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Inequality, Poverty and Development

Apr 14, 2018

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    Inequality and development

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    Inequality, savings, income and

    growth One possible way in which inequality might

    affect income is through the overall level ofsavings (and the related investments).

    This consideration has been used to justify the

    existence of moderate or high inequalities inincome distribution, as these would haveconcentrated money in the hands of thosewilling to save and invest, boosting growth.

    This however is only one side of the story. Itmight be true that a certain degree ofredistribution can enhance savings and push upgrowth rates.

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    Inequality, savings, income and

    growth: marginal saving rates

    The final effect will depend on themarginal saving behavior of the individualsinvolved:

    With increasing marginal saving ratesinequality increases savings;

    With decreasing marginal saving ratesinequality decreases savings.

    If marginal savings rates are unaffected byincome, inequality will have no effect oneconomywide savings.

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    Inequality, savings, income and

    growth: marginal saving rates

    Total

    Savings

    Income

    SubsistenceConspicuous

    consumption

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    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 andobjectives 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 samedirection.

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    Income, savings and the evolution

    of inequality

    Depending on initial historical conditions ofeconomic inequality, a society mightevolve in very different long-run patterns.

    Low inequality: this level might be sustainableover time (common savings behavior);

    High inequality: for many groups in societythere is a difference between desired

    standard of living and actualstandard ofliving. inequality could be preserved orwidened over time.

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    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

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    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 thanthe rich or the poor.

    There is a second possible way in which largeinequalities can be harmful for growth (Alesina andRodrik, 1994; Persson and Tabellini, 1994): through thearising of political demands for redistribution leading totaxes 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, thecreation and implementation of such policies as confiscation wouldrequire exceptional political will and availability of data andinformation. It would still be possible to try to disguise or parcel outwealth. Faced with these difficulties, it might be easier to move totaxing the increments to the stock of wealth.

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    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.

    U0U1

    A

    BC

    Consumption today

    Compare B (tax on

    investment returns) with C

    (lump-sum tax).

    The price effect (in B) tendsto lower the rate of saving

    and investment (lower

    consumption tomorrow)

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    Inequality and growth: evidence

    Lack of adequate data. Problem with use of contemporaneous data on

    inequality and growth (endogeneity) we need dataon 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 allprevious flows);

    Land (distorted, especially where there are land ceilingsfalsified data; moreover, it is a good proxy only if agricultureis important or has been important recently - in theeconomy)

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    Inequality and growth: evidence,

    cont.

    Alesina and Rodrik (1994): regressing per capita income growth (1960-1985) on a

    variety of independent variables including initial percapita income and a measure of initial human capital. Inaddition they included data on initial inequality of income

    and initial inequality of land. Substantial negative relationship between initial

    inequality and subsequent growth, particularly looking atthe impact of the Gini coefficient representing the initialinequality in LAND holdings (increase in land Gini

    coefficient by 1 standard deviation leading to decrease ofeconomic growth of 0.8% per year).

    Results do not change once we allow for structuraldifferences across democratic and nondemocraticpolitical systems (moreover, dummy for democracy notsignificant).

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    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 reformsplaced them among the lowest in land inequalities (0.34and 0.31 vs. over 0.5 for India and Philippines and above

    0.8 for Brazil and Argentina) and promoted equalityoverall (agriculture was still very important in the 60s).

    there might be a robust and negative empiricalrelationship between inequality and subsequent

    growth

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    Inequality and demand composition

    Another possible way in which inequality might beaffected is through demand composition.

    The intuition is the following. Whatever our initialinequality 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 demandgoods produced mainly by individuals of the poor class, therebyincreasing their income. The opposite would be true if demandwent to goods produced mainly in ways (for example with highcapital intensity or by a limited number of specialised individuals)benefiting the mainly the rich class.

    Other examples: England and US in manufacturing during the19th century; US government services during the two world warsand Great Depression.

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    Inequality, capital markets and

    development If capital markets were perfect, an individuals wealth

    would not influence the amount of credit obtainable forconsumption or investment, as long as repayment wasfeasible.

    However, when default becomes feasible, borrowingmoney requires leaving to the lender some valuableasset that will be lost in case of default (to reduce defaultincentives and communicating credibility of repayment).

    In unequal societies the poor might lack access to creditmarkets 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.

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    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 interestrate r, then the net profit is:

    (q-wm)-(1+r)I

    Given this information we can determine whether anindividual with a given starting wealth W will be able toobtain a loan to start an activity.

    If the enterpreneur puts his wealth as a collateral, at theend he will have the choice between reimbursing I(1+r)

    or losing W(1+r).

    O ti l h i d th dit

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    Occupational choice and the credit

    constraint: a simple model, cont.

    The expected cost of default is some fine F and a fraction of theprofits 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 theywant 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

    tmwqFIW

    1

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    Inequality, capital markets and

    development, cont. A missing or imperfect credit market for the poor is a

    fundamental characteristic of unequal societies, withpotentially severe macroeconomic implications.

    A situation in which the lack of a large amount of wealth

    prevents individuals from becoming entrepreneurs has adouble 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 thecondition of some individuals without damaging anybodyelse (pareto improvement).

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    Inequality, capital markets and

    development, cont. The inefficiency is not restricted only to high

    inequality regimes, but with sufficient equality itwill go away.

    There is no innate tendency for inequality to

    disappear over the long run. In a situation wherethe poor cannot accumulate enough wealth tobecome entrepreneurs, inequality tends toperpetuate itself, unless changed by governmentpolicy such as asset redistribution. This meansthat two countries with the same parameters ofproduction and preferences may never convergein terms of wealth distribution and output levels.

    Note: see chapter 7, Ray.

    I lit d d l t

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    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 thelower end of the wealth or income scale to fully exploit theircapabilities (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 choicesout of retained earnings, wealth or abstention from currentlyproductive work.

    For the society it would be efficient to transfer money fromthe rich to the poor. The outcome would be more than

    sufficient to compensate the rich. However this particularcredit market is missing, as loan repayment might beimpossible to enforce.

    Inequalities in education also operate to reinforce the initialdifferences in inequality. Again, there is no tendency for

    inequality to disappear over the long run.