Income Inequality and Economic Growth

Income Inequality and Economic Growth Chapter 1: Introduction Economic growth is the result of abstention from current consumption. An economy produces a variety of commodities, and then income is generated through sales of products. The very same income is used to buy other products which generate income for other producers. The very same income is used to buy a variety of commodities. The producers decide what to produce depending on their individual preferences and the distribution of income, initial endowments. In general, commodity production creates income, which creates the demand for those very same commodities. The cycle of production, consumption, saving, and investment that constantly regenerates itself is as old as human civilisation. In some cases, savers and investors are exactly the same individuals, using their own funds; in other cases, they are not. (51, Ray) The income inequality occurs because people in an economy differ from each other in many ways that are relevant to their incomes. These differences can be in forms of hum an capital (education and health), in where people live, in their ownership of physical capital, in the particular skills they have, and even in their luck. As explained above, economic growth and income inequality have a huge influence on each other. That is why there have been extensive studies in income distribution and its effect on other economic variables. Income distribution has always been considered to be an important topic because it tells us how incomes are distributed among the members of a population and allows the government to determine tax policies for redistribution to decrease inequality, or to implement social policies to reduce poverty. However, there are many debates about how reliable data is because they mainly are collected through surveys and the sources of errors are numerous. Furthermore, the income distribution measure, income gini-coefficient, does have its disadvantage because the best fit line method is used when representing the Lorenz curve which is used to calculate gini-coefficient. As outliers are ignored when a best-fit line is illustrated, the population in extreme poverty will not be accounted in income inequality measure. Thus, the measure of inequality may not be as accurate as it is believed to be. Because of these data features, it is important to complement classical statistical procedures with robust ones. (Maria-pia, Victoria-Feser, 2000) No concrete theory yet exists to explain the relationship between income inequality and economic growth. Most empirical research on income inequality and economic growth tends to focus on imperfect market, the politics of redistribution, the size of the market. Benabou (1996) and others argued that imperfect capital markets can slow the economic growth by increasing the level of inequality. The main input of economic growth is investment generated by savings or borrowing credits. A result of imperfect capital markets is that the poor credit applicants with high expected rate of return projects have limited access to credit compared with rich applicants with the lower profitable projects. Therefore, the imperfect capital markets create a higher level of inequality and limit both quantity and quality of investments, thereby lowering economic growth. As capital markets are more likely to be imperfect in developing countries, this theory implies that developing countries economic growth is affected greater by income inequality than developed countries. Deininger and Squire find that land inequality reduces growth more in low income countries. However, the effects of income inequality on growth do not differ across high and low income countries. Moreover, contrary to the theory, Perotti (1996) finds that income inequality affects school enrolment more in rich countries than in poor countries. 143-144 I am particularly interested in how East Asian countries managed to develop so rapidly while maintaining low income inequality during late industrialisation. This is because compared with many orthodox economic theories and research based on many European and North American states during their industrialisation, what East Asian countries achieved is unprecedented. Furthermore, I believe that there are much more complicated reasons behind this unique achievement unlike the suggestions by 1993 World Bank Report, East Asian Miracle. In this report, the neoclassical economi sts in the World Bank gave much credit to the new developing theories and state-intervened economies on the surface, but they managed to transform and relate the state-intervention and policies in East Asia to the orthodox economic theory, and concluded that the rapid economic growth in East Asia is the result of market friendly economies and well-operated macroeconomic policies. They are not completely wrong but I have found that the explanations are very vague and inaccurate. There is no consistency in their arguments because they are trying to explain state-oriented capitalism in terms of market-led capitalism. In addition, there is an obvious cultural factor. Johnson and few other economists and historians argue that cultural difference between in the East and in the West might play a crucial role in explaining the East Asian Miracle. They argue that Confucianism confers certain advantages