequality, poorer people save less than they would in a low-inequality alternative world. This savings drought means less investment, which reduces growth, and more systemic financial risk due to the high levels of indebtedness, which can reduce growth via financial crises.
Finally, reducing inequality can reduce crime, improve health, improve economic security, create more stable societies and governments, and so on. All of these welfare-boosting consequences can make people more productive, and thereby positively affect economic growth.
Again, the point of reducing inequality should not mainly be about economic growth. But the next time you hear someone say they are interested in growing the pie not merely reslicing it, just remember that the two are not totally oppositional to one another. Despite what the metaphor suggests, you can actually help grow the pie by reslicing it.