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Sosyal Bilimler Dergisi 2007, (1), 83-94

INCOME AND

Dr. Alpaslan İSAGİLLER

İstanbul Üniversitesi İktisat Fakültesi İktisadi Gelişme ve Uluslararası İktisat Anabilim Dalı

ÖZET Bu makale gelir dağılımı ile ekonomik büyüme arasındaki karşılıklı ilişkiler üzerine mevcut literatürü kalkınma açısından analitik olarak incelemektedir. Ayrıca yakın geçmişteki gelir dağılımı trendlerini değerlendirmektedir. Çalışmamız büyümenin gelir dağılımı üzerinde her hangi bir yönde sistemli etkisi olmadığını göstermektedir. Buna karşın gelir dağılımı birçok mekanizma aracılığı ile ekonomik büyümeyi etkileyebilmektedir. Ampirik çalışma gelişmekte olan ülkeler için bu yönde anlamlı kanıtlar sunmaktadır.

ABSTRACT This article considers an analytical survey of the literature about the interactions between distribution and economic growth with an emphasis to development issues. It also evaluates recent trends in . Our study does not suggests any systematic effect of growth on income distribution in any direction. On the other hand the distribution of income may affect economic growth through several mechanisms. Empirical work provides significant evidence for developing countries in that direction.

I. INTRODUCTION Economists have long sought to understand the links between economic growth and income In recent years Turkish has distribution: Does economic growth result in a showed great performance with high growth rates less unequal distribution of income by for successive nineteen quarters as declared by the forces? Should governments consider adopting Turkish Statistics Institution. However, there are redistributive policies to improve the conditions of some complaints that this is not reflected in the the poor? Do countries with unequal income distribution of income, based on the idea that distributions experience slower economic growth economic growth would improve the distribution than more egalitarian countries? The distribution of income, reducing poverty. On the other hand, of income within a country is very important, some economists have recently argued that since it affects the social and political stability, income distribution can be mainly enhanced by among others, by determining the poverty level economic growth. for any given GDP level. In some countries such 84 Alpaslan İSAGİLLER as Brasil, with relatively high per capita income, distribution. The first hypothesis is the Kuznets' the distribution of income is very unequal famous inverse U-curve, relating levels of per resulting in high polarization in society with high capita income to income distribution. In his 1955 levels of poverty. In some other countries, such as presidential address to the American Economic Costa Rica, with relatively more equal income Association, Kuznets proposed that the distribution, there is more cohesion in society with relationship between the level of per capita political stability (Sen, 1995). However, the above income and inequality in the distribution of questions need not to be asked from a normative income may take the form of an inverted U. That perspective alone, since the effect of growth on distribution has to be examined also from an is, as per capita income rises, inequality may analytical perspective if there are sistematic initially rise, reach a maximum at an intermediate effects in both directions. level of income, and then decline as income levels of developed countries are reached. The aim of this paper is to review analytically the interactions between income Kuznets discussed the population shift distribution and economic growth with an from traditional to modern sectors during emphasis to development issues in order to shed development process towards a theory of income- light on the frame of analysis for the above distribution evolution. He argued that income questions, and to identify the areas of the future distribution was relatively more equal at low research. levels of income in the early stages of The literature on the nexus of income development in which almost all labor were distribution and growth is enormous, and there are employed in agricultural sector. As the many comprehensive surveys on the subject, with development proceeded through industrialization, emphasis to different aspects of development such the distribution became more unequal with labor as poverty, age structure, fertility, human , allocated in both the agriculture and industry trade liberalization, foreign direct , sectors. Industrial exceeded agricultural and so on: Among them one may refer to wages (due for example to minimum law or Adelman and Robinson (1988), Lipton and to power), resulting in large inequality Revallion (1995) and more recently to Kanbur between the of two sectors. That is, in the (2000). The scope of our survey will be limited to early stages of development both economic the two-way inter-relationship between distribution and growth considering recent trends growth and income inequality rised. Eventually, in income distribution. as industrialization proceeded, most of the labor were allocated in industry, the weight of The paper is organized as follows: In agriculture in and income generation section I, the ways in which growth affects got smaller and the distribution of income, income distribution are reviewed; section II moving in reverse direction, became more equal considers the reverse causality, i.e. the possible mechanisms through which income distribution again (Kuznets, 1955). affects growth; section in evaluates recent trends Several formal explanations based on dual in the distribution of income; and finally last economy models have been put forward for the section concludes. Kuznets relationship. The above explanation of the Kuznets process was formally modeled as a dualistic model by Anand and Kanbur (1993). I. EFFECT OF ECONOMIC However another similar and earlier explanation GROWTH ON INCOME DISTRIBUTION can be found in the Lewis's labor-surplus growth There are two main hypotheses in the model (Lewis 1954; further developed and refined literature on how economic growth affects income by John Fei, Gustav Rannis and others). Income Distribution and Economic Growth 85

