Inequality and Development:

Interconnections
 Inequality, income, and growth: The inverted-
U hypothesis
• There are many studies which found the connection between inequality
and per capita income
• One such path breaking earliest work was by Kuznets in 1955
• Because of data limitations, Kuznets used the ratio of the income share of
the richest 20% of the population to that of the poorest 60% of the
population as a measure of inequality
• The comparison was between developing (Sri Lanka and Puerto Rico) and
developed countries (the United States and the United Kingdom)
• The results of the study indicated that the developing countries tend to
possess higher degrees of inequality than their developed counterparts
 Inequality, income, and growth: The inverted-
U hypothesis
• Kuznets again conducted the study in 1963 by expanding it to eighteen
countries
• Again, the sample had a mixture of developed and developing countries
• The study found that the income shares of upper income groups in
developed countries were significantly lower than their developing
counterparts.
• These observations of the study states that economic development is
fundamentally a sequential and uneven process
• Instead of everybody benefiting at the same time, the process appears to
pull up certain groups first and leave the other groups to catch up later.
• In the initial phase, inequality widens. Later, as everybody else catches up,
inequality falls.
 Inequality, income, and growth: The inverted-
U hypothesis
• Based on such reasoning Oshima [1962] and Kuznets [1955, 1963]
suggested a broad hypothesis of development
• So, economic progress, measured by per capita income, is initially
accompanied by rising inequality, but that these disparities
ultimately go away as the benefits of development permeate more
widely
• Thus if you plot per capita income on one axis and some measure of
inequality on the other, the hypothesis suggests a plot that looks like
an upside-down “U”: hence the name inverted-U hypothesis
 Testing the inverted-U hypothesis

• The discussion will be on following grounds

• An inverted-U in the cross section?
• Time series ?
• Panel Data ?
 Testing the inverted-U hypothesis:
An inverted-U in the cross section?
• A number of studies have attempted to test this hypothesis.
• There are two ways to do this.
• Time series method is where an individual country is tracked over time
and note the resulting changes in inequality that occurred
• But in this case we face the problem of lack of data for many countries
• Due to this countries which have already completed their “inverted-U”
path generally lack the data on inequality to go back centuries into the
past
• Hence the second best route is to carry out cross section study: which
examines the variations in inequality across countries that are at different
stages in the development process
 A Cross Sectional Analysis by Paukert - 1973
• Fifty-six countries were classified into
different income categories according to
their per capita GDP in 1965, in U.S. dollars
• Inequality was measured by the Gini
coefficient
• The table reveals two things. First, there
appears to be a relationship between
inequality and GDP of the kind predicted by
Oshima and Kuznets
• This relationship suggests that the broad tendencies described earlier in this section do work,
on average, across countries and over time in the development of each country.
• The third column in Table presents the highs and lows for the Gini coefficient among countries in
each category. A quick glance at this table certainly dispels the notion that the inverted-U is
inevitable in the history of each country’s development.
 A cross sectional analysis by Paukert - 1973
• This diagram uses cross-sectional data to show
the possibility of an inverted-U.
• This is a simple plot of the latest years for which
country-level data on inequality are available.
• Note how the share of the richest 20% of the
population rises and then falls as we move over
countries with different per capita incomes.
• Exactly the opposite happens with the income
share of the poorest 40% of the population.
• Thus at some very crude cross-sectional level, the
inverted-U hypothesis has some foundation.
 A cross sectional regression analysis by
Ahluwalia-1976
• This study also supported the pattern
• Ahluwalia analyzed a sample of sixty countries: forty developing, fourteen
developed, and six socialist, with GNP figures measured in U.S. dollars at
1970 prices
• Ahluwalia divided the population of each country in the sample into five
quintiles, running from the 20% of the population with the lowest income
share to the quintile with the highest income share.
• This way it was possible to keep track of the entire income distribution.
• Ahluwalia’s regressions reveal that for all quintiles but the highest,
income share tends to fall initially with a rise in per capita GNP and then
rises beyond a certain point.
• For the topmost quintile, the pattern is just the opposite: with rising per
capita income, income share first rises and then starts to fall
Testing the inverted-U hypothesis: Time Series
• While running regression by pooling different countries we make the
assumption that all countries have the same inequality-income
relationship
• So they believed to follow the same qualitative (inverted U) and
quantitative pattern. So the income –inequality curve is same curve for
all.
• This notion is hard to swallow. Countries do differ in their structural
parameters
• There are some extreme arguments that every country is (a priori)
completely different.
• So, that all countries should be studied separately and nothing is gained by
pooling the data
Testing the inverted-U hypothesis: Time Series
• This is a good idea if we have huge quantities of data for each country,
but we do not
• Income distribution data are hard to get, and if we try to go back a
century or so as well, that leaves us with very few countries indeed.
• Lin-dert and Williamson [1985] tracked inequality movements in some
European countries and in the United States using data going back into
the last century and earlier.
• For England the upward surge in inequality during the industrial revolution
is clearly visible.
• Other countries were picked up at a later stage (for lack of earlier data)
and show steadily declining inequality.
• The overall availability of data is quite sparse, though.
Testing the inverted-U hypothesis: Time Series
• There are few studies among one by Deininger and Squire (1996) found
that structural differences across countries or regions which may create
the illusion of an inverted-U, when indeed there is no such relationship in
reality
• When countries are examined separately, there is some evidence of a
direct U-shaped relationship among countries with a long series of data;
this is true of the United States, the United Kingdom, and India
• Fields and Jakubson [1994] used 35 countries and used several years of
inequality data their findings are very similar to those of Deininger and
Squire, and cast further doubt on the existence of an inverted-U shape.
• In their view, if any average conclusion can be drawn, it is that inequality
falls over the course of development, at least over the course of
twentieth-century development
 Income and inequality: Uneven and
Compensatory Changes
• In the process of economic development income and inequality do
not bear a simple relationship to each other

