Inequality
In this section
No pain, no gain
Equity of economic growth is a complex and politically contentious topic (IMF, 2014). While the idea that a capitalist system by it’s design permits inequalities may not be disputed, the subject of debate is the causes of inequality, whether it is a problem and whether there is any effective policy remedy whose benefits justify the costs. One common argument used to defend free market policy impact on inequality is the “Kuznets curve hypothesis” named after an inverted U shape of a chart of inequality vs GDP per capita in industrialized economies from a 1955 report by economist Simon Kuznets (Kuznets, 1955). The idea claims that inequality is a necessary, short term cost of an advancing economy and eventually the trend will reverse through the natural dynamics. Kuznets constructs his argument as a response to the null hypothesis in which wealth, savings accumulation accrues in a winner-takes-all manner to wealthy households (Kuznets, 1955). He proposes three alternative processes that could lead to a reduction in inequality through natural market processes - dilution of the upper class through middle-income immigration, entrepreneurial heterogeneity and relatively higher income of the service industry (Kuznets, 1955).
Kuznets main arguments were refuted by economist Thomas Picketty in “Capital in the 21st Century”. Picketty’s analysis supported the null hypothesis as a more accurate description of the “natural” market dynamics. Among other things, Kuznets did not account for the heterogeneous effects of intergenerational transfers on wealth concentration (Picketty, 2014). Also, the statistical evidence used in Kuznets’ analysis was taken from a limited time window in the Post WWII New Deal era and analysis on longer time scales do not hold the predicted inverted U shape (Picketty, 2014). Baumol’s cost disease hypothesis is that the service industry does not in general tend to have higher wages but instead the opposite and where they are higher it is the exception rather than the rule (Nordhaus, 2006).
Can anything be done about it?
Without the Kuznets’ defence, The Economic Freedom report does not attempt to claim a natural remedy but instead dismisses the role of the economic system in causing inequalities. The report instead pins the cause on initial conditions and social preference (Miller, 2020). The report downplays the potential for the state to resolve inequalities, advocates for broad-based vs progressive taxes, generally low size of government on taxes and spending (Miller, 2020). The report pivots from inequality to poverty and reiterates the role of “resilient growth” as the best remedy for poverty (Miller, 2020). It equates the fall of the Soviet Union to progressive policy efforts by the state to mitigate inequalities, declaring that “the debate is over” (Miller, 2020). It uses this line of reasoning to argue that a greater role of the state would lead to corruption and ultimately create higher levels of poverty by impeding aggregate growth (Miller, 2020). The report references statements that conform to the “incentives hypothesis” that claims that some level of inequality is good for economic growth overall for society by providing an incentive to work and be enterprising (Miller, 2020 ; OECD, 2015). The alternative hypothesis is that inequality eventually hinders economic growth once the wealth and incomes are concentrated to a minority and the opportunity for social mobility and growth in the broad public is not accessible to the broad majority (OECD, 2020).
Poverty and inequality
Inequality has received extensive attention in recent years in reports by international policy advisory organizations and economists (Piketty, 2014 ; OECD, 2015; UN DESA, 2020 ; World Bank Group, 2018 ; Corak, 2013 ; Ostry, 2014). There is a range of measures of inequality on a spectrum from extreme poverty to inequality of access to different types of goods and services. The word “poverty” and “extreme poverty” often refer to absolute measures of access or consumption of basic services and living conditions such as clean water, shelter. Standard cross-country measurement can be challenging so it’s often reported in USD$ per day (PPP) with two different threshold levels, one for low income ($3.20) and one for middle income ($5.50) countries (World Bank Group ,2018). In contrast to the absolute threshold concept of poverty, income inequality is defined based on the relative share distribution of wealth or income within a defined population. A common measure of inequality is the Gini index which is 0 for perfect equality and 1 for perfect inequality.