According to the Lewis's dualistic model, there assets also accumulate more. But eventually in the are unlimited supplies of labor in the traditional accumulation process, as the stock of assets agriculture sector in the early stage of increases, the rate of return to assets falls, and the development. If an economy starts with its entire distribution of income, along with increases in population in agriculture (stage of more or less labor income, moves in reverse direction (Stewart, equal income distribution), a large part of that 2003). population can be removed to the newly emerging The second hypothesis on how economic modern industry without any reduction in growth affects income distribution is that agricultural . Industry will have to pay that economic growth always leads to increased labor a wage a bit above the subsistence wage that inequality in income distribution. It has well- is prevailing in agriculture to get it to move. Even known origins that go back to classical if agriculture is completely stagnant, industry can economists. According to this hypothesis, growth grow without putting any demands on agricultural in market can not take place without a output. At this stage income growth takes place worsening of the income distribution (Ray, 1998: only in industry. As industry continues to grow, 284-92). There are three main explanations however, the supply of surplus labor will recently discussed. First, and other eventually be exhausted. Further removals of income-generating assets are historically unevenly labor from agriculture will tend to increase distributed and only the rich can save and invest, agricultural output , forcing industry to raise meaning that growth goes always to the initially the wage rate unless there is an offsetting rich. A second argument is related to the agricultural productivity growth or population composition of labor or broadly of : growth (Meier, 1989:120-132). Technological progress is inherently biased in The model suggests that inequality will first favour of the skilled and educated labor, whose increase and later diminish as development takes marginal product always rises more than the place. The income share of the modern sector unskilled labor. Then inequality between skilled increases as development proceeds while the and unskilled will always pertain. The third income of the traditional sector remains argument is concerned with the borrowing unchanged -or even falls as population growth capabilities. Only the asset owners are elligible to takes place-, thus causing to the inequality put up collateral and thus have access to credit for between incomes of the sectors to rise. The (Morduch, 1999). model's implications are consistent with Kuznets' There are mixed findings for the Kuznets generalization. This tendency toward increasing hypothesis in empirical studies. Kuznets for his inequality is finally reversed when all the surplus inverse U-curve provided evidence from a cross• labor is absorbed into the industrial employment, country study. Paukert (1973) studied the leading labor to become a scarce factor of historical data on income distribution in production with further increases in labor demand industrialized countries and also provided increasing real wages. The rise in the general supporting evidence. Several others have also wage level brings about the downturn in found some support for the Kuznets hypothesis inequality. (e.g. Oswang, 1994; Milanovic, 1994). However Another explanation of the Kuznets process one criticism had been that the Kuznets' work considers the distribution of assets. An initially related to levels of income per capita, not to the uneven distribution of income-generating assets growth rate. Empirical work on growth (as against contributes to rising inequality, as those with more levels) of per capita income shows no relationship 86 Alpaslan İSAGİLLER between growth rates and