over other traditions in the quest for economic development. Because Confucian beliefs pla ce a high value on hard work, loyalty, respect for authority, and punctuality, these characteristics are thought to have facilitated the national consensus around high-speed economic growth in East Asian countries since the 1950s and 1960s. (Johnson, 1983:6-10; and the chapters by Lucien Pye, Gordon Redding, and Siu-lun Wong in Berger and Hsiao, 1988) I believe that an argument stated above can be a more influential factor of East Asian Miracle than arguments based on the orthodox economic theory. Thus, in this paper, I aim to investigate not only orthodox economic theories behind the East Asian development but also focus more on political economic perspective during the late industrialisation periods in East Asian countries, especially in Republic of Korea (Korea hereafter) and Singapore. The political economic view of East Asian countries were taken rather lightly compared with theoretical economic analysis because there have been only few social-politic studies in East Asia and t he presence of military regimes in many East Asian countries made it difficult for researchers to gather accurate information. The reason that I have chosen Korea and Singapore is that they both are in OECD countries, which makes it easier to collect more accurate and more quantity of data. Most of all, Korea and Singapore maintain the lowest income inequality level during the late industrialisation, but the income inequality level in two countries took a complete different direction after the Asian financial crisis in 1997/8. Singapores income inequality did get worsened but it still stayed at reasonably low level, whereas Koreas income inequality level shoot up and still remains quite high at this point. This paper will contain five sections. They are; introduction; orthodox economic theory behind income inequality and economic growth; political economic section which will illustrate the policies employed in Korea and Singapore to develop rapidly while maintaining the income inequ ality level low with empirical evidences; the effect that Asian financial crisis had on Korea and Singapore, especially on two countries income inequality level; conclusion. Chapter 2: Orthodox Economic theory In this section, I shall discuss the orthodox economic growth theories and whether or not South Korea and Singapore followed neo-classical theory guidelines. To begin with, I will explain what causes income inequality and the consequence of it. I will especially focus on the spill-over effects of income inequality on economic growth. The level of income inequality is one of the main economic concerns for economists as it is directly related to poverty and also has significant effect on economic growth: Assuming that the average level of income per capita maintains constant in a country, a higher degree of income inequality will mean that poor people are worse off. According to this observation with implication of Kuznets curve -the level of inequality rises until income per capita has surpassed a critical point- then in theory; economic growth can be bad for the population placed at the low end of income spectrum. Specifically, growths effect of raising the average level of income may be counteracted by a widening of inequality as the poorest people fall farther below the average. (Weil, Economic Growth) The empirical study carried out by David Dollar and Aart Kraay shows how average GDP and the degree of inequality work together to determine the income of the poor. Mexico in 1989 and South Korea in 1988 had almo st the same level of GDP per capita ($8,883 and $8,948) but because South Koreas income distribution is so much more equal than Mexicos, the average income of the poorest quintile in South Korea was twice as high as that in Mexico ($3,812 and $ 1,923). A similar effect is observed when comparing Taiwan and Mexico. This study illustrates that a countrys average level of GDP is the most influential factor of the incomes of the poor population. Thus, the empirical evidence suggests that poor people in a wealthy but unequal country are better off than poor people in a poor and egalitarian country. Dollar and Kraay assessed whether specific policies had different effects on the income of the poor versus overall income. Their key finding was that policies that affect growth for good or ill generally do not significantly affect the distribution of income. For example, rule of law and openness to trade raise overall income in a country and have positive but very minor effects on the share o f income going to the lowest quintile. Similarly, a high rate of inflation and a high level of government consumption are bad for overall income and reduce the share of income going to the poor.372 The orthodox economic theory on income inequality and economic growth is that highly unequal distributions are necessary condition for generating rapid growth. In fact, in the 1960s and then again to a more limited extent in the 1980s and early 1990s with the dominance of free-market economic theory and policy, the explicit and implicit acceptance of this proposition by economists from both developed and underdeveloped countries tended to turn their collective and individual attentions away from problems of poverty and income distribution. If wide inequalities are a necessary