Unpacking the drivers of inequality

The relationship between growth and income inequality is more complex than the one between growth and poverty, and has been the subject of considerable study.

An early contribution in the 1950s by Nobel Prize-winning economist Simon Kuznets, for instance, noted that at least two forces tended to increase inequality over time. One was the concentration of savings in the upper-income groups; he observed that in the United States the wealthiest 5 percent of the population accounted for close to two-thirds of total savings.

A second factor, which has been a universal characteristic of development over the past century, was the gradual shift away from agriculture. Between 1991 and 2001, for instance, more than 8 million people left agriculture in India. Between 1965 and 2000 the share of the labor force employed in agriculture fell from 49 to 21 percent in Brazil, from 26 to 5 percent in Japan, from 55 to 11 percent in Korea, from 81 to 47 percent in China, and it fell to 2 percent in the United States.

As people moved from villages to cities, from agriculture into industry, they moved from a low productivity sector to one of higher productivity and this heightened income disparities. Incomes tended to be more equal in agriculture, but as people moved to the cities this meant the share of the population where income was more unequal increased.

Other factors were also at work, some of them exerting an influence in the opposite direction. One was the increasing role of government and the implementation of policies intended to reduce income disparities, whether through inheritance taxes, mechanisms for social protection,  or critically, the extension of publicly financed education to large segments of the population, including girls.

In some countries—particularly in East Asia—land reform also strongly contributed to diminished income disparities and, may have unleashed rapid economic growth and convergence. The role of government policy implied that, often, there was a growing distinction (or gap) between inequality in living standards and inequality in incomes, with the former often boosted through the redistributive attributes of the government budget. Demography and migration had an impact on the distribution of income too.

At least as important was the impact of technology and the dynamic forces associated with industrialization. New technologies, and associated processes meant that those with the skills to handle new machinery or read instruction manuals—the vast majority of them men—could command much higher wages, and this inevitably led to a widening of income disparities between the genders.

Moreover, this phenomenon was self-reinforcing. Those who, because of their skills commanded higher wages, could afford to get loans to start new ventures and save more, accumulated a growing share of the country’s wealth, something that provided additional opportunities for profitable investments and create new companies. In countries with weak institutions, ineffective regulations and poor law enforcement, this often translated into expanded opportunities for the unscrupulous, particularly those with access to the levers of political power.

The expansion of huge wealth stemming from corruption has surely been a regular feature of economic development during the past couple of centuries. Where growing income disparities were partly (or mainly) due to corruption and the abuse of power the result often was growing social tensions, political instability or, at the extreme, civil disturbances. However, absent corruption, the result was often the creation of new industries and the emergence of a powerful culture of innovation.

The relationship between education, training and a skilled labor force and inequality is strong and dynamic. At one level, as education spreads and a growing share of the population partakes of its benefits, one might expect a leveling off of income inequality. There is evidence that this is exactly what happened in England in the 19^th century, widening at first as the process of industrialization got underway and leveling off before the end of the century. (Benjamin Friedman argues in “The Moral Consequences of Economic Growth” that “Karl Marx’s claim that capitalism inevitably leads to ever increasing misery of the working classes, and hence to an explosive polarization of society, resulted from Marx’s myopic extrapolation of the widening inequality that accompanied England’s economic growth in the first half of the nineteenth century” (p. 349)).

However, there is no guarantee that this leveling off will be permanent. Since technological change is relative, the arrival of new technologies can, in principle, induce exactly the same sorts of changes which the introduction of simpler technologies had on skills-based wage differentials during earlier stages of the development process, leading, yet again, to rising income disparities.

Friedman (2005) offers an interesting analysis of the impact of outsourcing on income inequality. When an American manufacturer closes its plant in the United States and shifts it to India, American workers’ job losses will be offset by job gains in India. While some US workers may be able to find jobs elsewhere, others may not. Also, profits of the company are likely to rise because of the lower labor costs and the net impact, therefore, will be to widen inequality within the United States. Moreover, because some workers in India will now be earning wages well above the average in India, the closing of the plant in the United States will also widen inequality within India. However, inequality between the United States and India will have been narrowed. Friedman then asks: “If India’s average income draws closer to America’s, but in the process some Indians—in this example, the lucky workers who get the new factory jobs—pull ahead of their neighbors, is the net outcome a victory or a defeat for the cause of equality?”

We do not have a full understanding of the relative importance of all these factors—accumulation of savings, the declining role of agriculture, demography, government policy, migration, technological change, and globalization, to name a few—in shaping the evolution of income inequality. Some are obviously more amenable to change through shifts in the content of policies. Others—technological change being perhaps the leading example—are more exogenous in nature, responding to a combination of human creativity, the profit motive and, only at the margin, possibly government incentives and being, therefore, much more unpredictable in its impact.

One can reasonably assume that the importance of these factors will vary from country to country, depending on their stage of development, and that that importance will shift over time, in reflection of structural changes in the global economy. However, Kuznets was correct in arguing that without better knowledge of the evolution of income inequality and the factors that shape it, our own understanding of the process of economic development would be undermined as would our capacity to respond effectively to the challenges created by income divergence.