inequality (Ahluwalia, A more recent investigation of income 1976); and this is also confirmed by recent work distribution in China by Ravallion and Chen (e.g. Bruno, Ravallion and Squire, 1995; (2004) shows that it has become significantly UNCTAD, 1997). For example, Bourguignon more uneven over the 1982-2001 period, the GINI (1995: 47) concludes that the parabolic increasing from 28 to 40. Recent evidence from relationship, -if there is any-, between income India confirms also the increase in inequality in all inequality and GDP per capita across countries is dimensions. (Deaton and Dreze, 2002). Thus probably very weak and unstable over time. China and India, accounting for more than half of the population in all developing countries has Another criticism has been directed to using hence worsening income distribution. Inequality is cross-country data instead of time series. As noted also increased in developed countries in the 1980s by Easterly, King, Levine and Rabelo (1991), and 1990s as reported in theHuman Development results from intertemporal studies have not Report, 2005. supported the Kuznets hypothesis. As the relationship in the hypothesis was formulated on Despite the weak empirical results and the intertemporal basis, these intertemporal studies recent contrasting observations, the would seem more appropriate way of testing the has been widely accepted. It has been sometimes hypothesis than cross-country studies. used also as an excuse, for taking no action on income distribution, on the assumption that the Moreover, further work by Deininger and Kuznets process will unavoidably be realized in a Squire (1998) on the reduced form of the Kuznets . This may, of course, be true for curve with cross-section data has found the a liberal economy with laissez-faire development relationship weak and sensitive to alternative process leading 'naturally' to a Kuznets specifications of the estimated function. The work relationship, but policy can have a counter role of Deininger and Squire provided no significance which explains many exceptions to the curve. for the Kuznets hypothesis when controlled for Experiences of individual countries show different regional-specific differences. In their test on time- combinations of growth and changes in income series estimates with data available only for about distribution. In some countries with high growth 40 countries, only 5 countries (Brasil, Hungary, rates, income distribution has worsened over time: Mexico, Philippines and ) had a e.g. Brazil (1960s to 1990s), China (1980s), statistically significant inverted U-curve Pakistan (1970-1985), Thailand (1970s and development. Another 4 countries had a 1980s), Botswana (1970s). However, in some statistically confirmed development of a U-curve, others with again high growth rates, it has signifying that initial income distribution became improved: e.g. Indonesia (1973-1993), South more even and then more uneven (Costa Rica, Korea (1950-1980), Malaysia (1970-1990), India, United States and UK). The remaining 30 Taiwan, Province of China (1950-1980), Mauritus countries had no statistically significant change in (1980-1995). Some countries with low growth either direction. rates showed also differing outcomes. In some, Results from Barro (2000) on the basis of low growth rates has been observed with panel data provided weak support for the first part worsening income distributions: Post-Soviet of the hypothesis that the distribution became Russia and most eastern European countries more unequal as countries grow, and no support at (1980s), Mexico (1980s), Kenya (1980s), Ethiopia all for the second part of the hypothesis that as (1980s), Guatemala (1970s and 1980s). And in countries get richer, income distribution will some others, income distribution improved: e.g. inevitably become less unequal. Sri Lanka (1960-1970), Cuba and Colombia Income Distribution and Economic Growth 87