condition of maximum growth and if, in the long run, maximum growth is a necessary condition of rising standards of living for all, through the natural passed-down processes of competition and mixed economic systems, it follows that direct concern with the alleviation of poverty would be self-defeating. Needless to say, such a viewpoint, correct or not, provided a psychological, if not conscious, rationalisation for the accumulation of wealth by powerful elite groups. The basic economic argument to justify large income inequalities was that high personal and corporate incomes were necessary conditions of saving, which made possible investment and economic growth through mechanism such as the Harrod-Domar model. If the rich save and invest significant proportions of their incomes, while poor spend all their income on consumption goods, and if GNP growth rates are directly related to the proportion of national income saved, then apparently an economy characterised by highly unequal distributions of income would save more and grow faster than one with a more equitable distribution of income. 182 Simon Kuznets hypothesis also states that in the early phase of economic growth, especially that are growing at an abnormal rate, growth is generally associated with high levels of inequality. First, to generate the high savings rate that is a prerequisite of rapid growth, income, it is assumed, must be concentrated in the hands of relatively rich, whose marginal propensity to save is relatively high. Second, Simon Kuznets has suggested that as the labour force shifts from low-productivity sectors to high-productivity sectors, aggregate inequality initially increases substantially, decreasing only later. Contrary to this conventional wisdom, in East Asia rapid economic growth has been associated with relatively low and declining levels of income inequality. Improved equity is not unique to East Asia. What is unique is the combination of rapid growth with modest (and, in a few high performers, dramatic) improvements in equity and reduction in absolute poverty. Analysis of the high performing Asian economies has focused on their rapid growth over the past decades. Isolated studies on the distributive qualities of growth in a few of these countries exist, but not of the growth-equity nexus for the group as a whole. (Adelman and Robinson, 1978) The indicators show that the Asian hig h performers have been unusually successful in distributing the benefits of growth widely. (The key to the Asian Miracle, Making Shared Growth Credible, Jose Edgardo Capos, Hilton L. Root, 1996) The orthodox economic theory suggests that tax policies which directly affect saving rates will determine the economic growth rate depending on changes in the ratio of capital to labour. According to this theory, peoples incentives to save their income or wealth are influenced by the rate of returns to savings which effectively determines the income distribution. This theory would also imply that richer people are more encouraged to save their income or wealth in an economy with a regressive income tax. As a result of this, faster economic growth is achieved due to higher saving rates and thus higher level of investment driven by richer people. The rate of savings affects the long-run level of per capita income and, in many cases, the rate of growth of the economy. Thus the relationship between inequality and savings creates an additional channel through which inequality interacts with income and growth in income. The political force of the arguments presented here are also not to be taken lightly. The view that moderate or high inequalities in income distribution concentrate money in hands of those who are willing to save, accumulate, and invest, thereby boosting growth rate, has been used more than once to justify a hands-off approach by government in matters pertaining to redistributive taxation. However, there are opposing views as well, arguing that a certain degree of redistribution can actually enhance savings and push up growth rates. The effect of a reduction in income inequality on the rate of savings, and therefore in the rate of growth, is likely to be complex. High economic inequality might retard economic growth by setting up political demands for redistribution. Now redistributing might take one of two broad forms. First, a policy might aim to redistribute existing wealth among the broader population. A good example of this is land reform. If land is held very unequally, the government may have the option to simply confiscate land from large landowners and redistribute the confiscated land among smaller peasants or landless labourers. Likewise, it is possible to have confiscatory taxes that transfer large quantities of nonland wealth to the government, which are then redistributed to the poor. It goes without saying that the creation and implementation of such policies require extraordinary political will, as well as the availability of data on which to base such policies. Elected government officials with large land holdings are not uncommon, and even if they were uncommon, large landowners often act as vote banks, which swing the votes of an entire village or even a group of villages. In such situations, the enactment of a comprehensive land reform that would alleviate inequality becomes a very difficult proposition indeed. Even if the