Economic growth And Inequality

Economic growth can be defined as the increase in the value of aggregate resources in the country. Aggregate measures like Gross Domestic Product (GDP) or Gross National Product (GNP) are mostly used to measure it. Increasing economic growth means increasing the resources, this can be through conquests, increasing the value of already existing resources, trade or innovation. Increasing the value of human capital is vital in economic growth as it is provides skill development.

  Different nations have inequalities in wealth due to natural endowment whereby some countries have certain resources that others do not. For instance, oil-producing countries have that advantage and their economic growth is higher too. Countries that colonized others were able to acquire more resources through conquests. Developed countries have advanced technology and human capital, which they use in innovation and thus are better placed than less developed countries. In nations inequalities are also observed and they are attributed to the fact that people have different wages levels of skills or talent. Inheritance is different depending on one’s family and the willingness to take risks is different for different people.

            Inequality is bad for the economy as it leads to higher levels of redistribution, which in turn lowers economic growth in a country

 The impact of inequality is felt when the capital markets are imperfect. Then there lacks a trade off between equity and efficiency. There are negative effects of inequality and positive effects of redistribution of wealth. Economic growth can increase wage inequality across or within education cohorts. The issue of whether inequality is good or bad for growth has been a highly debated one over the years.

 It is an interesting topic to an economist since economic growth is the goal of all nations. Economic growth is not economic development. An increase in the countries GDP does not necessarily mean there has been development has taken place. It could have rose due to a tiny proportion of the total population causing a lavish life for some as others live in the margins of existence.

Kuznets School of Thought of 1955 is that economies are characterized with unequal distribution of wealth and that inequalities rises as economic growth rises, reaches a certain point and then declines. Economic growth is however not economic development. It only depends on the statistical aspects like GDP and GNP but does not address the structural or social development in a country. Economic growth in regions that have high inequality levels benefits only a section of the society.

The poor continue to be poor as the rich grow richer. This is not beneficial for the society as a whole. The essence of the growth is not felt when a part of the society is languishing in riches others are living in the margins of poverty. Kuznet’s perspective is that inequality in income will increase up to a certain level and then decreases as the income levels increase. According to him in the early stages of a nation’s development, a country invests on the physical capital as the main instrument for economic growth. (Kuznet, 22)

Inequality promotes economic growth and those who save and invest more get more resources. Allocation of resources is therefore divided into two categories where those with more investment have more resources. Again those with more resources are in a better position to develop the human capital. They advance in their education and get more skills and will use that to further increase their resources. On the other hand the poor do not have the resources to afford education. He used historical events to describe how the inequalities would be reduced due to change from agriculture based sector into the industry sector as well as intensive migration to the urban areas to search for jobs. (Li H. and H. Zou, 2)

Agri-based sectors offer lesser income compared to the industry. The urban wages are also higher and this translates to a positive shift in the economic well being of workers. Attainment of education will be easier and the opportunities availability for all will be realized. This reduces inequality to a large extent. As the country goes through the transition process from agriculture based to industry based the government incorporates social polices that reduce the inequality in wealth. Since the country is now richer its government provides transfers, welfare, and heath care provision as well as retirement pensions all of which ensure redistribution of resources.

Kuznet’s Curve

Inequality

                        Income per Capita

The United States is a case of Kuznet’s model can be applied. According to sources put forward in 1775 by Hansen Jones Wolff in 1915-1995, inequality rose and then declined. The top 1% owned 15% of the country’s wealth in 1775, in 1885 according to the U.S census it raised to 30%. 1935 had the highest percentage of 45. However this declined in the 1970s and continued to decline consistent to Kuznets theory. (Kuznet, 19)

However in the 1990s, U.S inequalities level started to rise deviating from Kuznet’s curve. This was attributed to the fact that though Kuznet foresaw the role of government in provision of social services, the impact of welfare capitalism has emphasized hard work.  This resulted to inequality, as rewards were higher for those who worked harder.

Kuznet’s approach is however criticized as it was based on historical data. This was cross-sectional and did not assess a single country. The poor in society as per Kuznet access to a share of total income as the economy grows. He used variations in per capita incomes across countries to represent per capital income increment of country overtime. There is a strong relationship between the overall growth and growth or rise in income of the poorest proportion of people in society.

 Today’s theorists oppose his view and argue that inequalities in wealth work to lower the economic growth and hence are bad for the economy.

            Economic growth is important for society, as it is the reason behind increasing real incomes and consumption levels. Economic growth is determined by employment and productivity growth. Economic growth through institutions over time and space results to more inequality.

According to a study of China in 1978-1984 there were economic reforms that broadened and led to an economic boom and many numbers benefited but the inequality levels remained high. This is an indication that economic growth will not reduce the inequality levels in the society. Inequalities between the rich and the poor in the country were visible. The rich benefit more through such arrangements. To attain sustainable economic growth it is crucial to address the inequality rates in any country.

