Economic growth and inequality.

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INTERNATIONAL ECONOMICS ADVANCED

PROJECT REPORT OF “ ECONOMIC GROWHT AND INEQUALITY “

REPORTER;

H. KUBRA BAYRAM

LECTURER;

PROF. TAMBERI, MASSIMO

Politecnico delle Marche, January – 2014

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CONTEXT

1. INTRODUCTION

2. WORK’S GUIDELINE

3. DEFINITION OF VARIABLES

3.1. Central Government Debt, Total ( % of GDP )

3.2. Foreign Direct Investment, Net Inflows ( % of GDP )

3.3. GDP per capita ( constant 2005 US$ )

3.4. GINI Index

3.5. Gross Capital Formation ( % of GDP )

3.6. Labor Force with Secondary Education ( % of Total )

3.7. Research and Development Expenditure ( % of GDP )

3.8. Internal Direct Investment

4. CONNECTION BETWEEN RATE OF GROWHT AND INDEPENDENT VARIABLES

5. CONCLUSION

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“ The causes which destroyed the ancient republics were

numerous; but in Rome, one principal cause was the vast

inequality of fortunes. “ - Noah Webster

1. INTRODUCTION

This report aims that explaining concept of economic inequality and its effects on

economic growth of countries. In this project, we focused on some particular economic

variables to explain their relationship with economic growth by analyzing for 73 countries in

order to period of 1993 – 2013. These variables consist of rate of growth (dependent variable),

central government debt, foreign direct investment, GDP per capita, GINI index, gross capital

formation, labor force with secondary education, research and development expenditure and

finally internal direct investment (independent variable). In next sections of the report, we

will explain more deeply each of these variables to understand better of their impacts on

economic growth.

So, what is the economic inequality ?

We can define economic inequality ( also described as the gap between rich and poor,

income inequality, wealth disparity, wealth and income differences of wealth gap ) is the

state of affairs in which assets, wealth, or income are distributes unequally among individuals

in a group, among groups in a population, or among countries ( Ref. Wikipedia ). There is a

great relation between economic inequality and economic rate of growth in all parts of the

world. According to reports of World Bank, we can indicate that huge differences in income

distribution affects to economic growth of the countries negatively, especially Latin American

and Asia Pacific countries.

There is dramatic extent of economic inequality within and between countries. In 2000 the

richest country in the world, Luxemburg reached a per capita gross national income level

more than 90 times that of the poorest Sierra Leone. In 1998, the average consumption level

of the richest 10 % of Zambians were 37 times those of the poorest 10 %. In 1990, in India 56

% of those aged 15 years and above were illiterate, while the 3,6 % that had attended tertiary

education had received around 16 % of the total bumper of person years of formal education.

In addition that, we can say that according to the economic indicators, inequality within

and between countries has been increasing over the last two decades. So, in the next steps of

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the report, we will explain clearly linkages among the rate of growth and economic variables

to see how they connect each other.

2. WORK’S GUIDELINE

The aim of this report is to analyze the relationship between rate of growth and inequality

in many countries, taking into account relatively short period of 20 years (from 1993 to 2013).

About the data, we have collected them from World Bank Databank archive that is the

primary source of information for economic indicators. Initially we have downloaded data for

all the countries of the world (214) but due to the lack of data for many of them, their number

have been reduced and our dataset in composed of 73 countries.

Our strategy is as follows: First, we choose a group of 8 variables that we think are relevant

to explain the rate of growth.

Second, we discuss the conceptualization of all variables at issue.

Third, after have collected and analyzed a huge number of data, we build a regression line

to better understand the relationship between variables and rate of growth. In particular we have

built 2 regression lines, slightly different in order to have the possibility to analyze variables

correlate to each other (ex. Gross Capital Formation regr.2; FDI and Internal Direct Investment

regr.1).

After that we concentrate our attention only on discussing reliable variables with t ≥|2|.

At the end we write our findings to explain what can be concluded through our analysis.