political will did exist, there are the almost insuperable difficulties of implementation. To redistribute large quantities of wealth, for instance, it is necessary to know who has the wealth. There exist enormous quantities of wealth that are not even subject to taxes, simply because the information base required to implement such taxes is nonexistent. Even when wealth takes the form of land, which is arguably highly observable, it is difficult to implement ownership ceilings. As a large and powerful landowner, I could parcel out my holdings in the names of various members of my family, so that each parcel fell below the legally imposed ceiling. Faced with these difficulties, most governments resort to redistributive policies that take an entirely different route: they tax increments to the shock of wealth, rather than the existing wealth base. Thus marginal rates of tax on high income purchase of various products, and business profits are taxed as well. These taxes, imposed as they are on the margin, tend to bring down the rate of investment and therefore the rate of economic growth. Chapter 3: Political economic theory In this section, I shall concentrate on three policies which were probably the main driving force behind rapid economic growth while maintaining low level of income inequality. They are Land Reform and Agricultural policy, Public-Housing policy and Education. These three political acts shaped up the main foundation in the early stage of economic development and because of this solid foundation; Korea and Singapore were able to achieve their current economic status in the international arena. Many people, in general, believe that industry, not agriculture, can only facilitate the economic growth and agriculture constrains the economic growth to some extent. I will attempt to argue that agriculture and industry are equally able to constrain or facilitate economic development, but that agriculture is perhaps more important in the earlier stages of development, while industry is possibly more important in the latter. In doing so, I attempt to emphasise the importance of land reform in th e earlier phase of development and how South Korea and Singapore achieved it. Public-housing policy is rather more relevant to Singapores case than of South Korea. Today, over 85% of Singapore population resides in housing provided by the government since its public housing policy began in 1930s. The initial quality of housing was poor, but the continuous revolutionary programme since 1960s dramatically improved living conditions. The success of public housing policy, thus the positive spill-over effect of the programme on income inequality and economic growth will be discussed more in detail later on. High level of education, thus high quality of human capital in East Asia has always been on top of the list whenever the driving force of East Asian Miracle was discussed. Thus, I will further investigate why the education is considered to be so much more important in East Asia compared to other developing countries and the effect education on income inequality and economic growth. Ho wever, most of all, the authoritarian political background of Korea and Singapore government must be stressed before the three policies are discussed. This is because without the complete control that President Park, Jung-Hee had in Korea and Peoples Action Party had in Singapore, these policies would not have had its full effect. Government intervention can determine four general areas of distribution of income. They are as follows; Functional distribution – the returns to labour, land, and capital as determined by factor prices, utilisation levels, and the consequent shares of national income that accrue to the owners of each factor. Size distribution- the functional income distribution of an economy translated into a size distribution by knowledge of how ownership and control over productive assets and labour skills are concentrated and distributed throughout the population. The distribution of these asset holdings and skill endowments ultimately determines the distribution of personal income. Moderating (reducing) the size distribution at the upper levels through progressive taxation of personal income and wealth. Such taxation increases government revenues and converts a market-and asset- determined level of personal income into a fiscally corrected disposal personal income. An individual or familys disposable income is the actual amount available for expenditure on goods and services and for saving. Moderating (increasing) the size distribution at the lower levels through public expenditures of tax revenues to raise the incomes of the poor either directly (e.g. by outright money transfer) or indirectly, through public employment creation or the provision of free or subsidised primary education and health care for both men and women. Such public policies raise the real income levels of the poor above their market-determined personal income levels. 