(1980s), Morocco (1970-1984). (Demery et al. technique literature (e.g. Dobb, 1956-57) argued ¡995, Chu et al. 1999) that more capital-intensive techniques should be chosen to maximize 'surplus' and reinvestible Economic growth is not necessary, nor funds. Based on these arguments, many sufficient for a better distribution of income. economists concluded that countries should grow Structural factors and policy stances are crucial in first and redistribute later, although very little the experiences of the countries. Logically empirical evidence was available. In contrast, speaking, even if there is no growth, a studies in the 1970s in mainstream development redistributional policy may improve the economics were aimed at identifying distribution of income in a country, albeit the redistributive mechanisms for feasibility of this kind of redistribution is severely that would not hamper growth. In opposition to limited. This is of course not saying that economic the Lewis's model characterization as "grow first, growth is not important; it opens up the possibility then redistribute", it has been argued that more of making at list some people better off without equal initial income distribution would lead to making anyone worse off. The above empirical higher growth. results suggest that growth is 'distribution neutral', so that it does not necessarily lead to This focus of the literature didn't last long either a worsening or an improvement in income and was reversed with the rise of neo-liberalism distribution, and may be consistent with either. and the Washington Consensus in the early 1980s. According to the Washington Consensus, growth itself would reduce poverty by 'tricle down' II. THE REVERSE RELATIONSHIP: mechanisms through which social acceptance of EFFECT OF INCOME DISTRIBUTION ON inequality would allow the rich to earn a greater GROWTH rate of return on their assets, motivating them to The growth-versus-equality trade-off of the accumulate wealth faster, some of which to be Lewis's surplus-labor model, influenced greatly redistributed to make everyone wealthier. (Clarke, the way of development thinking among 1995) mainstream economists from the 1950s into the In the 1990s, the arguments of both the neo¬ 1970s. It has been suggested that inequality is an liberal analysis and the earlier Lewis's trade-off unpleasant precondition for growth; more unequal between growth and inequality were challenged income distribution would lead to higher growth by a number of studies. Recent literature has now through higher . In case that individual again placed priority on poverty reduction and on savings rates rise with the level of income, then a possible growth enhancement from a more equal redistribution of resources from rich to poor distribution of assets and income. Several would tend to lower the aggregate rate of , mechanisms to explain the positive relationship reduce capital accumulation and slower growth. between income distribution and economic growth Higher savings propensities associated with more have been suggested. unequal income distribution were variously attributed to the effect of a rising share. One mechanism is related to Kaldor (1956) suggested that a redistribution to underinvestment in which is attributed high-income that have savings to imperfect capital markets. Economies with propensities greater than low-income households, imperfect credit markets are typically would increase aggregate savings, stimulating characterized by the limited ability to borrow, investments, thereby growth. The early choice-of- assymmetric information and limitations of legal institutions. Under the condition of limited access 88 Alpaslan İSAGİLLER to credit, the ability of the individuals to borrow income equality would promote economic growth. and invest depends on their levels of assets and This mechanism is studied in Alesina and Perotti incomes. Poor people in particular tend to forego (1994), Benhabib and Rustichini (1996), among investments in human capital (education) that others. provide high rates of return. In such a situation a Some other mechanisms suggested in the distortion-free redistribution of assets and income literature pertains essentially less developed tends to raise the average productivity of economies. Inequality in distribution may investment. Thus through this mechanism, a more also negatively affect growth. A widespread equal distribution of income stimulates economic ownership of land tends to absorbe more growth. An improvement in the capital markets employment and raises land productivity. That is, and legal institutions in poor economies will have more equal land distribution leads to a more equal larger growth effects than in rich countries. rural income distribution along with an increase in Examples of models of the economic effects of rural output. This mechanism is assumed to inequality with imperfect credit markets are Galor operate under the conditions of underutilization of and Zeira (1993) and Piketty (1997), among land (when ownership is concentrated), lack of others. incentives for waged agricultural workers or It is suggested that inequality slows growth existence of sharecroppers without any motivation by causing greater conflict over distributional to make productivity improving investments in issues, thereby stimulating greater government land. Especially in rural economies, an even interventions and higher distorting . Based distribution of land enhances the distribution of on a median voter type model in which the mean income and economic growth in the entire country income exceeded the , majority (e.g.Lipton, 1993; Deininger and Squire, 1998). would favor redistribution of resources from rich One another channel is associated with to poor through explicit transfer payments and scale economies. A more equal income public-expenditure programs such as health and distribution enlargens domestic markets, ensures education. A greater degree of inequality will greater and hence more motivate greater redistribution and create more industrialization and growth (e.g. Murphy, distortion on economic decisions, decreasing the Shleifer and Vishny, 1989). rate of return on assets, restricting capital accumulation that lower growth. Even if income A number of studies theorize a further redistribution does not occur, lobbying activities effect of inequality on growth through the effect promoting corruption can have negative effect on on education and fertility. Households with growth. Thus less unequal income distribution credit constraints, it is argued, do not use will not motivate such populist policies and will resources for the quality of children (education), not result in lower growth, e.g.Perotti (1993), but instead for the quantity of children (fertility). Alesina and Rodrik (1994), Persson and Tabellini Poor and less educated people tend to have larger (1994) and Benabou (1996). families. A variant of this argument (Lagerlof, 2003) considers gender gap. In countries with a It is argued that higher inequality raises gender gap, parents tend to have more sons and social conflict and political instability, invest more on the education of their sons than motivating the poor to engage in crime, and other that that of their daughters as their daughters are disruptive activities, incresing uncertainty and expected to marry an educated man. This results producing threats to property rights. These in turn in high fertility, since the of reduces investment and economic growth. Thus a having children for woman is perceived low- redistribution of income resulting in a greater Greater income inequality increases the number of Income Distribution and Economic Growth 89

