No. 119 ECONOMIC GROWTH AND INCOME INEQUALITY: THEORETICAL BACKGROUND AND EMPIRICAL EVIDENCE Cesar Gallo 2002 Working Paper No. 119 ISSN 1474­3280 ECONOMIC GROWTH AND INCOME INEQUALITY: THEORETICAL BACKGROUND AND EMPIRICAL EVIDENCE Cesar Gallo 2002 Development Planning Unit University College London 9 Endsleigh Gardens London, WC1H 0ED [email protected] 2 ECONOMIC GROWTH AND INCOME INEQUALITY: THEORETICAL BACKGROUND AND EMPIRICAL EVIDENCE CONTENTS 1 Introduction 4 2 The Theoretical Background 5 2.2 Inequality 5 2.2.1 Inequality in Income Consumption Or Wealth? 6 2.2.2 Definition of Income 7 2.3 Economic Growth 8 2.3.1 The Lewis’ Model 10 2.4 Income Distribution 12 2.4.1 General Theories of Income Distribution 12 2.4.2 Theories Of Size Income Distribution 14 3 Economic Growth and Income Inequality: The Empirical Evidence 17 3.1 The Kuznets’ Hypothesis 17 3.2 The Debate About The Inverted­U Hypothesis 18 3.3 The Effect on Poverty 19 3.4 The “U­Turn” In Developed Countries 21 3.5 Income Inequality As a Cause Of Economic Growth 22 4 Conclusion 25 References 27 Endnotes 33 3 ECONOMIC GROWTH AND INCOME INEQUALITY: THEORETICAL BACKGROUND AND EMPIRICAL EVIDENCE 1. INTRODUCTION All sciences should be aimed at providing the expense of one of the two productive humanity with a better quality of life. The factors, thus yielding economic classical economists were concerned with inefficiency. The concern was mainly with this objective of Economics as a science. the factor distribution of income, as it was According to Adam Smith (1884), no in classical economics. The division of society can be flourishing and happy, of national income between wages and which the far greater part of the members profits tells nothing directly about how are poor and miserable. David Ricardo incomes are distributed among people, placed the distribution of income at the which is usually understood as the centre of his thought when he stated that problem of income distribution. Political Economy should be aimed at The 1990s witnessed the re­ determining the laws that rule the incorporation of income distribution into distribution of income (Bigsten, 1983; the main body of economic analysis, Ferrán, 1997, Atkinson, 1997). Hartwell although economic growth still remained (1972) goes further in arguing that the ultimate objective. According to the “Economics is, in essence, the study of 1998­1999 Inter­American Development poverty” (p. 3). Bank report (IADB, 1998­1999), the However, this primary objective central argument behind this is that high seems to have been lost many times along inequality in income distribution can slow the history of economic thought. For down the pace of the accumulation of much of the last century, the subject of physical and human capital, which are the income distribution has been absent in the main sources of economic growth. Thus, agenda of economic theory and policy the main concern is that a poor income (Atkinson, 1997). Recent history has distribution harms economic growth. If witnessed changes in perception about the common welfare were the ultimate ultimate nature of the economic activity. objective, economists should be During the 1970s, in the developed world, concerned also with the effects of there was a growing concern with the quality of life, and which was manifested in economic growth on income distribution. protests against the consequences of An undesirable economic growth is one economic growth, such as pollution and which increases income inequality and depletion of natural resources. In the widespread poverty leading to social developing world the main concern was tension and political discontent that focused on the relationship between jeopardises the well­being of society. economic growth and income distribution, The elimination of widespread since many countries that had poverty and growing income inequality are experienced growth rates above their two of the main problems of development, historical standards realised that such and should be the principal objectives of growth seemed to have negatively development policy. However, the affected the income distribution, leading to problem of the distribution of income has increased inequality and a failure to relatively received little scientific study. eliminate, even reduce, the level of This paper reviews the theories that have poverty (Todaro, 1994). been developed on the subject and The revival of neoclassical discusses the empirical work on the economics during the 1980s, in a context relationship between economic growth and of a debt crisis that particularly affected income distribution. Section 2 is devoted Latin American countries, once again put to introducing the theoretical background, economic growth at the forefront of the while Section 3 presents a literature debate. It was becoming the ultimate review on what the empirical evidence objective of economic activity, despite the says about the relationship between fact that inequality was increasing and the growth and inequality. Section 4 poverty problem was