189 A contribution which agriculture makes to economic development is known as factor contribution which is related to functional distribution. This can be divided into a further two contributions labour contribution and capital contribution. Labour contribution is defined as the phenomenon when agricultural productivity improves and surplus labour form the agricultural sector is released in to the industrial sector. Yao (2006) noted that in pre-reform China this was not so as labour could not be immediately transferred from one sector to another. In Chinas case this resulted in depressed agricultural labour productivity and large underutilised human capital. In terms of capital contribution Thirlwall (2006) explains that capital contribution can be via voluntary investment in machinery or via involuntary contributions in the form of taxes. One way in which agriculture may constrain economic development is through the product contribution of forward linkage effect, wherein the agriculture sector is responsible for providing raw material, capital and labour for the rest of the economy (Todaro, 2006, 819). Economic development is characterised by a substantial increase in demand for agricultural products, and if the expansion in food supplies (Johnston, 1961, 567) cannot meet demand, then economic growth will be stunted: there will be a significant rise in food prices, leading to pressure on wage rates, which could adversely affect industrial profits, investment and hence economic growth; it could also cause political discontent (Johnston, 1961, 573). This pressure on wage rates can have extremely adverse effects in undeveloped countries where food has a dominant position as a wage good. Structuralists would argue this was at least in part due to a growing population putting pressure on food supplies, coupled with supply inelasticities (Thirwall, 2006, 452). A reliance on exports may also develop. Growth of demand for food is particularly significant as high rates of population growth (1.5%-3%) characterise most of the worlds developing countries, as the decline in death rates, due to increased medical knowledge and application, is frequently much sharper than the fall in birth rates (Johnston, 1980, 572). However, it is worth considering Engelss law at this point, which states that the income elasticity for primary commodities is in elastic; the implication being that as individuals, and a countrys income rise, they will spend proportionally less on these commodities (Thirwall, 2006, 550) and agriculture will become a less important component of economic development. Furthermore, the share of agriculture is GDP falls as per capita income increases; labour share also declines. Nevertheless, income elasticity for food tends to be considerably less elastic for developing countries in comparison with developed ones- 0.6 versus 0.2 or 0.2 Western Europe, the U.S and Canada (Johnston, 1961, 572), suggesting that at least in the short-run, or in the early stages of development, a lack of ability to provide product contribution could mean that agriculture is a main constraint to economic growth. Engels law also has implications for the foreign exchange contribution argument: which states that a country which primarily exports primary commodities will automatically suffer a balance of payments deterioration if there is a growth in world income, vis-Ã  -vis the balance of payments of a developed country largely exporting industrial goods (Thirwall, 2006, 550), as purported by the Singer-Prebisch thesis, whose import substitution industrialisation hypothesis advocates that developing countries replace imported industrial goods with their own domestically-produced versions. Furthermore, countries will have a heavy reliance on agricultural exports, particularly those which have a heavy reliance on one particular export, such as coffee, tea or fruits, are at the mercy of environmental factors within their own countries, as well as trade barriers and changes in taste, internationally. However, a long-run goal of diversifying from a reliance on one or two export crops can lessen th is vulnerability (Johnston, 1961, 575). In addition, primary commodities typically are the greatest source of foreign exchange and foreign exchange is needed to fund development projects (Todaro, 2006, 69). It is also worth noting that some countries have a marked comparative advantage in agriculture and that in these, a reliance on agricultural exports does not necessarily constraining at all. In some ways, agriculture is in fact an enabler of economic development as it can provide inter-sectoral transfers to faster growing industrial sectors, vis-Ã  -vis labour or capital transfers. As non-industrial sectors grow, they will need an increased quantity of labour, and whilst the assumption of the Lewis two-sector model that labour supply is perfectly elastic can never be entirely true (due to, lack of transferable skills, or cultural factors, such as an unwillingness on the part of women to move away from their families), it is likely that during the earlier stages of development at least, labour will be drawn from the agricultural sector, as there will be fewer other sources (Johnston, 1961, 576). This loss of labour might in turn provide incentives for agricultural sectors to become more productive, though investment from some source will obviously be necessarily to enable this. However, empirical evidence would appear to suggest that capital, rather than labour is the ma in limiting factor to industrial growth, at least in the case of Japan, where taxes levied on the agricultural sector constituted 80% of the tax burden and were used to subsidise the creation of a merchant and shipbuilding industry, as well as investments in