According to our approach of analysis, we thought the best variables that could be taken

into account for explaining rate of growth are:

1. Central government debt, total (% of GDP)

2. Foreign direct investment, net inflows (% of GDP)

3. GDP per capita (constant 2005 US$)

4. Gini Index

5. Gross Capital Formation (% of GDP)

6. Labor force with secondary education (% of total)

7. Research and development expenditure (% of GDP)

8. Internal Direct Investment(% of GDP)

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These variables are explained better in the following section.

3. DEFINITION OF VARIABLES

First of all we have to divide the variables into 2 main groups:

1. Dependent variable

Rate of Growth of GDP that is assumed to be dependent variable and it is computed

through this formula :

[(Gdp year 20/gdp year 1)^(1/20)-1]*100

“Annual percentage growth rate of GDP at market prices based on constant local

currency. Aggregates are based on constant 2005 U.S. dollars. GDP is the sum of gross value

added by all resident producers in the economy plus any product taxes and minus any

subsidies not included in the value of the products. It is calculated without making deductions

for depreciation of fabricated assets or for depletion and degradation of natural resources.

The main deduction we can make analyzing rate of growth of GDP is that GDP is

traditionally used to measure economic performance of a country so if his trend is positive,

we can assume that a country is growing and achieving a good economy; on the contrary if

the trend of GDP is negative, we can assume that a country is not improving his economy.

2. Explanatory variables

• Central government debt, total (% of GDP) :

“Debt is the entire stock of direct government fixed-term contractual obligations to others

outstanding on a particular date. It includes domestic and foreign liabilities such as currency

and money deposits, securities other than shares, and loans. It is the gross amount of government

liabilities reduced by the amount of equity and financial derivatives held by the government.

Because debt is a stock rather than a flow, it is measured as of a given date, usually the last day

of the fiscal year.”

More than the absolute value of the debt, an important indicator of financial and economic

stability of a State is the ratio of government debt to gross domestic product, because the GDP

in this case is an index of how a State is able to fix its debt through such taxation and related

tax revenue. In general a State may have a high public debt, but also a high GDP (ex. USA)

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without incurring in dangerous situations or financial insolvency risk, so the point is the

relationship and mutual development of the two values. We chose this variable to have a

better idea of what is actually the controversial relationship between debt and growth.

• FDI net inflows (% GDP) :

“FDI net inflows are the value of inward direct investment made by non-resident investors

in the reporting economy. Foreign direct investment is a category of cross-border investment

associated with a resident in one economy having control or a significant degree of influence

on the management of an enterprise that is resident in another economy. As well as the equity

that gives rise to control or influence, direct investment also includes investment associated with

that relationship, including investment in indirectly influenced or controlled enterprises,

investment in fellow enterprises (enterprises controlled by the same direct investor), debt

(except selected debt), and reverse investment.”

We choose FDI because of the growing influence of this form of investment on the economy

of each country, especially with globalization. FDI is calculated by the difference of new

investment inflows and disinvestment, divided by GDP.

• GDP per capita constant 2005 US $ (1993) :

“GDP per capita is gross domestic product divided by midyear population. GDP is the sum

of gross value added by all resident producers in the economy plus any product taxes and minus

any subsidies not included in the value of the products. It is calculated without making

deductions for depreciation of fabricated assets or for depletion and degradation of natural

resources. Data are in constant 2005 U.S. dollars.”

To analyze the impact of GDP on rate of growth we take into account the initial level of per

capita income of countries because, according to the catching up hypothesis, the initial level

of GDP can have strong influence on the rate of growth. In particular the catch-up effect consist

on the hypothesis that poorer economies will tend to grow at faster rates than richer economies.

As a result, all economies should eventually converge in terms of per capita income.

• GINI Index :

“Gini coefficient is a measure of statistical dispersion intended to represent the income

distribution of a nation's residents, and is the most commonly used measure of inequality.

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This coefficient that ranges between 0 and, 1 expresses perfect equality when it’s 0 (everyone

has the same income) and expresses maximal inequality when it’s 1 ( only one person has all

the income or consumption, and all others have none).”