• A country's per capita income increases for three main reasons

• Everyday progress
• Growth in specific sectors
• Spreading the benefits
 Everyday Progress

• This is the gradual increase in income that happens as people

accumulate wealth, gain skills, and become more productive at work.
• It's like receiving small raises each year and seeing your wealth grow
over time.
 Growth in Specific Sectors

• Sometimes, certain industries like engineering, software design, or

accounting experience rapid growth.
• This creates a higher demand for skilled individuals in those sectors,
leading to increased incomes.
• However, this growth is concentrated in specific areas, which can
create inequality.
 Spreading the Benefits
• As the high-income sectors grow, the money earned by individuals in
those sectors starts to flow into the economy.
• This leads to increased demand for various goods and services,
benefiting other industries.
• For example, engineers may buy houses, software engineers may
purchase cars, and accountants may go on vacations.
• Additionally, as more people acquire the in-demand skills, income
gains become more widespread and help reduce inequality.
 First uneven, then compensatory?
• There are chances that some combination of all three phenomena
may occur at a point
• The inverted-U would be a theoretical possibility if it is more likely
that uneven changes occur at low levels of income, whereas
compensatory changes occur at higher levels of income
• (1) A basic feature of economic development is that it involves large
transfers of people from relatively poor to relatively advanced sectors
of the economy. – Dual economy – initial access to only few people.
• This argument suggests that change is first uneven and then compensatory
 First uneven, then compensatory?

• (2) Technical progress initially benefits the (relatively) small

industrial sector.
• Capital abundant developed countries use labour saving technology whereas
it is difficult for labour surplus developing countries
• This leads to high income inequality in developing country as in the
beginning technical progress benefits only the fraction of the population
involved in industries
 First uneven, then compensatory?

• (3) There are other ways in which technical progress can be

inequality enhancing in developing countries.
• There are arguments that initially technical progress is biased against
unskilled labor and tends to drive down these wages
• In the later stage these skill gaps are compensated through growing
educational status of the labour but it is a slower process
 First uneven, then compensatory?

• (4) Even without the biases of technical progress, industrialization

itself brings enormous profits to a minority that possess the financial
endowments and entrepreneurial drive to take advantage of the new
opportunities that open up.
• Ultimately these benefits will spread to labour as well in the form of
increased investments by the capitalists but again the pace depends on the
size of the surplus labour
 Inequality, savings, income, and growth
• The rate of savings affects the long-run level of per capita income
and, in many cases, the rate of growth of the economy
• Proponents argue that income inequality drives growth by channeling funds
to savers and investors, justifying limited government intervention.
• Opposing perspectives suggest that redistributive policies can promote
savings and stimulate higher economic growth rates.
• Rohini and Paulo earns 55000 and 5000 respectively whereas
Thomson and Thomson earns 30000 each.
• With different income their savings also differ.
• Thomsons and Thomsons savings will be more than the rohini-Paulo’s
avg.
 Inequality, savings, income, and growth
• The preceding discussions haven’t given a clear picture on income
inequality and savings
• For a better judgement following factors are important to be
considered
• Subsistence needs
• Conspicuous consumption
• Aspirations and savings
 Subsistence Needs
• Foundation of economic lives: Subsistence needs include basic necessities
like food, clothing, and shelter.
• Disparity in developed and developing countries: While the fortunate
minority in industrialized nations rarely worry about these needs, millions
in developing countries prioritize them in their daily expenses.
• Limited savings capacity: Individuals in poverty-stricken areas often
struggle to save for the future due to the overwhelming demands of
meeting their present needs.
• Inability to afford savings: The average or marginal income may not allow
the poor to allocate funds for savings, resulting in minimal savings
opportunities.
 Conspicuous Consumption
• Ultra-rich aspirations: The ultra-rich in developing countries aim to
achieve high levels of consumption, comparable to affluent
individuals worldwide.
• High consumption patterns: Their desire for conspicuous
consumption leads to elevated levels of personal expenditure.
• Savings disparities: While the ultra-rich may save, their average
savings rate tends to be relatively low compared to their less affluent
counterparts.
• Marginal increase in income: Even with additional income, the
propensity of the ultra-rich to save may not increase significantly
due to their high consumption levels.
 Aspirations and Savings