worsening. summarizes a set of conclusions. According to the neoclassical perspective, any redistribution would be at 4 2. THE THEORETICAL BACKGROUND with social welfare. In this common usage the term embodies some sort of value There are three main concepts involved in judgement about fairness which will differ the debate presented in this paper that according to different ethical viewpoints. must be discussed: inequality, economic Debates on subjects such as the growth, and income distribution. relationship between inequality among Inequality is a multidimensional individuals and social welfare, fairness in concept. The discussion given in this the distribution of wealth, levels of paper refers to one of those dimensions: inequality allowed without being offensive the inequality in the distribution of income. to society, can not avoid some ethical Sub­section 2.2 discusses this concept, arguments. the different approaches to measure Naturally, these arguments are also inequality, and the definition of income. present when regarding the measurement Sub­section 2.3 gives a quick overview of issue. According to Sen (1973) there are the theories of economic growth and their broadly two categories of inequality extensions which helps to understand the measures. On the one hand those which possible connections between economic try to catch the extent of inequality from an growth and income distribution. objective point of view, using statistical However, these connections can measure of relative variation of income, only be seen in the light of the theories of and on the other those that try to measure income distribution. How the total income inequality in terms of some normative generated in a society is distributed notion of social welfare which introduces among its members and what determines the complication of ethical valuations. The such distribution have been questions problem is that there is not a clear line placed at the top of the debate in some drawn delimiting the two approaches. periods in the history of the economic "Even if we take inequality as an objective thought and relegated to the background notion, our interest in its measurement during others. The dominant ideas in a must relate to our normative concern with specific period are linked with those in it, and in judging the relative merits of former periods, even in times when different objective measures of inequality, revolutionary changes have occurred. it would indeed be relevant to introduce Therefore, having knowledge of the main normative considerations. At the same ideas about the distributive problems time, even if we take a normative view of developed in the past contributes to a the measures of income inequality, this is better understanding of the current not necessarily meant to catch the totality theoretical debate on income distribution. of our ethical evaluation" (Sen, 1973, p. 3). This is the subject of Sub­section 2.4. But the problem goes even beyond this point. It has been said earlier that inequality is about comparison. What one 2.2 Inequality would want to compare is the living In any context the concept of inequality standard of each individual in a specific refers always to comparability between society. Unfortunately, no agreement has elements. The comparison is usually been achieved among social scientists based on specific characteristics which about what exactly the standard of living of can be measured using adequate indexes an individual means and how to measure or indicators. Thus, the fact is reduced to it. The controversies arise not only from comparisons between quantities and the different ethical points of view of those inequality will relate to differences in these who want to measure the extent of quantities. In these terms, inequality inequality, but also from the difficulties in seems to be a straightforward concept capturing accurately the person's well­ which, as Cowell (1995) states, being. As reflected by Sen, "obviously" suggests a departure from the simple idea of equality, this is, the fact that You could be well off, without being well. two or more quantities are the same size. You could be well, without being able to However, difficulties arise when the lead the life you wanted. You could have concept is framed into the social context got the life you wanted, without being and in connection with economic happy. You could be happy, without having much freedom. You could have a problems. In this context, the concept is good deal of freedom without achieving generally related to differences in income, much (Sen, 1985, p. 1., quoted by consumption or wealth and associated 5 Goodman, Johnson, and Webb 1997, p. are sometimes used to compensate the 11). weakness of income or consumption based measures in capturing adequately Then, it seems quite unlikely to find many aspects of well­being. Some of out a single index able to provide a full those indicators are life expectancy, infant description of living standard as this mortality, nutrition, the proportion of outlined by Sen.