For a given time interval, Gini coefficient can therefore be used to compare diverse

countries and different regions or groups within a country; can also be used to compare

income distribution over time, thus it is possible to see if inequality is increasing or

decreasing independent of absolute incomes. We have taken into account the average of Gini

index in the selected period of 20 years (1993-2013) for every country. Considering the

strong economic debate on these issues, these variables are analyzed in this report to better

understand whether inequality is bad or good for growth.

• Gross Capital Formation (%GDP) :

“Gross capital formation (formerly gross domestic investment) consists of outlays on

additions to the fixed assets of the economy plus net changes in the level of inventories. Fixed

assets include land improvements, plant, machinery, and equipment purchases; and the

construction of roads, railways, and the like, including schools, offices, hospitals, private

residential dwellings, and commercial and industrial buildings. Inventories are stocks of

goods held by firms to meet temporary or unexpected fluctuations in production or sales, and

"work in progress."

We choose this variable because the fluctuations in this indicator are often considered to

have strong relationship with economic growth. In times of economic uncertainty or

recession, typically business investment in fixed assets will be reduced, since it ties up

additional capital for a longer interval of time, with a risk that it will not pay itself off.

Conversely, in times of robust economic growth, fixed investment will increase, because the

observed market expansion makes it likely that such investment will be profitable in the

future.

• Labor force with secondary education (% of total) :

“Labor force with secondary education is the proportion of the labor force that has a

secondary education, as a percentage of the total labor force.”

We choose this variable to analyze how a high level of human capital can affect

economic growth. Because of data limitation we use secondary education instead of the

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tertiary one, in this way we have had the possibility to collect more data both from rich and

poor countries, where may have no available data for tertiary education.

• Research & Development expenditure (% GDP) :

“Expenditures for research and development are current and capital expenditures (both public

and private) on creative work undertaken systematically to increase knowledge, including

knowledge of humanity, culture, and society, and the use of knowledge for new applications.

R&D covers basic research, applied research, and experimental development”

We choose that variable because of the increasing importance of this expenditure by countries

to sustained productivity and technology improvements that are becoming necessary to modern

economic growth. Analyzing this variable we have to consider also that data for research and

development are more reliable considering a long-term period of growth and productivity.

• Internal Direct Investment (% GDP) :

That value is obtained through the difference between the Gross Capital Formation and

Foreign Direct Investment that are analyzed earlier. That difference is also divided for GDP

in order to make data useful and homogeneous with the other data.

We can define that variable like the amount of investment made by a country in the internal

territory at issues.

3. CONNECTION BETWEEN RATE OF GROWHT AND INDEPENDENT

VARIABLES

In terms of analysis relationship between rate of growth and independent variables,

we studied on two regressions model to show clearly correlation among the variables of

gross capital formation, foreign direct investment and internal direct investment. As we

know that meaning of gross capital formation is equal to accumulation of variables of

foreign direct investment and internal direct investment.

Gross Capital Formation ( % of GDP ) = Foreign Direct Investment + Internal Direct Inv.

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In the first regression model, we eliminated the variable of gross capital formation and

kept other two interrelated variables which are foreign direct investment and internal

direct investment to find impact on rate of growth together with other variables which are

included research and development expenditure, labor force with secondary education,

GINI index, GDP per capita and central government dept.

In the second regression model, we eliminated the variables of foreign direct

investment and internal direct investment by focusing on gross capital formation together

with other economic variables. In the next step of the report, we will explain impacts each

of these variables on rate of growth by indicating numbers on table and also on linear

graphs.

As we presented below, Table 1 shows that the regressions for economic growth.

