Inequality and development

Inequality, savings, income and

growth
One possible way in which inequality might
affect income is through the overall level of
savings (and the related investments).
This consideration has been used to justify the
existence of moderate or high inequalities in
income distribution, as these would have
concentrated money in the hands of those
willing to save and invest, boosting growth.
This however is only one side of the story. It
might be true that a certain degree of
redistribution can enhance savings and push up
growth rates.
Inequality, savings, income and
growth: marginal saving rates
The final effect will depend on the
marginal saving behavior of the individuals
involved:
With increasing marginal saving rates
inequality increases savings;
With decreasing marginal saving rates
inequality decreases savings.
If marginal savings rates are unaffected by
income, inequality will have no effect on
economywide savings.
Inequality, savings, income and
growth: marginal saving rates
Total
Savings
Income
Subsistence
Conspicuous
consumption
Inequality, savings and growth
Given the complexity of the relation between
inequality and the rate of savings, we migh face
a trade-off (especially in very poor societies)
betwen the pursue of egalitarian policies and
objectives in terms of savings and growth.
In medium-income countries this might be very
different with redistributive policies and
objectives in terms of growth going in the same
direction.
Income, savings and the evolution
of inequality
Depending on initial historical conditions of
economic inequality, a society might
evolve in very different long-run patterns.
Low inequality: this level might be sustainable
over time (common savings behavior);
High inequality: for many groups in society
there is a difference between desired
standard of living and actual standard of
living. inequality could be preserved or
widened over time.
Income, savings and the evolution
of inequality, cont.
Savings
rate
Shortfall
In contrast to standard models of economic growth, savings behavior is not only
determined by income but by income and aspirations, depending on existing
inequalities of income and wealth.
Thus, the SAME society can end up in potentially very different outcomes (even
without intrinsic differences in technology or preferences) E.g. Possibility of low-
income trap for the poor.
Rich Middle Class Poor
Desired standards of living,
income and savings rates
Inequality, political redistribution
and growth
We have seen that inequality can be harmful for growth if
the middle class has a higher marginal savings rate than
the rich or the poor.
There is a second possible way in which large
inequalities can be harmful for growth (Alesina and
Rodrik, 1994; Persson and Tabellini, 1994): through the
arising of political demands for redistribution leading to
taxes on increments to the stock of wealth.
Why should there be such political demands?
It is likely that the first request might be of redistributing existing wealth
among the broader population (e.g. land reform). However, the
creation and implementation of such policies as confiscation would
require exceptional political will and availability of data and
information. It would still be possible to try to disguise or parcel out
wealth. Faced with these difficulties, it might be easier to move to
taxing the increments to the stock of wealth.
Inequality, political redistribution
and growth, cont.
Taxing the increments to the stock of wealth
tends to bring down the rate of investment and,
therefore, the rate of economic growth.