The Gini index or a similar relative distribution measure is reported in several reports on inequality (Picketty, 2014 ; Corak, 2013 ; World Bank Group, 2018 ; OECD, 2015 ; UN DESA, 2020 ; Ostry, 2014). The World Bank Group report on poverty and inequality adopts a hybrid approach using “Societal poverty”. Like extreme poverty, societal poverty is a threshold concept with a sliding linear threshold that is a function of the country’s median income. The threshold rises for richer countries to account for the higher “cost of social participation” in particular in education and access to broadband and personal computing devices (World Bank Group, 2018). While each of these reports may apply different measures, they ultimately arrive at similar conclusions on the economics of inequality - that the costs of inequality fall on everyone, not just those on the margins, that there are multiple causes - initial conditions, structure as well as policy and institutions, that progressive tax-and-transfer policy does work with varying degrees of effectiveness, and that progress on reducing inequality has mixed results between different economies.
Economics of inequality
Inequality imposes economic costs on society
Aside from the ethical concerns on the political acceptance of persistent inequality, there are economic costs of inequality to the groups affected in the lower income end and society-wide that impede the pace and quality of economic growth (Ostry, 2014 ; OECD, 2015 ; World Bank Group, UN DESA, 2020). Looking beyond material health and security costs of poverty, disadvantaged groups absorb social costs from inequality in the form of barriers to access for opportunities for investment in human capital (education) (OECD, 2015 ; Ostry, 2014) lower accumulated financial resources to respond to crisis, shock events and explicit and implicit forms of race and class social exclusion (UN DESA, 2020). Other direct costs on the lower income groups reported in research are lower productivity and poor health outcomes which can be traced to inequality both in terms of under-capitalization (social, human capital) and the long term developmental consequences of chronic stress (Sapolsky, 2017 ; Pickett, 2005 ; Pickett, 2017). These costs on the lower income groups impose costs on the rest of society in the form of lower economic growth from the under-capitalization of human, weaker social capital, more volatility and shorter peak-to-peak growth periods in the business cycle (Ostry, 2014, UN DESA, 2020). The economic and political systems cannot be separated from one another. Ultimately economic policy that tolerates high inequality is unsustainable as it undermines the social contract and political legitimacy (Ostry, 2014, UN DESA, 2020).
Causes of inequality are related both to initial conditions and structural, institutional factors
Inequality is a pattern that emerges in a complex adaptive social network with different economic and political processes occurring on different time scales. In the absence of state policy intervention, inequality emerges from a capitalist system due to initial conditions, share of capital/labor returns, cost of social participation, inter-generational transfers, and class stratification (Piketty, 2014 ; Barro, 1991 ; Ostry, 2014 ; Sapolsky, 2017). Economist Thomas Picketty described how wealth inequality emerges over time when the returns of capital outpace the returns to wage labor, which is usually the case (Picketty, 2014). This dynamic directly affects wealth inequality, which is more extreme than income inequalities (OECD, 2015). The returns to wage labor track the pace of productivity growth which tend to slow as an economy matures (typical range 1-2% p.a.), whereas returns to capital are less sensitive to the development stage (typical 4-6%), so wealth inequality accelerates as an economy becomes more advanced (Barro, 1991 ; Picketty, 2014). Wealth inequality is a positive feedback that reinforces and creates further income inequality because household wealth can be invested in human capital to increase wages and social mobility either within the same generation or through inter-generational transfers (Picketty, 2014 ; Ostry, 2014 ; OECD, 2015).
As a society advances, the cost of social participation, opportunity to earn competitive wages increases along with the increasing cost of developing human capital (education) and other access and connectivity features such as broadband internet access (Barro, 1991 ; OECD, 2015 ; World Bank Group, 2018). The “Gatsby Curve” was a relationship identified between social mobility and income inequality (Corak, 2013). Evidence from advanced economies in Europe and the US found that income inequality could cause lower social mobility, and visa versa (Corak, 2013). When the gaps of socioeconomic inequality become very large, class stratification can occur, undermining the social capital of society and further deepening the inequalities (Sapolsky, 2017). In a class stratified society, the large visible difference is a source of cognitive dissonance. This gap can result in a perception barrier for members from very different classes to empathize with one another and can lead to “othering” of the other classes as a way of resolving the dissonance through justification/rationalization (Sapolsky, 2017). The othering behaviors can take many forms of social rent-seeking such as segregated communities or preferential patronage of elite educational institutions (Sapolsky, 2017).
