What determines income distribution and how income distribution might affect growth

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What determines income distribution and how
income distribution might affect growth
Branko Milanovic World Bank Training Poverty and
Inequality Analysis Course March 3, 2011
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A. From Kuznets to Piketty determinants of
income distribution
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1. Relationship between income and inequality
the rise and fall of the Kuznets hypothesis
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Kuznets inverted U-shaped curve (defined in 1955)

• As income increases, inequality at first goes up
  and then declines
• It seems plausible to assume that in the process
  of growth, the earlier periods are characterized
  byforces that may have widened the
  inequalityfor a while because of the rapid
  growth of the non-A non-agricultural sector and
  wider inequality within it.
• It is even more plausible to argue that the
  recent narrowing in income inequality observed in
  the developed countries was due to a combination
  of the narrowing inter-sectoral inequalities in
  product per worker, the decline in the share of
  property incomes in total incomes of households,
  and the institutional changes that reflect
  decisions concerning social security and full
  employment."

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Kuznets curve history

• Evidence for Kuznets curve in cross-sectional
  data analyzed in the 1970s, 1980s (Paukert,
  Lecaillon, Koeble Thomas)
• More than 90 of pooled time-series and
  cross-sectional Gini variability is due to
  differences between countries gt factors that
  determine country inequality are stable (Li,
  Squire, Zhou)
• Elusive evidence in time-series (Oshima)
• Strong historical evidence for Western Europe
  before and during Industrial revolution (Lindert
  and Willianson, van Zanden, Prados)
• Modifications of the Kuznets curve strong and
  weak formulations

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The same idea Tocqueville 120 years earlier

• If one looks closely at what has happened to the
  world since the beginning of society, it is easy
  to see that equality is prevalent only at the
  historical poles of civilization. Savages are
  equal because they are equally weak and ignorant.
  Very civilized men can all become equal because
  they all have at their disposal similar means of
  attaining comfort and happiness. Between these
  two extremes is found inequality of condition,
  wealth, knowledge-the power of the few, the
  poverty, ignorance, and weakness of all the rest.
  (Memoir on pauperism, 1835).

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• General formulation (used by Ahluwalia 1976)
• We expect ß1gt0 and ß2lt0
• Control variables include socialist dummy,
  government transfers, share of state sector
  employment, openness, age structure of population
  (Milanovic 1994 Williamson and Higgins 1999)

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Relationship between Gini and GDP per capita
(about 1100 Ginis between 1970 and 2005)
Kuznets curve
twoway (scatter Giniall lngdpppp if Ginialllt65)
(qfit Giniall lngdpppp, yline(20 60,
lpattern(dash))), legend(off) xtitle(ln of GDP
per capita in international dollars)
ytitle(Gini) From global_new2.dta
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• No controls a weak inverted U relationship (more
  than 1300 Gini obs)
• Huge variability in inequality R2 only 0.11
• The upward sloping part of the curve generally
  hard to discern
• Turning point quite unstable here about PPP
  4,000 (level of Sri Lanka or Paraguay in 2008)
• Some disenchantment with the hypothesis hard to
  see inverted U in time-series for a single country

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No downward portion plotted against time or
income example of the USA
twoway scatter Giniall year if contcod"USA",
connect(l) ylabel(30(5)45) From allginis.dta.
twoway scatter Giniall gdpppp if contcod"USA",
connect(l) ylabel(30(5)45) From global_new2
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Example of China
Against income, 1970-2004
Against time, 1950-2004
twoway scatter Giniall year if contcod"CHN"
yearlt2005, connect(l) ylabel(30(5)45) Based on
giniall.dta
twoway scatter Giniall gdpppp if contcod"CHN"
yearlt2005, connect(l) ylabel(30(5)45) From
global_new2.dta
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2. Credit market imperfections theory pull
yourself by your bootstraps
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Credit market imperfections

• Poor households do not invest in human K even if
  the returns are high they invest in
  subsistence-related types of investment
• Indivisibilities minimum threshold of K needed
  for investment convex returns
• Societies with these problems both more unequal
  and wasteful in terms of human and capital
  resources
• Example of win-win strategy (inequalitygrowth)
• Solutions asset redistribution, no school fees,
  deeper capital markets, micro finance

