Causal Link between Growth and Inequality in Theory - Essay Example

? Inequality and Growth Contents Contents 2 Causal Link between Growth and Inequality in Theory 3 Empirical Evidence of the Causal Link between Growth and Inequality 10 Case Study on the Basis of OECD Countries 13 Works Cited 19 Name of the Student Name of the Professor Course Number Date Inequality and Growth Causal Link between Growth and Inequality in Theory In the contemporary world, the state of economic affairs in the nations is run by the mixed economic principles. The public and the private authorities constantly try to enhance the level of economic development and growth in the nations. At present, one of the primary tasks of the governments of every country is to simply impose certain policies that would help to augment the income levels and standard of living of all the individuals of the society. The political parties in most of the economies try to enhance the lifestyle of the individuals through economic growth and income redistribution in the market. Redistribution of income and raising the standard of living in society are mutually exclusive goals of the government. Figure 1: Economic Growth (Source: Scully, “Economic Freedom and the Trade-off between Inequality and Growth”) The economic freedom of a country is directly proportional to the level of economic growth in it. Figure 2: Income Inequality (Source: Scully, “Economic Freedom and the Trade-off between Inequality and Growth”) On the other hand, the level of income inequality is desired to fall with the rise in the level of economic freedom and hence, economic growth. However, there is a strong debate regarding the relationship between income inequality and income growth. Economic Inequality is the discrimination among individuals in terms of income or wealth. It basically elaborates the differences among the individuals of a society in terms of their income, wealth and assets. Income Inequality can either be absolute or relative. Absolute income is the gross income received by the individuals. John Maynard Keynes states that the consumption expenditures of individuals are estimated on the basis of absolute income. Thus, absolute income inequality is the income inequality that denotes the differences in gross income thresholds of the individuals. James Duesenberry claimed that savings and consumption spending decisions of the individuals do not depend on the level of absolute income. Instead, it depends on the relative income level. The savings and consumption expenditures of the individuals are made by them after analyzing their position of income relative to others. Relative income inequality would occur when the absolute income levels would be unevenly distributed in an economy (NBER). Among all the methods, the most important method of measuring income inequality is Gini Coefficient measurement method. This measure estimates the statistical dispersion of income distribution of a nation. The value of income inequality on the basis of a frequency distribution is given by the Gini Coefficient. The value of this index lies from 0 to 1. Where, 0 indicates a situation of perfect income equality and 1 indicates a situation of perfect inequality of income. The diagrammatical representation of a Gini Coefficient is provided is a Lorenz Curve. Figure 3: Lorenze Curve Perfect Income Equality Line Income Inequality Cumulative % of Income Lorenze Curve Cumulative % of Population (Source: Authors Creation) The above graph is of a Lorenze curve (the convex curve). The distance between the perfect income equality line and the Lorenz curve measures the degree of income inequality. Therefore, greater the distance, greater is the level of inequality. The above coefficient is calculated by: It is believed that a greater extent of inequality in income in a nation implies the concentration of economic power in the hands of a small group of individuals. In such a situation, the producers in the market get tempted to allocate resources to luxuries and comfort products, instead of basic necessities. The lack of basic necessities reduces the net social welfare in the economy and finally, diminishes its long run growth. Thus, it is highly rational, on behalf of the policy makers in a nation, to take active steps to reduce the income inequalities in their economies. A low income inequality of a nation depicts a good status of its social welfare function. This is a function that ranks the different social states in terms of more desirable, less desirable or indifferent (for all the possible pairs of social status). This theory is analogous to the consumer theory. It maps the preference of an individual as the representation or judgement of the whole society (Benhabib). However, there are also other measures of income inequality. Some are one-dimensional while the others are multidimensional. Figure 4: Measures of Income Inequality (Source: PPT) The answers always vary for the different measures of income inequality. Economic growth of a nation is actually the growth of the Gross National Product (GNP) of a country. This is the measurement that denotes the aggregate value of final goods and