Income Inequality

Sheahan characterises Latin America as having the highest indices of income inequality of any
region in the world. What accounts for this? Is such inequality an impediment to growth and
development?

Inequality is one of the key characteristics of Latin America. Examine its causes and its relationship
with economic growth with reference to Chile in particular.

Chile has one of the best records of recent economic growth in Latin America and one of the worst
with regard to inequality.’ Critically discuss the evidence of the relationship between economic
growth and inequality in Chile.

Kuznets (1955) argued that the process of growth would be accompanied by a movement of labour
from low-productivity sectors to high-productivity sectors 1. If the wage in the high-productivity
sector was greater than the wage in the low-productivity sector, the migration process would result
in some labourers in high-productivity high-wage employment while others remained in low-
productivity low-wage employment. Consequently, inequality rises initially before falling as
migration leads to the saturation of the high-productivity high-wage sector. Hence the existence of
Kuznets inverted U-curve highlighted in figure 1.

FIGURE 1: DIAGRAMATICAL REPRESENTATION OF THE KUZNETS CURVE

The Kuznets hypothesis is, to an

extent, endorsed by the Stopler-Samuelson Theorem (1941) that technological progression and
labour-saving opportunities that often coincide with growth will result in an increase in wages for
high-skilled labourers and a reduction in demand for low-skilled labour hence a divergence of
relative incomes. In illustration, in Brazil labour-intensive industries national output contribution fell
from 36% in 1970 to 26% by 1996, increasing unemployment rates for low-skilled workers whilst

1
Where typically rural employment constitutes low-productivity sectors and urban employment the high-
productivity sectors
increasing wages for the minority of highly skilled workers and causing income inequality to grow
(Kniivilä, 2005).

Chile experienced a similar experience as in Mexico, trade liberalisation in 1985 left labour-intensive
industries unprotected to Chinese competition, which contributed to a significant relative reduction
in the wages of low-skilled workers, and consequently an increase in income inequality [ CITATION
Han99 \l 2057 ]

For the majority of economies, initial income inequality acts as a significant barrier to economic
growth, particularly in the long run. Amongst others Alesina and Rodrik (1994), Perotti (1996),
Person and Tabellini (1994) and Deininger and Squire (1998) uniformly found a significant and robust
negative cross-country correlation between GDP Growth and the Gini Co-efficient. In illustration, in
the 1960s both the Philippines and South Korea shared similar macroeconomic conditions; however
the Philippines suffered an income distribution twice as unequal as that of South Korea. In the
following three decades South Korea experienced growth in output nearly 3 times that of the
Philippines [ CITATION Ben96 \l 2057 ].

There are three commonly cited channels through which income inequality inhibits economic
growth: unequal income distribution limits investment in human capital, induces social conflict and
creates greater pressures for redistributive policy.

Income distribution affects the efficiency of aggregate investments, particularly in human

capital[ CITATION Lou81 \l 2057 ]. Unequal income distribution means that while the rich inherit
wealth which allows them to invest in human capital, the poor are unable to afford the investment.
This is particularly relevant when imperfect credit markets exist, which reduce the ability of low
income earners to attain credit, restricting their ability to gain education [ CITATION Per \l 2057 ].

Alesina and Perotti (1996) find that income inequity incites social conflict, in turn inducing socio-
political instabilities. In particular, a volatile socio-political environment creates uncertainties over
policy and threatens the protection of property rights, significantly 2 discouraging domestic
investment and consequentially limiting economic growth.

Not only does income inequality cause political instabilities, but it also creates resentment and a lack
of security between income classes. This substandard relationship reduces co-operation, increases
transaction costs and increases unproductive expenditure on protection against crime [ CITATION
Fay93 \l 2057 ]. Income inequality itself is a major cause of crime; a 1% increase in the Gini
coefficient has been found to cause a 1-4% increase in crime rates (Fajnzylber, Lederman, & Loayza,
2002). Disparities in income make the potential gains from theft greater for those at the bottom of
the income spectrum[ CITATION Bou03 \l 2057 ]. High levels of crime have numerous physical costs;
in 2008 crime cost the Mexican economy $65 billion, constituting nearly 8% of GDP (Chronicle,
2008). Furthermore, the illegal drug sector in Columbia offers, on average, double the wage offered
in legal employment, diverting labour away from economically productive causes (Richani, 1997).