• The desire to imitate and attain the high consumption levels of the
industrially developed world has often been criticized as an insult to
one’s “traditional” ways of life and as aping the customs of the
“Western World.”
• There is, however, nothing that is intrinsically antitraditional or
Western about economic well-being, and striving for economic self-
betterment is a large part of what we are all about.
 Effect of inequality on savings and growth
• The effect of a reduction in income inequality on the rate of savings and
rate of growth is very complex.
• In an extremely poor country, redistributive policies may bring down the
rate of savings and therefore the rate of growth in the medium or even
long run
• Without redistribution, there is a fraction of the population (however
small) who possess the desire and the means to accumulate wealth
• With redistribution, no person saves anything of any significance
• Does that mean for the interests of growth, we can recommend
inegalitarian policies?
• This is a difficult choice
 Effect of inequality on savings and growth

• For medium-income countries, the story may well be dramatically

different.
• Redistributive policies may generate a surge of savings at the
national level, because they create a large and ambitious middle
class with international aspirations
 History: From income and savings to the
evolution of inequality
• How a society changes economically depends on how unequal things
start.
• If there's low inequality at the beginning, it usually stays that way
because people have similar lives and savings habits.
• But if inequality is high from the start, it can get even worse over
time.
• This happens because different groups want different lives than
what they have, affecting how much they save.
• This shows how history plays a big role in how a country develops,
more than just technology or personal choices.
 Inequality, political redistribution, and growth
• Who Saves More Matters: When middle-class people save more than rich or
poor ones, lots of inequality can slow down the economy.
• Sharing Money Fairly: When rich and poor people are really different, some
people want to make things more equal. But changing rules or taxes is tricky
because of politics.
• Tax Trouble: Taxing money as it grows can make people not want to invest, which
can slow the economy.
• Less Money, Less Saving: If taxes are taken from the money people make from
their investments, they might not save as much or spend as much. This can slow
the economy too.
• Inequality and Slow Growth: When the gap between rich and poor is huge, and
people want things to be more equal, the new rules they make can sometimes
stop people from wanting to save and invest. And that can make the economy not
grow well
 Inequality and Demand Composition
• Income and consumption: The amount of money people have affects what they can buy. As
people earn more, they tend to spend less on basic necessities like food and more on other
things.
• Spending and income distribution: How people spend their money affects how wealth is
distributed. The things people buy require workers and resources to produce, and this influences
who earns what.
• Feedback loop: The way people spend their money also affects how much money they have. It
creates a cycle where spending patterns influence income distribution and vice versa.
• Historical inequalities: We wonder if inequalities that exist from the past continue or change over
time. The answer depends on what people want to buy. If there is more demand for luxury goods
that require a lot of money to produce, inequalities can grow. But if there is more demand for
everyday items that require a lot of workers, inequalities can decrease.
• Complex observations: Figuring out how spending affects inequality can be complicated.
Researchers study what different groups of people buy and how it affects the distribution of
income.
• Historical differences and development: Differences in the past shape how societies develop.
They affect things like income inequality, what gets produced and bought, how much money
people make, and how fast economies grow.
 Inequality, capital markets, and development

• Credit markets play a crucial role in economic transactions, allowing

people to borrow money and invest in various endeavors.
• However, access to credit is not equal for everyone, and the
availability of collateral becomes a significant factor in determining
who can participate in credit markets.
• This has implications for economic inequality and occupational
choices within a society.
 The inefficiency of inequality
• Inequality causes problems in the economy.
• When inequality is high, people in the subsistence sector can't become
entrepreneurs and earn more money.
• Access to credit is limited because of wealth inequality, which makes the
economy less efficient.
• Even in situations with moderate inequality, the lack of credit
opportunities prevents income growth for potential entrepreneurs and
other workers.
• Just accumulating wealth over time doesn't solve the problems caused by
inequality, as the costs of starting a business also increase.
• If startup costs rise faster than wealth, inequality will continue to harm
the economy in the long run.
 Inequality and development: Human capital
• Inequality hampers economic efficiency by limiting opportunities for those at the lower
end of the wealth scale.
• Credit market failure prevents access to educational loans, hindering productive
educational choices.
• Poor individuals must rely on their own resources for education, which may be costly and
unaffordable.
• High-inequality societies may have prestigious institutes of higher education but
inadequate resources for primary education.
• Inequalities in education contribute to the perpetuation of initial inequality, leading to
multiple development paths.
• Lack of inter-family loans and difficulties in loan repayment contribute to the constrained
accumulation of human capital.
• Limited human capital accumulation is seen as a significant inefficiency in both
developed and developing countries.