ODI Explains: Why Inequality Matters

Economists are keenly interested in how income is distributed among the population. Why? It is only fair to be concerned about inequality because, the number of poor persons in country and the average quality of life depends on the equal or unequal distribution of income. Also, though high levels of inequality may lead to growth as some stages of development (see Kuznet’s hypothesis), high inequality tends to be tricky for the economy at other times.

What then is inequality? Whenever there exists a disproportionate distribution of total national income among households, there is inequality. In most cases, the share of income attributed to the rich in a typical country is far greater than the share attributed to poor segments of the population. Needless to say that inequality of income is observable in every country of the world, developed and developing countries alike. However, the extent of inequality differs from country to country. For the most part, higher observable inequality in developing countries stems from differences in the amount of income derived from ownership of property as well as differences in earned income.

How is inequality measured? The extent of income inequality in a society is measured by estimating its social welfare function, the outcome of which results from the interaction of per capita income, absolute poverty and an index of inequality. While the level of per capita income tends to have a positive effect on welfare, both inequality and absolute poverty negatively affect welfare. There are two common measures of income inequality based on size distribution of income – Lorenz curve and Gini coefficient. Within the framework of the size distribution of income, individuals or households and the total incomes received by them are considered. It disregards locational as well as occupational sources of incomes earned and focuses on the amount of incomes received. The Lorenz curve and Gini coefficient are drawn out and computed based on this personal or size distribution of income.

A Lorenz curve shows the actual relationship between the percentage of income recipients and the percentage of total income received within a given period, usually a year. The plot shows the cumulative percentages of total income received against the cumulative percentages of recipients, starting with the poorest household/individual. As a rule of thumb, the greater the curvature of the Lorenz curve the greater will be the relative degree of inequality.

There are four basic steps to the construction of a Lorenz curve. First, we rank all individuals or households in a country by their income level, from the poorest to the richest. Secondly, we divide all individuals or households into five (5) groups20 per cent in each [or ten (10) groups 10 per cent in each], then calculate income of each group and express it as percentage of GDP. Next, we plot the shares of GDP received by these groups cumulatively against 100 per cent of the population. Finally, the Lorenz curve emerges when we connect all points on the chart. A linear Lorenz curve connotes an equal distribution of income. When comparing inequality levels across countries, the country whose Lorenz curve is farthest from the line of equality is the most unequal in its income distribution.

Gini coefficient is the area between a Lorenz curve and the line of absolute equality expressed as a percentage of the triangle under the line. As an aggregate measure of inequality, its value varies between 0 [perfect income equality] and [perfect income inequality]. If we are set about comparing income inequality among many countries, Gini coefficient is a more convenient alternative than the Lorenz curve. Using the Gini coefficient, one could also examine inequality trends in a country over a period of time.

According to Todaro and Smith, there are four (4) desirable properties of a measure of inequality, which the Gini coefficient satisfies comfortably. First is the anonymity principle. Anonymity here implies that measures of inequality should not be dependent on the nature of the individuals who are either rich or poor. It should not matter whether the individuals across the distribution are industrious or lethargic, moral or immoral. A second desirable property is scale independence. A good measure of inequality need not depend on the size of the economy being considered, for instance whether the economy under study is rich or poor on the average. Otherwise stated, a measure of inequality should be principally concerned about the dispersion and not the magnitude of income.

Thirdly, for a measure of inequality to be reliable and widely applicable to various country contexts, it should not rely on the number of income recipients (i.e. population independence). For instance, the economy of India should be considered no more or less equal than the economy of Haiti simply because India has a greater population than Haiti. Lastly, a good measure of inequality such as the Gini coefficient is based on the transfer principle. According to the transfer principle, assuming all other incomes are held constant, if there are moderate transfers of income from a richer person to poorer person, the resulting income distribution is more equal.

There is no consensus in empirical literature on the effect of inequality of economic growth across countries. According to the Nobel Laureate, Simon Kuznet, as a country develops inequality would first rise then later fall. Kuznet’s inequality-growth hypothesis posits that as a country’s industries achieve economic growth, the gap between the rich and poor first widens and then gradually narrows. This hypothesis suggests that increased inequality is a necessary condition for accelerating economic growth. On the other hand, studies based on data collected by the World Bank state otherwise, that income inequality adversely affects economic growth. The latter results are most instructive for economies of developing countries.

There are certainly costs and benefits to inequality. Fundamentally, a moderate level of inequality is required to promote economic efficiency in any human society. A phenomenon of perfect equality, with no opportunity for private profits and characterised by minimal differences in wages and salaries, creates inefficiencies. Equality deprives individuals of the incentives for entrepreneurship and diligent labour. For example, sheer socialist’s wage equalization systems promote indiscipline and low initiative among workers, poor quality of output, sluggish technical progress and economic growth.

On the other end, high inequality has adverse effects on quality of life. Amongst other things high inequality threatens economic stability, induces higher incidence of poverty, limits progress in education and health, increases social problems – crime and conflict, triggers political instability, discourages foreign investment. Notably, countries with higher inequality are characterised by low human capital accumulation (via education), higher fertility rates, considerable levels of socio-political instability and poor institutions.

Can and do individuals or households move up the income distribution? Yes, they can and they do. The more economically mobile a country is, the better the quality of life. Economic mobility refers to the movement of people from one part of the income distribution to another. The higher is economic mobility, the more equal the income distribution in the country. Wherever intergenerational economic mobility is high, children may not likely be in the same part of income distribution with their parents. Whole households could also move from one income group to another. A country with a high degree of economic mobility tends to enjoy increased capacity utilization and minimal class conflicts.

Several factors could contribute to economic mobility in a country. Examples include: increased access to education and health care, the nature of institutions, nature of marriages, extent of ethnic or racial discrimination are a few such determinants of economic mobility. On one hand, weak institutions, assortative mating practices and presence of racial or ethnic discrimination are detrimental to economic mobility. On the other hand, equal access to human capital development opportunities via education and healthcare provision promotes access to economic opportunities and enhances economic mobility.

In conclusion, it is pertinent to note these main ideas about inequality:

•      High income does not necessarily mean equal distribution of income.

•      The level of development tends to affect the level of inequality.

•      Too equal income distribution promotes economic inefficiency.

•      Too high inequality produces socially undesirable outcomes.

•      Decreasing income inequality in developing countries is useful to accelerate economic and human development.

•      Pro-growth policies may not inevitably lead to equal income distribution.

•      Institutional frameworks with mobility-enhancing policies provide the enabling environment for human development.

The discussion continues…

References

Souboutina, T. P. (2004). Beyond Economic Growth: An Introduction to Sustainable Development (2nd ed.). Washington, D.C.: The World Bank.

Todaro, M. P., & Smith, S. C. (2004). Economic Development (8th ed.). Delhi: Pearson Education Singapore.