railways and education. (Johnston, 1961, 578) This evidentially, presents an example of agriculture enabling, not constraining economic development. However, using agriculture in this way to provide capital for industrialisation inhibits the farming sector from aiding economic development in another way; namely through market contribution, otherwise known as the backward linkage effect, where the agricultural sector generates a demand for industrial products, such as fertilisers, insecticides, machinery, transportation and so on, positively impacting on the economy as a whole. In fact, in the early stages of development, the agricultural sector is likely to provide the largest market for industrial goods. Hence, if a countrys agricultural sector is very largely subsistence, as it is in many developing countries, with farmers able to afford very few of such capital inputs, then agriculture may indeed be the main constraint to economic development. (Thirwall, 2006) Thirwall in fact goes as far to say that, a precondition for rapid industrial growth is a rapidly expanding agricultural sector (2006) Some economists, such as Hirschman, have argued that there are in fact higher linkage effects in the industrial, rather than the agricultural sector and in particular, that in many less developed countries, linkages are to be found within manufacturing industries, but not between industry and agriculture. According to Hirschman idea of Unbalanced Growth, the key to economic development is investment in a leading sector, an industrial sector with high linkages, rather than in agriculture. A problem with this however, is the previously-mentioned inflation, due to lack of coordination between supply and demand. Propagating a single industry might indeed lead to the similar problems with lack of trade diversification that occur when primary commodities are the sole export. As a consequence of land reform, Korea has enjoyed a reputation among countries as one with a relatively equitable income distribution (World Bank, 1983). In1945, when Korea was liberated from Japan and soon afterwards partitioned into South and North, about 80 per cent of the labour force in South Korea was engaged in agricultural and less than 3 per cent in the mining, manufacturing and construction sector. Under these circumstances, two land reforms in 1947 and 1949 meant the collapse of a traditional social order based on land, especially a rice-cultivating society, and the start of a new social order. Furthermore, the Korean War (1950-1953) had a profound impact on South Korean society, destroying existing capital stocks and levelling out the distribution of non-agricultural assets, and leaving the majority of Koreans in destitution. (Pg9 Korea housing) In a rather elaborate simulation-planning exercise, Irma Adelman and Sherman Robinson have investigated the interactive effects of various rural development programmes on income distribution and poverty South Korea. Land reform is one component. (Adelman and Robinson, 1978) Their objective was to determine what types of programmes would yield the largest impact over the medium term. They constructed a basic model of the Korean economy, taking great pains to calibrate it so that its predictions came close to actual outcomes over a predetermined period. In essence, the basic model was made to mimic the development of the Korean economy over a nine-year period, 1964 to 1972. The result is significant. First, among the individual programmes, land reform has the most favourable impact on income distribution. Second, land reform and the public works and small-scale industry programmes are much more effective in reducing poverty than are the other programmes. Third, promoting rural development, that is, implementing all the simulated programmes, leads to greater reductions in the incidence of poverty and income di sparities than either of the two programmes taken individually or jointly. And fourth, without land reform, rural development programmes would be less successful at addressing both poverty and income inequality. (The key to the Asian Miracle, 55) Therefore, the inequality in landholdings is resulting in inequality in all spheres of economic activity, social and political life. The inequality in landownership is leading to inequality of other productive assets also. The inequality is further resulting in un-equal access to the much needed agricultural inputs like credit etc. (Krishna Rao, Growth and Inequality in Agriculture, 1991, 55) Nevertheless, Alice Amsden argues that the reputation of Korea as a country with low income inequality might be due to false information for three reasons: (1) The value of real estate and other assets, which lends to appreciate with inflation, rose more rapidly in the 1970s than wages. Because this value is excluded from income and these assets tend to be owned by higher income earners, the treatment of such assets is likely to result in the understatement of inequality. (2) The equivalent of the United States Internal Revenue Service in Korea sometimes includes and sometimes excludes from the calculation of personal income, capital gains, rent, and interest payments. Such income is also taxed differently from wage income. (3) It was possible until 1988 to open bank accounts in Korea under an assumed name. Nevertheless, land reform did respond to the ancient cry for ega