High inequality weakens poverty reduction from growth rate

'Attempts to redistribute income from the rich to the poor through progressive taxes may discourage work effort, investment and risk-taking, and the consequent shrinking of the pie may leave the poor worse-off compared to the case of a larger pie but with the same share as before,' says Pranab Bardhan.

Illustration: Uttam Ghosh/Rediff.com.

There is widespread concern about increasing or high economic inequality in many countries, both rich and poor.

At a global level, according to the World Inequality Report 2018, the richest 1 per cent in the world reaped 27 per cent of the growth in world income between 1980 and 2016, while the bottom 50 per cent of the population got only 12 per cent.

Over roughly the same period, however, absolute poverty by standard measures has generally been on the decline in most countries.

By the widely-used World Bank estimates, in 2015 only about 10 per cent of the world population lived below its common, admittedly rather austere, poverty line of $ 1.90 per capita per day (at 2011 purchasing power parity), compared to 36 per cent in 1990.

This decline is, by and large, valid even if one uses broader measures of poverty that take into account some non-income indicators (like deprivations in health and education) for the countries for which such data are available.

If absolute poverty is declining, while measures of relative inequality (of income or wealth) show a significant rise (or remain very high), this implies that the conditions of the poor may be improving, but those for the rich may be improving much more.

But if people are less poor than before, should we be concerned about high or rising inequality, about how much better-off the rich are, and, if so, why?

This is an important question on which more clarity is needed, as quite often when people tell you why they dislike inequality, many of the examples they cite are really about their aversion to the stark poverty around them.

To moral and political philosophers steeped in the theory of justice, inequality in society may simply be ethically distasteful.

To utilitarians, increasing income inequality, controlling for the average income, reduces social welfare simply because the same dollar has lower marginal utility for the rich than for the poor.

Many non-utilitarian philosophers also find some kind of inequality simply unconscionable.

There is, however, an important discussion among philosophers (and some economists) about the kinds of inequality that are morally permissible.

The latter, for example, may pertain to cases where between two individuals facing similar life chances one may end up richer than the other simply because the former is more ambitious or hard-working than the latter.

This brings to the fore a distinction between inequality of opportunity and that of outcome.

As philosophers, public commentators and the general public increasingly find the issue of personal responsibility in one’s choice or life decision quite socially salient, one can make a clear distinction between opportunity-egalitarianism -- seeking to offset only those inequalities that are due to circumstances beyond an individual’s control (like the characteristics of a family or neighbourhood a child is born in or its biological characteristics) -- and outcome-egalitarianism that, often on grounds of social norms, seeks to offset even those differences in outcome that are due to an individual’s own choice (say, in blowing away one’s opportunity by indulging in drugs or alcohol) or initiative (or lack of it).

Many economists take a much narrower approach on inequality, even when they are sensitive to issues of absolute poverty.

They find relative inequality acceptable if it does not harm economic performance or efficiency; in fact, they are prepared to tolerate even a large dose of inequality if it improves the aggregate economic performance -- the presumption is that the larger surplus keeps open the possibility of redistributing some to the poor (a possibility that is infrequently realised in actual politics), thus making everyone better-off.

The main purpose of this essay is to indicate why we may have sufficient reasons to worry about inequality even from this narrow economist’s point of view.

Most undergraduate economics textbooks to this day talk about an equality-efficiency trade-off.

This is mainly about the disincentive effects of attempts to redistribute income from the rich to the poor.

Progressive taxes to fund such redistribution may discourage work effort, investment and risk-taking, and the consequent shrinking of the pie may leave the poor worse-off compared to the case of a larger pie but with the same share as before.

Economists have compared such redistributive transfers with carrying water in “leaky buckets”.

In general, it is argued, allowing inequality is a way of encouraging entrepreneurs and other fortune-seekers, whose enterprise, new ideas and innovations enrich them but also improve the conditions of the whole economy from which others can benefit.

The wealthy are more willing and able to take risks with new ideas, and hence redistribution may reduce productive risk-taking if it transfers wealth from less to more risk-averse agents (unless there is a public risk insurance policy to cover it so that even people with limited means are induced to take more risks).

It is also the case that the rich save more than the poor, so inequality can generate more savings and investible funds, which can expand the productive base of society.

Such expansion or growth may eventually trickle down to the poor (though economists on the opposite side usually argue that such trickle-down is not enough).

Both sides, however, can agree that high inequality may weaken the poverty-reducing powers of the same growth rate.

Pranab Bardhan is professor of Graduate School at University of California, Berkeley. His most recent two books are Awakening Giants, Feet of Clay: Assessing the Economic Rise of China and India, and Globalisation, Democracy and Corruption: An Indian Perspective; the article was first published in the international blog 3 Quarks Daily.