services produced by the nationals of a nation, either within their own domestic territory or across the international borders (Heshmati). When the causal link between the income inequality and a nation’s economic growth is analyzed, the results are highly contrasting in case of developed and developing nations. It has been analyzed that high level of inequality in income enhances the growth levels of relatively poor countries, but it encourages the growth of richer economies. This analysis of the causal link is established by following the theory stated by Simon Kuznets. The Kuznets curve is a “U” shaped curve that states that income inequality first increases and then decreases in the process of economic enlargement. This explanation was made by assuming that economic development takes place in a nation as it transforms from an agricultural to industrial sector. Figure 5: Kuznets Curve (Source: Park, "Comparison of Income Inequality Measures") This theory explains that at the stage of industrialization, as the economic system of a country transforms itself from an agrarian to an industrialized state, then at the initial stages, the rural urban gap of income expands. However, in the later stages of development, the income gap reduces as the rural sector gains wealth by becoming industrialized. Thus, the theory state that income inequality reduces growth in developing (industrializing) nations, unlike the case of developed nations (where the situation is opposite) and this is proved by the Kuznets Analysis. The theory is also proved by the Barro analysis that states that in the initial stages of development, the rural sector of a nation uses old unproductive technologies. This is the reason for which they generate low income and hence, experiences high income gap with the urban sector. On the other hand, when the nation starts to grow, modern technologies are first practiced by the rich sections only and not by the poor classes. This is the situation when the income inequality in the country increases. However, over time, the fruits of the modern technologies are also reaped by the poorer sections and hence, the level of inequality between nations reduces. Therefore, both on the basis of Kuznets and Barro analysis, it can be stated that the causal link between growth and income inequality is negative for the developing (poorer) nations. On the contrary, the precise nature of relationship between growth and income inequality becomes ineffective for developed (rich) nations. This is because initially the growth levels of the developing nations are low. The degree of income inequality in these countries remains high until the economy’s industrialization process is complete (Kuznets analysis). Simultaneously, the fruits of technological process are only enjoyed by a certain class of rich individuals. A large section of individuals’ per person income levels in these nations remains low. High inequality of income in these economies results in misallocation of resources. As a result, the manufacturers in the economy primarily engage in the production of non-necessary products that are demanded by the small rich sections of the society. A large section of poor individuals in the nation does not get to access the basic necessities and hence, transforms into inefficient human capital. Finally, in such a situation, when the developing nation comprises of a substantial share of individuals, whose skills are highly unproductive, then the growth rate of the economy of the country, in terms of productivity, significantly falls. This shows that the simple casual link between growth and income inequality is negative in developing or poorer nations, where the high level of income inequality of these nations dampens the growth rates. On the other hand, the levels of income inequality in the rich developed nations are already very low. These are the countries that show low growth rates as their economies remain almost saturated in terms of growth potentials. The economies of these nations already experience high income thresholds, thus, the growth rates remain low. The average per person income levels of these nations is already high. Here the low level of income inequality cannot affect the growth rates significantly. Thus, in case of such rich economies, the existing low level of income inequality cannot disturb the growth potential. At this stage, income inequality and growth becomes almost unrelated and the former cannot hamper growth (Wildman and Jones). Empirical Evidence of the Causal Link between Growth and Inequality This section of the essay would provide the empirical analysis of the causal relationship between growth and income inequality in the real world. It is found that in the real world, there are a lot of cases where the Barro and the Kuznets theory are proved wrong. The East Asian Miracle has proved that the theory of Kuznets is not always correct. Countries in East Asia like Taiwan, Japan, South Korea, Hong Kong and Singapore, were industrializing at a rapid rate during 1965 to 1990. It was assumed that the health status of these nations was also improving with the degree of industrialization. The average