Through Alesina and Rodrik’s (1994) median voter theorem, income inequity induces demand for
redistributive policies; policies which have the consequential and unintended effect of inhibiting
economic growth. The median voter theorem states that tax rates (and other redistributive policies)

2
Both economically and statistically.
will be determined by the preferences of the median voter. Low income voters prefer taxes which
have the greatest redistributive effect upon wealth. Since an economy with greater wealth inequality
implies a lower income for the median voter3, more inequitable economies will be pressured into
employing greater taxes and redistributive policies; policies which impede growth by generating
economic distortions and disincentives [ CITATION Per94 \l 2057 ]. Higher taxes reduce the private
marginal product of capital, reducing the incentive to invest, inhibiting capital accumulation and
subsequently growth [ CITATION Per \l 2057 ]. Rodrik (1997) highlights a related factor, arguing that
such policies may inhibit the government’s ability to respond to shocks in output, resulting in greater
output volatility. Greater output volatility is negatively related to growth, as output volatility
discourages both domestic and foreign investment [ CITATION Ber94 \l 2057 ]. Rodrik infers that
income inequality may be an explanation for why East Asian economies recovered earlier than Latin
American countries in the 1980s Debt Crisis.

Despite the strength of these arguments, the debate is not complete; the implications of income and
wealth inequality ought to shape policy decisions and research for the foreseeable future. Changes
in income distribution cannot simply be considered the product of market mechanisms; income
inequality is drastically affected by pre-existing economic, political and social conditions, policy
decisions and exogenous factors such as trade relations. Such considerations will become more
prominent in upcoming years as rapidly growing ‘superpower’ economies look to maintain growth
rates. China has experienced rising income inequality since the late 1980s (Chang, 2002). In view of
the findings in this essay, their growth prospects may be threatened by rising levels of inequality. For
the Chinese, uniting an effort to tackle income inequality with current growth promoting policies
may be vital in order to achieve sustained long-run growth.

Latin America 1950-1990: gini coefficients increase by 20% in most countries.

 Colombia: “comprise politics” in light of the deal struck by Liberal and Conservative leaders
in 1956 did little to alleviate worries of the poor. Thus the poor found little outlet other than
to continue with disorganised guerrilla activity. Illegal drugs market pulls resources away
from more growth enhancing methods.
 Growing inequality throughout 1980s and 1990s. Policy change and growth as of 1990s lead
to sharp increase in Gini coefficients.
 Chile: Pinochet’s 1970s reforms ignored the complaints of the poor.
 Financial pyramiding: concentrated ownership in oligopolistic holding companies – the
grupos.
 Pinochet reforms made position of the poor worse: 1970 = 20% population in poverty, 1983
= 29% population in poverty.
 Income share per household: bottom quintile hold 4.55% income 1978 vs. 4.23% in 1988.
 Index of public spending (1970 = 100): family allowances in 1985 = 54.6; health, education,
housing in 1985 = 88.5.
 Mexico: distribution of income in mexico becoming substantially more unequal thanks to te
introduction of free market policies. According ot Alercon and McKinley: “economic
restructuring and trade liberalisation were rewarding the more elite, skilled sectors of the

3
Since inequality is measured as the gap between the mean and median voter, for a given mean income,
greater inequality reduces the median voters income.
 Mexican labour force” and “this differentiation became most marked in 1992 after four
years of economic growth”.
 Argentina: Over the last quarter-century, the distribution of income in Argentina has
deteriorated steadily. In the 1970s, the deterioration was due to real reduction and relative
dispersion of wages; in the1980s, it was linked to growing unemployment resulting from
successive crises; in the1990s, under the new economic order, the deterioration continued
as a result of the unemployment generated by the restructuring of production and the
increase in labour force participation, coupled, in the last phase, with greater inequality in
wage levels.
 Ginis: 1974 = 0.37; 1980 = 0.40; 1985 = 0.42; 1987 = 0.46; 1989 = 0.54; 1991 = 0.47;

Chile's Gini coefficient as of 2001 was 0.571

Colombia-0.586
Bolivia-0.601
Argentina-0.528
Peru-0.546
Brazil-0.580

UK-0.36