poor households with high fertility rates, which in cross-country gowth regression and to the various turn reduces growth (e.g.Benabou, 1996; Khoo kinds of inequality measures. It is also and Dennis, 1999). independent upon the political regime; inequality has similar effect both in democracies and non- Finally, a more equal income distribution democracies. However, as noted by Clarke, some reduces poverty, leads to higher human care should be taken when interpreting these development with higher education attainment results. Although equal income distribution is and improved health and nutrition levels, allowing positively correlated with growth, this does not poor people to improve their capabilities and their necessarily suggest that redistributional policies productivities, which in turn results in higher will improve long term growth in any way, in any growth (e.g. Ranis and Stewart, 2002). economy. First, theoretical studies pointed out that These are main hypotheses on how income this positive relationship between equality and distribution affects economic growth. However growth is mainly due to the observed coincidence one must be carefull in assessing the possible of high levels of inequalities with high levels of mechanisms. The explanations government intervention. Hence, the reason of this of disturbing populist policies are mainly based on correlation may be that there is less need for these an assumption about the behaviour of the 'median redistributional policies where there is less voter' and the existence of a democratic society. inequality. Second, Clark states that the direction Some mechanisms seem to be more relevant for of causality has not been determined and the developing countries than others, as suggested by effects of specific redistribution policies have not Deininger and Squire (1998). been tested. Finally, if policies to lower inequality result in greater government spending with costs There is a tremendous literature growing outweighting the benefits of greater equality, recently on the subject. Several independent long-term growth may be harmed. However, studies, based on cross-country regressions and according to Clarke, these results do indicate new data, concludes that countries with more conclusively hat inequality is not a necessary equal income distribution have higher growth. The precondition for growth. studies by Alesina and Rodrik (1994), Persson and Tabellini (1994), Bourguignon (1995), Barro (2000) extended the analysis by using Alesina and Perotti (1994) and many others large panel data and investigated the relationship provide support for this theoretical outcome with distinguishing between low-income and high- cross-country growth regressions. Most of the income countries. His results confirmed the recent studies involve cross-country regressions findings of earlier studies, but only for developing due to data constraints.There are especially severe low-income countries. For the developed high- data problems in the area of income distribution, income countries, he found a positive effect of as underdeclaration of income is common inequality in income distribution on subsequent especially in developing countries. In these studies growth. the robustness of the findings has been questioned by many (e.g.Barro, 2000). Investigations of time-series data in developed countries have confirmed substantially Clarke (1995) concludes that although the the relationship between greater equality and magnitude is relatively small, inequality is higher growth. Panizza (2002), using a cross-state negatively, and robustly, correlated with growth, panel data for the United States to assess the and that this result is independent upon many relationship finds some evidence in support of a different assumptions about the exact form of the positive relationship between inequality and 90 Alpaslan İSAGİLLER growth. The very large number of studies finding many different countries, each with specific some relationship seems to point out the existence characteristics, it is not appropriate to make easy of a positive relationship between equality and generalizations, but it appears that each of these economic growth. changes have played an important role in the rise of inequality, along with the 'well-known' causes such as credit market imperfections, access to III. RECENT TRENDS IN INCOME education, land concentration and so on. DISTRIBUTION These well-known causes may explain most Some studies suggest that within individual of the variations in cross-country inequality, but countries, income distribution or levels of income they are not relevant for the recent rise in inequality has little or not changed in decades inequality within countries. The specific reasons (e.g. Angeles-Castro, 2006). The report of the should be linked to the process and United Nations on the World Social Situation the neoliberal policy reforms that have been (2005), using the data in the World Income increasingly adopted in almost all countries.The Inequality Database (WED), indicates that within- following reasons have been frequently suggested country income inequality decreased during the for the rapid rise in inequality over the last two 1950s into the 1970s in most of the countries. decades (Cornia and Court, 2001; Steawart, Since the 1980s, however, inequality has risen in 2003): the majority of countries. Over the last two decades inequality has increased in 48 out of the i. Trade Liberalization 73 countries for which sufficient reliable data are In labor abundant developing economies, available. In contrast, inequality remained trade liberalization is expected to decrease income constant in 16 of these countries, although three of inequality as increases in exports of labor- them show a rise in inequality over the last years. intensive manufacturing sectors would raise Only 9 of the 73 sample countries which account employment and the share of wages, and this was for only a small portion of the sample's what has been observed over long periods. In population showed a decline in income inequality. resource abundant countries, however, exported The rises in inequality are rather woldwide; they are not labor intensive, and trade have affected high- and low-income countries liberalization can undermine the wage earners. equally, which is perfectly consistent with the According Cornia and Court 2001, trade finding that growth does not affect income liberalization has mixed effect on the income distribution. Similar results can be also found in distributions of the middle-income countries. the Human Development Report 2005 and some There has been a rise in inequality in the Asian other studies (e.g. Cornia and Court, 2001). countries that rapidly expanded their manufacturing exports in the 1980s. In contrast to We need to understand the causes of this East Asia, trade liberalization has caused to movement towards greater inequality in order to increased wage inequality. One explanation of this determine whether there is any scope for policy to is through the change in the structure of labor reduce inequality. The rise in inequality has demand in favor of skilled workers; the imports of occurred in a new environment of globalization advanced technologies or exports of high-tech characterized with liberalization, increased products both require highly skilled labor, which marketization, rapid technological change and increases the returns to skilled labor and reduces change in labor market institutions. Most the demand for the locally abundant unskilled countries in the world have been affected in one labor (Goldberg and Pavcnik 2004). way or the other by all these changes. As there are Income Distribution and Economic Growth 91