            Many economic theories have been coined to explain economic growth. Adam Smith for instance emphasizes on division of labor that causes specialization. The issue of absolute advantage arises, as countries will put more efforts to the areas that they are best in. To him the nature and cause of wealth of nations also depends on the amount of capital that the country has accumulated. Inequality to his viewpoint is inevitable. Higher social division will result to higher productivity and income gaps will widen. To smith inequality plays a lesser role in the overall economic growth.

            Effects of inequality on economic growth depend on the country in question. Democratic countries have negative relationships between inequalities in wealth and economic growth. Poor countries would have negative relationships while rich countries may have a positive relationship (Barro). Inequalities in rich countries are reduced as those countries have the means and skills to improve their infrastructure. Inequalities in wealth would harm economic growth as it could result to increased taxation so that respective governments can earn revenues. Such inequalities can cause socio-political disturbances or conflicts, which can result to reduced investment. Reduced investment results to reduced economic growth. (Persson, 610)

            Incase of imperfect capital markets inequalities would cause or precipitate reduced investments, which translates to reduced growth. Again inequality in wealth means there are those who have low incomes and they tend to bear more children. This would result to reduced human capital investment and eventually reduced growth.

To Solows and other Neo classical theorists capital accumulation is a major tool for economic growth. Savings play an important role in ensuring economic growth. This is because saving will ensure sufficient finances needed to invest. Other economists like Schumpeter see technological progress as the reason behind economic growth.

To him the more a country is advanced in terms of technological know-how or modern equipment the more the country is economic growth will rise. Economic resources can be used to explain economic growth. The labor force is one aspect that can be used in establishing economic growth of a country. With high inequality levels the fewer with economic well being benefit. Countries are endowed differently in terms of technology and consequently economic growth will differ.

David Ricardo views economic growth based on the idea of or notion of diminishing marginal returns. He does not emphasize a lot on the role of innovation in economic growth but stresses on specialization and internal trade. To him, countries take advantage of their comparative advantage in attaining economic growth. (http://www.wiwi.hu-berlin.de/im/publikdl/2001-inequality.pdf.)

 Population does affect the economic growth of a country. Population can translate to the labor force available in the country. The increased population can be a reason behind economic growth due to expanded or enlarged domestic market. With a wider market firms can increase their output production resulting to economic growth. The quality of the labor force is also very important in economic growth. (Bloom, 400) High skilled manpower will produce quality products and services and the ultimate result will be economic growth. Illiteracy results to reduced innovation and technological know-how and economic growth will not be realized. High levels of inequality will lead to reduced growth as fewer people will access education to improve on the human capital. (Bertola)

            Entrepreneurship organization of a country affects economic growth of a country. Well-organized entrepreneurship and quality developed capital markets results to increased profits. It affects the economic growth of a country and where entrepreneurship is not well organized lesser profits are made thus lower savings and investment levels. Quality investment and positive externalities lead to economic growth. Government policies also affect economic growth. Government intervention in the market system affects people’s investment rates and this in return affects how the economic growth will be, open markets promote economic growth. The government therefore can affects or influence economic growth.

Reduced money supply translates to reduced investment. Government spending can influence growth. If the government spends more in improving the social facilities it will reduce costs incurred by firms or entrepreneurs and they will make more profits. Using such profits to invest more eventually lead increased economic growth. By protecting private property rights the government may increase the economic growth, as such entrepreneurs will be encouraged in their work. To encourage or promote a good or service the government can give incentives to the entrepreneurs. The markets should be favorable. The government has the role of ensuring equality in distribution of resources. The role of the government is very critical in reducing the poverty levels in the society.

It can create opportunities for its citizens by investing in education and by so doing it is influencing the economic growth by influencing the investment rates.

             However there lacks empirical evidence to show that inequality is related to redistribution or that redistribution is related to growth. Post Keynesian theorists argue that inequality is good for economic growth of a country as it ensures resources are put into the hands of those who have the capacity to accumulate capital and will therefore not be wasted. The poor in society have lower incomes and will therefore have lower propensities to save. This perspective can be countered by the fact that workers do actually have higher propensities to save than the capitalists as they may tend to spend their incomes on health and education- enhancing projects compared to the rich family’s savings to capital accumulation.

            Inequality precipitates sociopolitical instability. This arises due to the fact that poor groups who feel polarized from the mainstream may pursue their economic objectives outside the normal and acceptable means. They may therefore result into violent political groupings that lead to instability, which has negative effect on investment. If the political system is controlled by the economically elite the poor may try to overthrow the system using protests and riots. There is however no theoretical link between inequality and political instability and therefore this needs to be studied more.