life expectancy of the country’s individuals was rising and the percentage of individuals living above the level of absolute poverty was also increasing. According to the Kuznets analysis, the income inequality of developing or relatively poorer nations should have increased during the initial stage of industrialization. However, the falling level of income inequality, along with the rising rate of industrialization, proved that the analysis made by Kuznets was not very correct. In reality, it has been analyzed that there exists a strong link between income inequality and growth, but the degree of exact nature of causality between the two facts are highly complex in nature. Economists have conducted several statistical tests like, the Granger Causality test, to find the empirical causal link between income inequality and economic growth. A study of nine countries, from the year 1960 to 2011, was conducted for this purpose. In order to get the test results, the indicators that were used are: GINI index Openness rate in terms of trade (Trade) Secondary ratio for school enrolment (School) Gross fixed capital formation as a percentage of GDP (GFCF) The derived results are given in the following table. It was also claimed that the time series data was made stationary with the help of Unit Root Test. Figure 3: Results of the Test (Source: Jihene and Ghazi, “The Causality between Income Inequality and Economic Growth: Empirical Evidence from the Middle East and North Africa Region”) Test Results It was found statistically that there existed a long run relationship between growth and income inequality. However, the short run linkages are unstable. In the cases of three countries (Iran, Morocco and Israel), the test error correction terms were significant and confirming, thereby claiming that the consequences of income dissimilarity in long-term monetary growth was positive. For most of the countries, the causality was unidirectional, but for Turkey, it was a case of reverse causality. Iran, Tunisia and Morocco experienced a bilateral causality between income inequality and growth. The Johanson test of co-integration claimed the long run growth of an economy is never positively related to income inequality. However, there were some nations that experienced income inequality after attaining high growth rates. Some nations do have bilateral causality with each other. On the whole, the precise nature of causation between income inequality and growth rate of a nation depends on the nature of policies undertaken by the public authorities. It is not always necessary that the two variables would be negatively linked in case of poorer nations and opposite for rich economies. This is because in reality growth and income inequality are factors that are influenced by a large number of other independent variables. Case Study on the Basis of OECD Countries The paper generally deals with a case study where the Prime Minister Strategy Unit in the latest report of OECD mentioned that “high level of income inequality is harmful for growth”. However, the empirical volatility of the precise nature of causation among the two factors highly confused the officer regarding the validity of the statement. The Organization of Economic Cooperation and Development (OECD) is an international organization formed by a group of 34 nations. This organization was formed in 1961 with the intension of stimulating economic growth in these nations and improving the level of world trade. It is a platform where these economies can restore and analyze the policies that can be implemented in their respective economies to achieve a greater growth level. Figure 4: Gini Coefficients in OECD Countries (Source: PPT) The above graph explains the Gini Coefficients of the OECD countries in mid-90s and late 2000s. Except Turkey, Mexico and Chile, the level of inequality have not reduced largely in any of the nations. Rather in some countries like, Denmark, Canada and Israel, the level of income inequality have relatively increased in later 2000 than earlier. The property market price bubble in some of the member countries of OECD had generated a Global Financial Crisis in at around 2007 to 2009. It has been noted that the real disposable level of per person household incomes of almost all the OECD countries have increased, the rise was almost 1.7% on average. However, survey data have claimed that the rise in the income level of the top 10% rich individuals in these nations have occurred at a faster rate than the rise in the income level of the poorest 10% individuals. This proves that the extent of income inequality or gap between these nations have increased significantly, over time. In countries like, Israel and Japan, the decrease of income level of the poorest 10% individuals is noted to be higher that the fall of income in 1980. The following table explains the trends in the income distribution changes in the OECD countries for the top and the lowest 10% individuals (in terms of income groups). Figure 5: Changes in the Income Distribution (Source: OECD, “Growing Income Inequality in Oecd Countries: What Drives It And How Can Policy Tackle It”) Considering