income inequality - its - boston college€“ develop lorenz curve. – line of perfect equality is...

Copyright © 2013 Pearson Education, Inc. Publishing as Addison-Wesley

INCOME INEQUALITY

Chapter 13

Modified for EC 375 byBob Murphy


Copyright © 2009 Pearson Education, Inc. Publishing as Pearson Addison-Wesley

Facts About Income Inequality

• Focus so far has been on country averages.• Now look at how residents of a country differ from the

country’s average.• Two approaches to considering income distribution:

– Divide population into equal-sized groups and consider how much income each group has.

– Divide income into equal-sized intervals and consider how much of population falls into each group.

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• For United States in 2006:– Top one-fifth (ranked by income) of households had over 50

percent of total income.– Bottom two-fifths had just 12 percent of total income.– Mode of income distribution was between $10,000 and

$14,999.– Mean was $66,570 and median was $48,201.– Mean higher than median implies distribution is skewed with

long right tail.– Figure 13-1 doesn’t show 3.5% with income above $200,000.

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Table 13.1 Household Income in the United States by Quintiles, 2009

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Figure 13.1 Income Distribution in the United States, 2009

Source: DeNavas-Walt, Proctor, and Smith (2010).

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• Measure by computing Gini Coefficient:– Develop Lorenz curve.– Line of perfect equality is straight line with slope of one.– Gini coefficient is the area between the Lorenz curve and the

line of perfect equality, divided by the total area under the line of perfect equality.

– Varies from 0 to 1 as income inequality rises from perfect equality to one household having all the income.

– Gini for U.S. in 2006 is 0.470.

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Figure 13.2 The Lorenz Curve for the United States, 2009

Source: De Navas-Walt, Proctor, and Smith (2010).

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• Kuznets Hypothesis:– Inequality rises as a country develops and then declines.– Inverted-U shaped curve plotting inequality versus income

per capita.– Can plot for a single country over time or to look across

countries at a single point in time.– Works well for a single country through time, but no so well

for cross-section of countries.– But if control for other factors, then Kuznets curve emerges--

peak at income of $4,815.

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Figure 13.3 The Kuznets Curve

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Figure 13.4 The Kuznets Curve in England and Wales, 1823–1915

Source: Williamson (1985).

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Figure 13.5 Income per Capita versus Inequality

Source: World Development Indicators database, Heston et al. (2011).

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Is Growth Good for the Poor?

• Holding average income constant, if inequality increases, then poor are worse off.

• So, if Kuznets curve does exist, raising income may lead to poor being worse off as inequality could offset average income gains.

• Study by Dollar and Kray (2002):– Most important determinant of incomes of the poor is a

country’s average level of income.– Poor people in rich, unequal countries are far better off than

poor people in poor, egalitarian countries.

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Is Growth Good for the Poor?

– Also find that policies affecting growth either positively or negatively have little effect on the distribution of income:• Rule of law and openness to trade raise overall income and

have only a small, positive effect on share going to poorest quintile.

• Bad policies of high inflation and high government consumption reduce overall income but have only a small, negative effect on share going to the poor.

• Other work looking at individual episodes of growth finds income of poorest quintile typically grows when overall economy grows.

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Figure 13.6 Income per Capita versus Income of the Bottom Quintile

Source: Dollar and Kraay (2002).

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Sources of Income Inequality

• To understand reasons for income inequality:– Consider the distribution of economic characteristics across

the population.– Look at how these differences give rise to different outcomes

in terms of income.– A country may have a high degree of inequality:

• Because of great disparity in these characteristics across the population.

• Or, because these characteristics generate large effects on the amount of income a person earns.

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Figure 13.7 Determination of Income Inequality

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Figure 13.8 How the Return to Education Affects the Distribution of Income

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Figure 13.9 How the Distribution of Education Affects the Distribution of Income

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Figure 13.10 Income Inequality in the United States: 1947–2009

Sources: Weinberg (1996), Jones and Weinberg (2000), DeNavas-Walt, Proctor, and Smith (2010).

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Explaining the Recent Rise in Income Inequality

• Technological Advances:– Raises the return to education.