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Credit constraint, education, democracy (Li,
Squire Zhou)
pooled IV formulation
Schooling 1960 -4.6 -4.4
Democracy 1.6 1.5
Land Gini 60 0.16 0.15
Financial depth (M2/GDP) -7.7 -10.1
R2 0.62
No. of obs. 166 166
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3. Political theory of income distributionMethod
ologically, move from household survey data to
fiscal data
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Long-run studies using income and inheritance tax
data (Picketty et al.) France 1901-98

• Secular decline in inequality
• Due to the declining share of top 1
• Due to the decreasing importance of large capital
  income
• Due to progressive taxation and progressive (and
  high) inheritance taxes
• Produces no effect on average K stock but
  truncates large K holdings (lower concentration
  of capital income)

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Story for the US (Piketty Sanz)

• Top K incomes decreased during the Depression and
  WW2 and never recovered (top estates still lower
  in real terms than around 1900)
• Total K income did not decrease its
  concentration did
• Change in factoral income composition among the
  top 1 no longer mostly capitalists but salaried
  workers. ? more pronounced in the US than in
  France
• Conclusion No spontaneous decline in inequality.
  Role of depression, wars and progressive
  taxation. Policy and politics matter the most. A
  political theory of income distribution

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Explanation by E. Saez in Striking it richer

• The labor market has been creating much more
  inequality over the last thirty years, with the
  very top earners capturing a large fraction of
  macroeconomic productivity gains. A number of
  factors may help explain this increase in
  inequality, not only underlying technological
  changes but also the retreat of institutions
  developed during the New Deal and World War II -
  such as progressive tax policies, powerful
  unions, corporate provision of health and
  retirement benefits, and changing social norms
  regarding pay inequality.

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Recent findings

• A number of similar studies for developed
  countries reaches the same conclusion a U-shaped
  inequality in the 20th century in
  English-speaking countries (UK Atkinson 03
  Netherlands Atkinson Salvedra 03 Italy
  Brandolini)
• But also for India Banerji and Piketty 2005
• Long L shaped curve for the rest of developed
  countries

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Source Piketty and Saez (2006)
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Source Piketty and Saez (2006)
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Source Piketty and Saez (2006)
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But this finding crucially depends on strong ?
btw. Gini and top income share while true among
recent data, not true historically!
Source Milanovic, Williamson and Lindert (2009)
twoway scatter top_percent gini2 if
Dancient1, msize(vlarge) mlabel( country)
xlabel(20(10)70)
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B. How inequality might affect growth
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Channel 1 The median voter hypothesis
(Meltzer-Richard)

• Political mechanism
• Greater inequality in factor incomegt
• Relatively poor µ votergt
• Chooses relatively high tax rate

• Economic mechanism
• High redistribution and distorsionary effect of
  taxes gt
• Lower growth rate

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Extent of redistribution fct (inequality in
market income)

• Hypothesis 1. More market-unequal countries
  redistribute more (using two definitions of
  market income, without and with government
  pensions)
• Hypothesis 2. An increase in market share of a
  given decile is associated with a lower sharegain
• Question. If countries do redistribute more, is
  the mechanism through which it happens, the
  median voter hypothesis?

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Redistribution is greater if market income share
of the poor is less
Source Milanovic 2000, 2009
From figure.do based on data_voter_checked.dta
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It holds for all deciles if a decile is
better-off in terms of marketP income
distribution, it loses more through the
redistribution
Bottom (first) decile
Second decile


Richest (top) decile
Second richest decile

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More market unequal states of the world
associated with greater Gini reduction through
redistribution
Without controls With controls
Gini of marketP income 0.438 (8.9) 0.473 (8.2)
Openness 0.002 (0.9)
GDP per capita (in logs) -0.004 (-0.6)
Constant -0.010 (-5.3) -0.070 (0.3)
R2 (within) 0.47 0.54
Number of observations 110 100
Dependent variable Gini reduction through
redistribution. Country fixed effects regression.
Source Milanovic (2009)
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But we cannot show that the middle deciles gains
more if market inequality high
Source Milanovic 2000
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Sharegain of the very poor, 1973-2005 (using
market income)
twoway (scatter gain3 year if contcod"DEU"
decile1, connect(l)) (scatter gain3 year if
contcod"USA" decile1, connect(l)),
legend(off) text(4 2000 "USA") text(7 2000
"Germany") ytitle(Distributional gain of the
bottom decile) Based on data_voter_checked.dta
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Channel 2 Inequality and property rights