the above graph, it can be claimed that on an average, the income inequality of all the OECD countries have increased with time. This is because the rise in the income of the top 10% individuals, on average in all these countries, has been 2% and on the other hand, the rise in the income level of the poorest 10% income groups in these nations were only 1.4%. Thus, on average, the income group of the OECD countries was .6%. Figure 6: Income Inequality of the OECD Countries (Source: OECD, “Growing Income Inequality in Oecd Countries: What Drives It And How Can Policy Tackle It”) The above figure shows that, in most of the OECD countries, the level of income inequality has increased. Only in Turkey and Greece, the income inequalities have decreased. There have been little changes in the level of income inequality in France, Hungary and Belgium. It has been analyzed that the extent of income inequalities in these nations increased primarily due to differentials in wages, capital incomes and employments. It has been claimed that the rise in the level of self-employment in these nations has fostered the degree of income inequality in their economies, by increasing the percentage of the low income group individuals. It has been noted that rises in the income inequality levels of the OECD countries have occurred at times when the level of growth had sustained in these economies. It became a matter of concern to analyze the reason for which the fruits of growth could not be experienced by all the sections of the society. With the emergence of globalization, the growth of nations had been skill-based in nature. The higher degree of technological progress and institutional reforms has been largely responsible for the rise in the income discrepancies between the nations. Rather, the changes in the family and household structural levels have also influenced the income inequality in these nations. The tax and beneficiary systems in these nations have also affected the degree of income inequality in these nations. On the basis of the Traditional Trade Theory, the rise in the trading activities in nations augments the wage rates of skilled labourers in the rich economies, thereby augmenting the level of income inequalities in these nations. On the contrary, it decreases the level of income inequalities in the low income nations (William Shepherd and Joanna Shepherd 132). Thus, the rising level of income inequality in the OECD countries is actually caused due to rise in the trading activities and hence, the growth levels in these nations. The growth thresholds of these countries, associated with the rising trading activities, have augmented the degree of outsourcing activities in these nations, which have generated disproportionate loss in the skilled occupation levels of these nations. Rather, higher degree of trade has increased the state of technologies in OECD countries which could not be used by certain group of individuals, thereby increasing the income inequality. It was stated in an OECD meeting in 2007 that “technical change is a more powerful driver of increased wage dispersion than increased trade”. Conclusions of the Prime Minister Strategy Unit After the analysis of the above context, it would be correct to conclude that the PM was wrong in commenting that “high level of inequality is harmful to growth”. It should be observed that higher growth levels associated with increased trading activities of the OECD nations have augmented the level of income inequality in the economies. At this juncture, it is the duty of the state to redistribute the concentrated resources in these economies and hence, lower the income inequality levels to assure long-term sustainable growth (OECD 222). Works Cited Benhabib, Jess. “The Tradeoff Between Inequality and Growth.” Department of Economics, New York University, 2003. PDF file. Web. 23 December 2013. Heshmati, Almas. “The Relationship between Income Inequality and Globalization.” The United Nations University, 2003. PDF file. Web. 23 December 2013. Jihene, Sbaouelgi, and Boulila Ghazi. “The Causality between Income Inequality and Economic Growth: Empirical Evidence from the Middle East and North Africa Region.” REPEC, 2013. PDF file. Web. 23 December 2013. NBER. “Inequality and Growth.” NBER, 2013. Web. 23 December 2013. OECD. “Growing Income Inequality In Oecd Countries: What Drives It And How Can Policy Tackle It?” OECD, 2011. PDF file. Web. 23 December 2013. OECD. OECD Regions at a Glance 2009. Paris: OECD Publishing, 2009. Print. Park, Kang H. "Comparison of Income Inequality Measures." Studies in Economics and Finance, 8.2 (1984): 35 – 58. 1984. Web. 23 December 2013. Scully, Gerald W. “Economic Freedom and the Trade-off between Inequality and Growth.” NCPA, 2008. Web. 23 December 2013. Web. 23 December 2013. Shepherd, William, and Joanna Shepherd. The economics of Industrial Organization: Fifth Edition. Canada: Waveland Press, 2003. Print. Wildman, John, and Andrew M. Jones. “Is It Absolute Income or Relative Deprivation that Leads to Poor Psychological Well Being? A Test Based on Individual-Level Longitudinal Data.” JEL, 2009. PDF file. Web. 23 December 2013. Read More