U
0
U
1
A
B
C
Consumption today
Compare B (tax on
investment returns) with C
(lump-sum tax).
The price effect (in B) tends
to lower the rate of saving
and investment (lower
consumption tomorrow)
Inequality and growth: evidence
Lack of adequate data.
Problem with use of contemporaneous data on
inequality and growth (endogeneity) we need data
on inequality at the START of a relatively long time
period.
Which proxy?
Would like inequality of wealth or assets at the
beginning of the period (hard to find)
Proxies:
income (imperfect, one flow, while wealth is sum of all
previous flows);
Land (distorted, especially where there are land ceilings
falsified data; moreover, it is a good proxy only if agriculture
is important or has been important recently - in the
economy)
Inequality and growth: evidence,
cont.
Alesina and Rodrik (1994):
regressing per capita income growth (1960-1985) on a
variety of independent variables including initial per
capita income and a measure of initial human capital. In
addition they included data on initial inequality of income
and initial inequality of land.
Substantial negative relationship between initial
inequality and subsequent growth, particularly looking at
the impact of the Gini coefficient representing the initial
inequality in LAND holdings (increase in land Gini
coefficient by 1 standard deviation leading to decrease of
economic growth of 0.8% per year).
Results do not change once we allow for structural
differences across democratic and nondemocratic
political systems (moreover, dummy for democracy not
significant).
Inequality and growth: evidence,
cont.
Deininger and Squire (1996):
Initial land inequality is more significant than initial income
inequality and stays even under several variations;
Insignificance of the political system;
Summarizing
These results suggest a possible explanation of high rates
of investment in Korea and Taiwan. Early land reforms
placed them among the lowest in land inequalities (0.34
and 0.31 vs. over 0.5 for India and Philippines and above
0.8 for Brazil and Argentina) and promoted equality
overall (agriculture was still very important in the 60s).
there might be a robust and negative empirical
relationship between inequality and subsequent
growth
Inequality and demand composition
Another possible way in which inequality might be
affected is through demand composition.
The intuition is the following. Whatever our initial
inequality might be, its evolution will depend by the
pattern of consumption of members of the society.
For example, in the case of high inequality, there might be a
trend towards the reduction of inequality if the rich demand
goods produced mainly by individuals of the poor class, thereby
increasing their income. The opposite would be true if demand
went to goods produced mainly in ways (for example with high
capital intensity or by a limited number of specialised individuals)
benefiting the mainly the rich class.
Other examples: England and US in manufacturing during the
19th century; US government services during the two world wars
and Great Depression.
Inequality, capital markets and
development
If capital markets were perfect, an individuals wealth
would not influence the amount of credit obtainable for
consumption or investment, as long as repayment was
feasible.
However, when default becomes feasible, borrowing
money requires leaving to the lender some valuable
asset that will be lost in case of default (to reduce default
incentives and communicating credibility of repayment).
In unequal societies the poor might lack access to credit
markets exactly because they lack the necessary
collateral. This might prevent them from:
Starting a small business;
Educate themselves of their children;
Buy inputs (land to cultivate);
Smooth out consumption.
Occupational choice and the credit
constraint: a simple model
Three categories: subsistence producers (z); industrial
workers (w); enterpreneurs (hires industrial workers,
needs a loan to start).
Startup cost: I
Business consists of hiring m workers to produce q.
Profit is equal to q-wm. It the loan is repaid at an interest
rate r, then the net profit is:
(q-wm)-(1+r)I
Given this information we can determine whether an
individual with a given starting wealth W will be able to
obtain a loan to start an activity.
If the enterpreneur puts his wealth as a collateral, at the
end he will have the choice between reimbursing I(1+r)
or losing W(1+r).
Occupational choice and the credit
constraint: a simple model, cont.
The expected cost of default is some fine F and a fraction of the
profits from your business. is only a fraction as you might not be
caught and your profits might not be ALL seized. Therefore, the
loan will be repaid if
I(1+r)W(1+r)+F+ {q-mw(t)}

That is

Individuals who start with a wealth lower than the critical level W
are, therefore, unable to become entrepreneurs whether they
want it or not.
NOTE: the smaller F and (low probability of getting caught and
low penalties), the larger will the critical level. For F and =0, you
can be entrepreneur only if you can finance completely your
investment.
( ) { }
r
t mw q F
I W
+
+
>
1

Inequality, capital markets and

development, cont.
A missing or imperfect credit market for the poor is a
fundamental characteristic of unequal societies, with
potentially severe macroeconomic implications.
A situation in which the lack of a large amount of wealth
prevents individuals from becoming entrepreneurs has a
double negative effect:
On the individuals themselves, who could improve significantly
their condition and have to remain poor;
On the society, where other individuals might have been hired by
the new entrepreneur.
This means that market equilibrium under high inequality
is inefficient, as it could be possible to improve the
condition of some individuals without damaging anybody
else (pareto improvement).

Inequality, capital markets and
development, cont.
The inefficiency is not restricted only to high
inequality regimes, but with sufficient equality it
will go away.
There is no innate tendency for inequality to
disappear over the long run. In a situation where
the poor cannot accumulate enough wealth to
become entrepreneurs, inequality tends to
perpetuate itself, unless changed by government
policy such as asset redistribution. This means
that two countries with the same parameters of
production and preferences may never converge
in terms of wealth distribution and output levels.
Note: see chapter 7, Ray.
Inequality and development:
human capital
As we have seen, inequality has a built in tendency to lead
to inefficiency, because it does not permit people at the
lower end of the wealth or income scale to fully exploit their
capabilities (Ray, p. 237)
Inequality prevents the buildup of adequate human capital.
The marginal cost of education for the poor may be too
high, especially as they have to finance educational choices
out of retained earnings, wealth or abstention from currently
productive work.
For the society it would be efficient to transfer money from
the rich to the poor. The outcome would be more than
sufficient to compensate the rich. However this particular
credit market is missing, as loan repayment might be
impossible to enforce.
Inequalities in education also operate to reinforce the initial
differences in inequality. Again, there is no tendency for
inequality to disappear over the long run.