The rich have the resources and can use them to suppress the poor and the overall effects of instability affecting investment may not be felt. Again the poor may be motivated to overthrow the system if they have higher expectations that this would be for a good cause. If they stand to improve their standards of living by overthrowing the system they would go for the disruptive approach but if their expectations are minimal then they will tend to be comfortable with their plight. Inequality is associated with lowered levels of fertility. This is attributed to the fact that if incomes of the poor are raised and it raises the level of human capital it raises the opportunity cost of raising children. Fertility is associated with growth in a basic economic growth model.

Higher population increases the domestic market and this translates to increased output production to match higher demand. Economic growth is realized when output of goods and services are produced. The population affects the labor force and low population would lead to inadequate labor supply, which translates to reduced economic growth. Inequality affects education accessibility. For instance, if a society has equality given the same income levels a greater percentage of the poor would be more willing to invest in education unlike if the society had inequalities. (Chang, 230)

According to a research by Klaus Deininger an economist in World Bank policy research and Lyn Squire, a director of the World Bank’s Policy Research Department, as growth increases inequality also increases. There is also a relationship between the overall growth and the growth of a fifth of poorest in society. Their incomes increase with a higher percentage when overall economic growth takes place. This is to say that the positive effects of income can be outweighed by the plight of the poor.

They also found that fears that economic growth alone has negative effect on income distribution are uncalled for. Again, redistribution policies are only beneficial to the poor if they do not affect the investment process. They concluded that unequal distribution of resources or ‘assets’ is an impediment to rapid growth. The poor can use political mechanisms to vote in favor of redistribute taxes. In democratic countries this would be a disincentive to investment but in undemocratic countries there wouldn’t be an effect on investment. (Chang, 399)

Inequality in assets is transmitted through financial markets. Those with assets can use them as collateral requirement to help them access finances or credit. Investment in human capital is therefore affected; as such collaterals cannot be used. Fewer individuals will be able to access education when there are inequalities. This translates to lower stocks of human capital and consequently reduced growth.  Policies developed to enhance equality in distribution of wealth can be a disincentive to investment. Although it benefits the poor in society, it may reduce growth of the economy. A strategy that promotes redistribution of wealth at the expense of investment may have a negative effect on economic growth. The incomes of the poor may remain low.

 Governments should be cautious of the measures they take in trying to solve the inequality problem. Investment is a vital tool towards economic growth and it should not be discouraged.  According to Su inequality has a negative effect to the environment. It causes the elasticity’s of substitution of factors of production to widen leading to slower production process or economic growth.

Inequality is therefore negatively correlated with economic growth. Deininger and Squire are criticized of transforming data to make it more comparable. Again arguments that inequalities affect economic growth are based on the assumption that progressive taxes will be implemented reducing investment or that people with higher incomes save more and will hence invest more. Most of the studies on the effects of inequalities on economic growth are more likely to be felt in the long run.

  Increasing opportunities is a positive measure for the economic growth of any country but creating conducive social environment is very important in maintaining economic growth and social stability. Inequalities are the reason behind social crimes and disruptive behavior in society all of which affect investment and consequently economic growth. Establishing efficient legal system can work towards reducing social instability created by the poor or ‘neglected’ groups in society.

Absolute equity is not achievable as it would result into distortions in the market mechanism and this would lead to inefficiency in economic growth. Factor mobility can be assessed in establishing if it would have a positive impact on the economic growth and reduce inequality. Other areas like the political and social institutions can also be further addressed. This will ensure that the impact of inequality is not highly felt by the poor in the society. In general the non-economic factors ought to be checked. (Chang, 230)

Works cited:

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 on Public Policy, 40.1994

Bertola, G. “Macroeconomics of income distribution and growth. Handbook of income

distribution, Amsterdam: North-Holland. Population change and economic development: The great debate revisited, Caer II Discussion Paper No. 46. 1999

Bloom, D. and R. B. Freeman “The effects of rapid population growth on labor

Supply and employment in developing countries, Population and Development Review12, 1986.pp. 381-414.

Chang R “Political party negotiations, income distribution, and endogenous growth,

             Journal of Monetary Economics 41.1998.pp 227-255.

Kuznets S .Economic growth and income inequality, American Economic Review 45,    1955. PP. 1-28.

Li H. and H. Zou .Income Inequality is not Harmful for Growth: Theory and Evidence,

  Review of Development Economics, 2(3).1998.

Persson T and G Tabellini.Is inequality harmful for growth? Theory and

evidence. American Economic Review.pp 600-615

Qi Su.Economic inequality and economic growth. Retrieved on 5^th November 2007 from http://www.wiwi.hu-berlin.de/im/publikdl/2001-inequality.pdf.