Regression Model 1:

Y = Rate of Growth

X1 = Internal Direct Investment

X2 = R & D Expenditures

X3 = Labor Force with Secondary Education

X4 = GINI Index

X5 = GDP per capita

X6 = Foreign Direct Investment

X7 = Central Government Debt

Y = β0+β1.X1+β2.X2+β3.X3+β4.X4+β5.X5+β6.X6+β7.X7+ε

Y = β0 + 0,0661518.X1 + (-0,216420032).X2 + 0,009571458.X3 + (-0,042251023).X4 + (-

4,04989E-05).X5 + 0,167317.X6 + (-0,01578).X7 +ε

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Regression Model 2 :

Y = Rate of Growth

X1 = R & D Expenditures

X2 = Labor Force with Secondary Education

X3 = Gross Capital Formation

X4 = GINI Index

X5 = GDP per capita

X6 = Central Government Debt

Y = β0+β1.X1+β2.X2+β3.X3+β4.X4+β5.X5+β6.X6+ε

Y = β0 + (-0,32184).X1 + 0,01452.X2 + 0,064439208.X3 + (-0,04977).X4 + (-3,782E-

05).X5 + (-0,01652) + ε

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-0,042510235 -0,049768862 St.error ( 0,016306482) (0,016783349)

t (-2,606953215) (-2,965371398)

TABLE 1: Regressions for Economic Growth

Explanatory Variable ( 1 ) ( 2 )

GDP per capita -4,04989E-05 -3,782E-05St.error (1,99879E-05)

t (-2,026175673) (2,07742E-05) (-1,82052513)

Internal Direct Investment 0,0661518 _

St.error (0,028825549) t (2,294901633)

R & D Expenditure -0,216420032 -0,321838216 St.error (0,291075324) (0,300097366) t ( -0,743518994) (-1,072445986)

Labor Force with 0,009571458 0,014520321 Secondary Education St.error ( 0,007926923) (0,007964467) t (1,207461966) (1,823137925)

GINI Index

Foreign Direct Investment 0,167316599 St.error ( 0,04994903) _

t (3,349746749)

Central Government Debt -0,01578 -0,016569497 St.error ( 0,004621075) (0,00480713)

t (-3,41427877) (-3,446858661)

Gross Capital Formation _ 0,064439208 (0,030188345) (2,134572388)

R- squared

0,540015209

0,49284153 1,024782066 1,067864951

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Rat

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% )

a) Rate of Growth and Internal Direct Investment ( % of GDP ) :

As we see on Table.1, for the Internal Direct Investment, the coefficient is about

0,0661518, standard error that indicated by parenthesis is about 0,028825549, R^ 2 is

about 0,540015209 and t-value is about 2,294901633. According to our analysis, the

variable of internal direct investment has a significant effect on rate of economic growth (

t-value; 2,294901633 ). In addition that, as the linear graph shows us, most of individual has

correlation each other except for the countries of Azerbaijan and Madagascar. For these

two countries, the variable of internal direct investment hasn’t strong effect on rate

of growth.

Rate of Growht GDP

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5

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3

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-1 0 10 20 30 40

Internal Direct Investment ( Average % )

Rate of Growht GDP

Linear (Rate of Growht GDP)

b) Rate of Growth and Research and Development Expenditure ( % of GDP ) :

According to our analysis in terms of Research and Development expenditure, it has (-

0,216420032) coefficient value, standard error is 0,291075324, R^2 is 1,024782066 and t-

value is (-0,743518994). Thank to these values, we can indicate that Research and

Development Expenditure has negative effect on rate of economic growth for these analyzed

73 countries. In addition, this variable is not significant for rate of growth of the countries.

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Rate of Growht GDP

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-1 0 1 2 3 4

Rate of Growht GDP

Linear (Rate of Growht GDP)

Research & Development Expenditure ( Average % )

c ) Rate of Growth and Labor Force with Secondary Education ( % of total ) :

In term of variable of Labor Force with Secondary Education, coefficient value is

0,009571458, standard error is 0,007926923 and t-value is, 1,207461966. The variable of Labor

Force with Secondary Education is not significant and has not strong effect on rate of growth

of these countries. As the linear graph shows us, one group of countries which are included

Albania, Austria and Magadascar has not strong correlation with rest of other

countries.

