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It's the economy, stupid: Why income equality matters

Aaron Task
Editor in Chief

Income inequality is the "defining issue of our time", according to President Obama. It's also become one of the most heavily discussed and debated issues of our time, often devolving into partisan bickering.

A new report from Standard & Poor's seeks to go beyond the right-left debate and address a more fundamental issue: Income inequality is hurting U.S. economic growth. In part because of income equality, S&P has reduced its 2014 forecast for U.S. GDP to 2% vs. 3% at the beginning of the year and forecasts the 10-year annual average growth will be 2.5% vs. a prior forecast of 2.8%.

"Income distribution is not necessarily a bad thing; it's part of a market economy" that provides incentives for individuals to work harder, says Beth Ann Bovino, S&P's U.S. chief economist. "But when it gets to extreme levels, it starts to harm the economy...[because it] squeezes out a good percentage of participants who can no longer basically invest and grow the economy."

A Gallup poll this week speaks to this point, showing average daily spending steadily rising for Americans making over $90,000 per year while falling slightly for middle- and lower-income Americans. With wage growth tame and many Americans saddled with debt, spending patterns for those making less than $90,000 -- which is the majority of U.S. workers -- have flattened even as the job market has picked up steam in recent months.

Many factors, including U.S. tax policy, globalization and technology have helped bring U.S. income inequality to the highest levels since 1928.

As we discuss in the accompanying video, Bovino says investment in education is well worth the cost, both for individuals and the government, because the "wage gap" between college graduates and high school graduates is growing. According to S&P's analysis, if every American worker had just one additional year of education, the resulting productivity gains could add about $525 billion to U.S. GDP over the next five years.

While higher levels of education seem to be the key to individual success and reducing the nation's wealth gap, Bovino notes that "college graduation rates have stagnated for low-income students, in sharp contrast with strong gains for wealthy students."

In other words, the rich are getting better educated while the poor are increasingly dropping out before even getting to college, which is only going to exacerbate income inequality. According to S&P, a child born in the bottom 20% of America's income distribution has a 19% change of reaching the top quartile as an adult with a college degree, but only a 5% chance without one.

While other policies, notably spending on public infrastructure, could help overall economic growth, Bovino concludes that additional spending on education will have the biggest return on investment for the country.

The good news is that Bovino believes the U.S. has not yet reached the proverbial tipping point where income inequality destabilizes the economy but warns we're getting close to it. "A rising tide lifts all boats," she writes, "but a lifeboat carrying a few, surrounded by many treading water, risks capsizing."

Aaron Task is Editor-in-Chief of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at altask@yahoo.com.