• Political mechanism
• Greater inequality creates cleavages gt
• They are particularly strong if coincide with
  ethnic differences (high horizontal inequality)gt
• Insecure property rights

• Economic mechanism
• Insecure property rights gt
• Lower growth rate

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Inequality and property rights (Keefer Knack)
Dependent variable protection of property rights Cross section
Ln GDP per capita 1985 7.61
Ethnic tensions -0.933
Income Gini circa 1985 -0.196
Land Gini 1985 -0.097
R2 0.80
No. of obs. 64
Dependent variable Property rights ICRG measure
1986-95. Ranges from 0 to 50.
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Excursus the reverse link and the reverse sign
greater protection of property rights increases
inequality
Dependent Gini Gini (time-dummies included on the RHS)
Property rights 0.929 0.709
Financial development (M2/GDI) -0.064 -0.07
Education 0.026 -0.016
Land inequality -0.016 -0.02
Democracy 0.438 0.323
Prop. Rights x Democracy -0.056 -0.046
R2 within (N) 0.26 (203) 0.35 (203)
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• Greater protection of property rights increases
  inequality
• The rich elite is also politically powerful and
  protects its economic assets
• The effect is mitigated by the introduction of
  democracy
• gt The negative effect of property rights
  protection is particularly strong in
  low-democracy environments
• But the regression does not include an income
  term
• (results based on Savoia and Easaw, 2007 World
  Development, Feb. 2010)

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Channel 3. Inequality caused by morally
irrelevant characteristics

• Inequalities which are independent of individual
  effort, entrepreneurship or luck
• Wasteful (vs. instrumental or useful)
  inequalities
• Examples education, health, opportunity to
  better oneself economically, to have a political
  voice
• Horizontal inequalities between ethnic/religious
  groups, education levels, socio-economic
  categories, geographical areas

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Assumed ?s for different parts of the world
Base case Optrimistic (high mobility) Pessimistic (low mobility) Average Gini (year 2002)
Nordic 0.2 0.15 0.3 27.5
Rest WENAO 0.4 0.3 0.5 33.7
E. Europe 0.4 0.3 0.5 30.6
Asia 0.5 0.4 0.6 37.6
LAC 0.66 0.5 0.9 53.8
Africa 0.66 0.5 0.9 42.6
Also a super-optimistic ?0.2 for all and
super-pessimistic ?0.9 for all. ?s based on
literature review.
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How ones income depends on circumstances(depend
ent variable own household per capita income, in
PPP, logs)
Eq.
Mean per capita country income (in ln)
Gini index (in )
Parents estimated income class (ventile)
Constant
Number of observations
R2 adjusted
Number of countries
6 (Pessimistic)
0.991 (0)
-0.019 (0.00)
0.109 (0.00)
-0.582 (0.00)
232,000
0.83
116
4 (Base)
0.986 (0.00)
-0.019 (0.00)
0.105 (0.00)
-0.513 (0.00)
232,000
0.81
116
5 (Optimistic)
0.987 (0)
-0.019 (0.00)
0.100 (0.00)
-0.462 (0.00)
232,000
0.80
116
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• Circumstances at ones birth (country parents
  income class) explain between 83 percent (if
  world is fairly income-mobile within countries)
  and 85 percent (if there is less social mobility)
  of variability in income globally
• gt thus, only a very small portion of global
  income differences can be due to effort
• Coefficient on country mean income remains 1
  coefficient on parental income 0.1 (each notch is
  worth 10 increase in childrens income) coeff.
  slightly higher if there is less social mobility

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• As a proxy, WDR06 looks at the contribution of
  horizontal inequalities to total inequality, or
  total feasible between- inequality (total Y of
  countrygiven number and sizes of groupsgiven
  pecking order by group mean incomes given gt
  find new group mean incomes that maximize the
  between component)
• Up to 40-45 of feasible between inequality
  explained by education differences
• Inequality traps and the interaction between
  political and economic power