Rate of Growht GDP

7

6

5

4

3

2

1

0

-1 0 20 40 60 80 100

Rate of Growht GDP

Linear (Rate of Growht GDP)

Labor Force with Secondary Educatication ( Average % )

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% )

R

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( A

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)

d ) Rate of Growth and GINI Index :

According to our analysis for variable of GINI Index, coefficient value is (-0,04251023),

standard error is 0,016306482 and t-value is (-2,60695321). So, we can explain that GINI index

has negative effect on rate of growth. And, as we see on the linear graph below, the

countries of Albania and Azerbaijan have not strong correlation with other countries.

Rate of Growht GDP

7

6

5

4

3

2

1

0

-1 0 20 40 60 80

GINI Index ( Average % )

Rate of Growht GDP

Linear (Rate of Growht GDP)

e ) Rate of Growth and Foreign Direct Investment Net Inflows ( % of GDP) :

As we indicated on Table 1 in order to variable of Foreign Direct Investment, coefficient

value is 0,167317, standard error is 0,049949 and t-value is 3,349747. According to our analysis,

Foreign Direct Investment is significant variable and it has strong positive effect on rate of the

growth.

Rate of Growht GDP

7

6

5

4

3

2

1

0

-1 0 5 10 15 20

Foreign Direct Investment ( Average % )

Rate of Growht GDP

Linear (Rate of Growht GDP)

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% )

f ) Rate of Growth and Central Government Debt, total (of %GDP):

In our analysis in order to variable of Central Government Debt, the value of coefficient is (-

0,01578), standard error is 0,004621 and t-value is (-3,41428). We can clearly say that the

variable of central government debt has strongly negative effect on rate of economic growth

in order to these 73 countries. So, if debt of these countries increases, the rate of economic

growth will be decrease immediately. The correlation of each individual shows also on below

linear graph.

Rate of Growht GDP

7

6

5

4

3

2

1

0

-1 0 50 100 150 200

Central Government Debt ( Average % )

Rate of Growht GDP

Linear (Rate of Growht GDP)

g ) Rate of Growth and Gross Capital Formation ( % of GDP):

The analysis shows us for the variable of gross capital formation, coefficient value is

0,064439208, standard error is 0,030188345 and t-value is 2,134572388. According to the

analysis, we can indicate that gross capital formation is significant variable and it has strong

effect on rate of growth in order to the countries which we studied on. As we see on the linear

graph, individuals have correlation each other except for some of them such as the country of

Nigeria.

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R

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( A

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Rate of Growht GDP

7

6

5

4

3

2

1

0

-1 0 10 20 30 40

Gross Capital Formation ( Average % )

Rate of Growht GDP

Linear (Rate of Growht GDP)

h) Rate of Growth and GDP per capita constant 2005 US $ (1993) :

In terms of variable of GDP per capita constant, the value of coefficient is (-3,782E-

05), standard error is 2,07742E-05 and t-value is (-1,82052513). As we see on table 1,

GDP per capita is not significant and it has negative impact on rate of growth. The

correlation of each individual, we can see on the linear graph below.

Rate of Growht GDP

7

6

5

4

3

2

1

0

-1 0 20000 40000 60000

GDP per capita constant ( Average % )

Rate of Growht GDP

Linear (Rate of Growht GDP)

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5) CONCLUSION

In this paper we have done an empirical analysis of how some variables are linked with

economic growth. We have taken into account 8 variables in a period of time of 20 years and

we discovered that some of them have stronger relationship with economic growth that the other.

The most reliable variables that we consider is the GINI Index that is the measure of

inequality and we can say that inequality have a strong negative relation with economic growth,

so an high level of GINI tend to retard growth.

Other robust discriminant of economic growth are the central government debt and GDP

per capita that have a negative relation with it, instead gross capital formation, foreign direct

investment and internal direct investment that have a positive impact on growth.

The other variables that are R&D expenditure and Labor force with secondary education

have not a strong impact on growth. In particular R&D expenditure should have a positive

impact on growth but in this case the relation is negative so we have to take into account that

the data are from an aggregation of very different countries (73) and from an average of 20

years so the result should not reflect the real trend.