ii. Financial Liberalization reduction of employment protection, dilution or breaking up of bargaining power, reduction in Liberalization of international capital flows public sector employment. These changes in labor in the 1990s has been encouraged in the majority market institutions have significantly affected of the developing countries, followed by the rises in wage inequality and overall inequality, opening of the domestic banking and financial especially in developing economies and OECD sectors. Lenders and rentiers benefited from countries. The real minumum wage and the share increases in real rates at the expense of of wages have declined during the reform process borrowers, including governments. Interest in many countries (Cornia and Court, 2001; payment on public debt has increased rapidly. As Steawart, 2003). a result a large part of the government budget in many developing countries is now used for v. Transition of socialist countries to interest payments rather than social expenditure. capitalism International financial deregulation in turn has caused growing instability, as is obvious by the Income inequality has increased in all of the rise in the frequency and severity of financial former centrally planned economies of Europe crises in recent years. As a result income and the former Soviet Union. Among the inequality has arisen. Comia and Court (2001) transition countries of Central Europe, there were reports that financial crises raised inequality 73 moderate changes in income inequality due percent in Latin America and 62 percent in Asia. probably to the preservation of the welfare state In a recent study by Figini and Gorg (2006), the system. In the former Soviet Union countries and effect of financial liberalization is found to differ in south-eastern Europe, income inequality rose in developed and developing countries. Wage by an average of 10 to 20 Gini points, and the inequality increases with inward foreign direct population in poverty increased from 14 million in investments in developing countries, whereas it 1989 to 147 million in 1996. This is mainly decreases in developed countries. explained by taking away of the factors that iii. Technological change previosly assured a higher equality consisting of New technologies generate a demand for the of assets, reduced restrictions on skilled labor which favors higher-skilled workers earning differentials and a rising share of self- over lower-skilled ones and leads to increasing employment including the black market wage differentials between them. New (Milanovic, 1998). technologies also tend to replace labor and These are the main explanations for changes thus the functioanal distribution of increasing inequality in the last two decades in income. In developing countries, this effect is evident through the industrialization process in most of the countries. Despite the feasible which a shift occurs from agriculture and labor- mechanisms available to raise income equality, intensive manufacturing to skill-intensive globalization seems to restrict the ability of the manufacturing (e.g. Taiwan, Province of China, governments to practice redistributive policies Thailand). In developed countries this takes place because of the feared impact on competitiveness, in high-tech industries ( Cornia and Court, 2001; trade and capital movements. The situation in Acemoglu, 2002). each country depends on specific country iv. Changes in labor market circumstances and policy mixes. There is some scope in each country for policy towards increased During the 1980s and 1990s there was a equality and growth, reduced poverty with more shift in policy towards greater wage flexibility, stable social and political environment. reduced regulation, erosion of minimum wages, 92 Alpaslan İSAGİLLER

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