Another factor driving inequality are the structural shifts in the labor market from automation. Automation creates a U-shape in the labor market of low and high income jobs because typical middle-income jobs are highly automatable (UN DESA, 2020 ; Lee, 2017 ; Lawrence, 2017). These jobs often are either in predictable environments or involve a large amount of data manipulation - tasks where computers and robots have a comparative advantage. and the remaining jobs fall into two types - low human capital and high human capital. Knowledge intensive, high human capital jobs fetch higher salaries in managerial and technical occupations, while the lower human capital services are areas where the sensory, motor and human contact skills are a comparative advantage to robots such as healthcare and delivery services (Lee, 2017 ; Lawrence, 2017).
Progressive policy, taxes and transfers reduces inequality with a range of effectiveness
Picketty concluded that the capitalist system on its own would not resolve the inequality but instead the condition could be avoided through progressive (redistributive) tax policy, in particular those that deal directly with inter-generational transfers through inheritance tax (Picketty, 2014). An IMF discussion note report from 2014 reviewed the relationship between redistributive tax policy, inequality and growth. The report found that growth in more equal societies tended to be more stable and resilient for longer stretches and that redistributive policies had a benign effect on level of growth rates (Ostry, 2014). While generally taxes and transfers do reduce inequality, there is a wide range of effectiveness between countries (Ostry, 2014 ; IMF, 2014 ; UN DESA, 2020 ; Santiago, 2012, MOF, 2015). Policies that mitigate inequalities aim at relief for vulnerable groups on the edge of poverty and leveling inequality at the source. Intervention points are inter-generational transfer points and education access barriers. The policies use a variety of approaches from payroll tax transfers, safety nets, parent relief and education investments. Payroll tax transfers are progressive tax policies that have higher marginal tax rates for higher incomes and lower, even negative taxes for lower income. Safety nets provide direct assistance as a stop-gap measure to limit inequality from cascading into absolute poverty by applying a means tested basis for eligibility such as age, income or underemployment (IMF, 2014 ; OECD, 2015). Parental relief are programs aimed at parents either for the pregnancy period, early childhood designed to share the financial burden of parenting to level the inter-generational opportunity gaps. Finally education investments are considered efficient at leveling the access barriers to higher paying jobs (OECD, 2015).
Progress on inequality reduction is mixed, some successful, others stalled or reversing
Cross-country comparison shows mixed results with generally poverty and inequality in the decline globally, but with large disparities by region, income group and more lackluster results in recent years since 2005 than in the previous 3 decades (World bank Group, 2018, OECD, 2015 ; UN DESA, 2020). East Asia, Pacific islands, the Caribbean and Latin America have realized greater progress in inequality reduction, whereas inequality has been flat or increasing in South Asia, Europe and North America and worsening in Sub-saharan Africa (World bank Group, 2018). Advanced economies compared to low income or developing economies are observing stagnant or increasing inequality with much of the profits of the national income returning to capital owners and the high income households (OECD, 2015).
The trend in Figure 5.4 illustrates the growing gap between the growth of households income between the lower and upper percentiles with the top income households realizing +50% gain since 1985 compared only to <15% gain from the bottom 10% of households during the same time period (OECD, 2015). The challenges of income inequality intensify for higher income countries since the opportunities and the upper limit for economic growth are constrained, the cost of social participation, human capital formation increase and spreads of cumulative effects of comparative advantages between households have widened with time (Barro, 1991 ; Picketty, 2014). The breakdown of the relationship between income in the bottom 40% of households and overall economic growth is more uniform for higher income countries than for the middle, lower income countries (World Bank Group, 2018). For the developing countries, there is a wider spread of the equity of economic growth, with some countries, regions experiencing equitable growth path - East Asia (China) and Latin America, whereas South Asia and Sub-saharan Africa are experiencing decoupling of gains of the bottom share of the population with the aggregate income growth (World Bank Group ,2018).
Last updated