• Increases in International Trade:– Raises the return to factors that are abundant and reduces

return to factors that are scarce. • Superstar Dynamics:

– People with highest levels of some qualities earn far more than those with only slightly lower levels.

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Effect of Income Inequality on Economic Growth

• Accumulation of Physical Capital:– Inequality can affect growth through saving rates.– Saving rates rise with income.– Total saving is sum of all saving in the economy.– More unequal is income, the higher the fraction earned by

high-income people, and the higher is total saving.

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Table 13.2 Saving Rates by Income Quintile, 2003

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• Accumulation of Human Capital:– More unequal distribution of income leads to less

accumulation of human capital.– Differs from physical capital because human capital is

“installed” in the person--works only when person works and can’t be transferred.

– Unlike physical capital, opportunities any one person has for investing in human capital are limited to the amount they can invest in themselves.

– Marginal product of human capital faced by any investor declines, unlike that of physical capital.

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Figure 13.11 Marginal Products of Physical and Human Capital

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• Accumulation of Human Capital:– Most people do all of their investing in human capital and

own no physical capital.– Many wealthy people hold nearly all of their wealth in

physical capital.– Implies more equal distribution of human than physical

capital:• Gini coefficient for physical capital in the U.S. is 0.78.• Gini coefficient for years of education in the U.S. is 0.14.

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• Redistribute a dollar from rich to poor:– Accumulation of human capital rises while accumulation of

physical capital falls.– Total output rises.– Implies inequality may have different effects on economic

growth at different stages of development:• Early in industrial revolution, accumulation of physical capital

was key.• In recent decades, growth has been driven by accumulation of

human capital.• Inequality good for growth early on but now is detrimental to

growth.

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• Inequality, Redistribution, and Efficiency:– Taxation with lump sum redistribution.– Efficiency loss from taxation.– People below mean income will favor redistribution.– Median income is below mean income, so median

voter will favor redistribution.– Rise in inequality will lead to more redistribution,

higher taxation, and lower efficiency.

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Figure 13.12 Relationship between Income Inequality and the Desired Tax Rate

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Figure 13.13 How an Increase in Income Inequality Affects the Desired Tax Rate

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• Sociopolitical Unrest:– May not have simple majority voting giving rise to

more redistribution.– Instead have more pressure for redistribution:

• Unstable political situations may hinder growth.• Crime may directly hinder growth and cause

resources to be spent on prevention.

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• Empirical evidence on overall effect:– Difficult to answer as depends on stage of growth or

degree of international capital mobility.– Can draw conclusions for specific channels:

• Countries with more inequality have lower accumulation of human capital (education) and higher fertility.

• Sociopolitical instability is higher in countries with more inequality.

• Taxes are lower in countries with greater inequality--counter to prediction.

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Figure 13.14 Relationship between Income Inequality and Sociopolitical Instability

Sources: Kaufmann, Kraay, and Mastruzzi (2010), Heston et al. (2011).

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• Can also use historical evidence on growth to understand the effect of inequality:– Gap between Latin America and U.S.-Canada:

• Inequality from colonial era persists.• Political institutions capture this--i.e., rule of law, voting.• Provision of public education lags far behind--U.S. and

Canada reach 80% by 1870, rest of Americas takes 75 more years.

• Failure to invest in human capital and construct institutions good for growth, and the instability from conflict over income distribution, led to poor growth performance.

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Economic Mobility

• Income inequality may not matter as much if people have a lot of economic mobility:– Intergenerational mobility:

• Measure by correlation of children's education with parents.

• Measure by transition matrix for income groups.• Data not available for many countries so can't

easily relate mobility to income per capita or growth.

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Table 13.3 Intergenerational Income Mobility in the United States

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Economic Mobility

• Can influence growth by:– Allowing fuller utilization of society's talents.– Limiting pressure for income redistribution.

• Mobility is determined by:– Access to education, which is probably the most important fact,

along with public health policies and access to medical care.– Nature of institutions and government--allowing new ideas or

blocking them.– Nature of marriages--assortative mating, less likely in societies

with less inequality.– Degree of racial and ethnic discrimination.

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