Lecture 12 - Income Inequality

1. Intrinsic reasons

   -Poverty

   -Aversion to inequality

2. Functional reasons

   -Effect of inequality on growth

-Differences in characteristics (education, gender, ethnicity, type of employment, occupation, etc.)

-Differences in the way the characteristics are rewarded (e.g. returns to education)

-Accumulation of physical capital

-Accumulation of human capital

-Income redistribution through taxation and efficiency

-Sociopolitical unrest

1. Divide income into equal-sized intervals and ask how much of the population falls into each interval

2. Divide the population into several equal-sized groups (e.g. quintiles) and measure how much each group earns

3. Draw a Lorenz curve and compute the Gini coefficient

1. Order the households in a country from lowest to highest income

2. Then, compute the fraction of the total income earned by the poorest X% of the population.

For example, using the data in the previous table we know that

I the poorest 20% earns 3.4% of total household income

I the poorest 40% earns 12% of total household income (3.4%+8.6%)

I the poorest 60% earns 26.6% of total household income (3.4%+8.6%+14.6%)

1. Plot these values in a figure with the cumulative percentage of income on the y-axis and the cumulative percentage of population on the x-axis: we obtain the Lorenz curve!

   
   

“As a country developed, inequality would first rise and then later fall”

1. Increase in inequality with growth

   Economic growth (arrival of new technologies) would initially raise the rate of return to skills

2. Decrease in inequality with further growth

   -Over time, the higher return to skills would induce unskilled workers (or their children) to get education, and workers would migrate into growing regions or sections

   -Also rates of return to skills would decline

   
   

1. Differences in characteristics

   -Education

   -Health

   -Gender

   -Ethnicity

   -Type of employment (self-employed vs. wage earnes)

   -Occupation

2. Differences in the way the characteristics are rewarded

   -Returns to education

-> Both the distribution of characteristics and their rewards can change over time

Changing one determinant of inequality at at time is useful to understand Kuznets’ hypothesis that income inequality would first grow and then fall as countries developed

New technologies not only foster economic growth, they would initially raise the rate of return to skills (because skilled workers adapt faster better than unskilled workers to new modes of production) and the rate of return to physical capital

Since richer people are usually more skilled and wealthy (own more capital), growth would rise inequality

Over time, new forces tends to reduce income inequality:

-the higher return to skills would induce unskilled workers to get an education

-as technological progress and structural change slowed down, the rates of return to skills would decline

This increase in inequality can be explained by:

1. Technological advances

   -Increases the returns to skills and physical capital disproportionally

2. Increase in openness

   -If education is more abundant than abroad, returns to education increase

   -benefit locations more exposed to trade (e.g. coastal vs interior provinces in China)

3. “Superstar” dynamic

   -Extremely highly paid CEOs, athletes, entertainers, etc.

(Through factor accumulation)

1. Effect on the accumulation of physical capital (+)

2. Effect on the accumulation of human capital (-)

(Through efficiency)

1. Income redistribution through taxation (-)

2. Sociopolitical unrest in response to income inequality (-)

The saving rate tends to rise with income

-> Hence, if some income is transferred from a poor to a rich person, the aggregate savings (and investments) will rise and more capital will be accumulated

Solow: Two equal countries except for saving rate. yss and kss are higher in the country with a higher saving rate

-> Ineqaulity may actually increase capital accumulation

-Unlike physical capital, human capital is useful only if the person who acquired it uses it (i.e. human capital not transferable for production)

-While the marginal product of physical capital investments is constant, the marginal product of human capital investments is decreasing

⇒ Physical capital is usually more unequally distributed that human capital U.S. Gini coefficient for physical capital: 0.78, for years of education: 0.14

Human Capital Example:

Redistribution of income through taxation has two effects:

1. Lowers inequality through the transfer of income from the richer to the poorer workers

2. Lowers efficiency through disincentivizing work introduces inefficiencies (workers work less hours or evade taxes)

Consider a simple tax scheme: lump-sum transfer

-the government taxes all workers at the same rate

-the total collected revenue is paid back to workers in equal amounts

Desired tax rates for different pretax incomes:

1. Worker with pretax income above the mean level: worse off by redistribution

– lump-sum transfer lower than tax

– reduction in economic efficiency lowers the worker’s pretax income

1. Worker with pretax income equal to the mean: worse off by redistribution

-0 transfer equal to tax

– reduction in economic efficiency lowers the worker’s pretax income

1. Worker with pre-tax income below the mean: trade-off

+ lump-sum transfer higher than tax

– reduction in economic efficiency lowers the worker’s pretax income (the farther below the mean the pretax income, the lower the reduction in pre-tax income, and the higher the desired tax rate)

Desired tax rate & pretax income graph:

How an increase in income inequality affects the desired tax rate:

If a country is more unequal, the median income is much lower than the mean income. The tax rate that is favored by a person with median income increases.

-> The country would have a higher tax rate and higher inefficiency

To test the theory that income inequality leads to sociopolitical unrest, economists have constructed an index of sociopolitical instability.

However, the theoretical prediction is not supported by the data

We considered a static inequality: how different people in a country compare in a single point in time

A second key aspect of inequality is dynamic: economic mobility

Economic mobility: how likely is that people move from one part of the income distribution to another

-Widely studied type of economic mobility: Intergenerational mobility (Equality of opportunities)

1. Public provision of education and health care

2. Institutions (most powerful people in society often oppose policies that raise the degree of mobility)

3. Positive assortative mating

4. Racial or ethnic discrimination

1. Society with a high degree of mobility is more likely to be more able to utilize the talents of all of its citizens

2. Perception of economic mobility also matters: US vs. Western Europe

Countries with lower inequality also have a low intergenerational earnings elasticity