Wednesday, 21 March 07

ECON 4915 – seminar week 12: Kuznets curve and poverty traps

Written by Dimitri and Ingrid

Problem 1

Part 1

Based on Selection VIII.A.1. in Meier & Rauch. (Written by Kuznets.)

Kuznets poses the question: “Does inequality in the distribution of income increase or decrease in the course of a country’s economic growth?”

Part (1a): What is the Kuznets curve?

Kuznets assumes a long swing in the inequality:

(i)widening inequality in the early phases of economic growth

(ii)inequality then becomes stabilized for a while and

(iii)inequality narrows in the later phases of economic growth

This is the so-called inverted-U hypothesis.

Part (1b): How can we explain such a relationship?

Kuznets looks at data from Germany, the United Kingdom and the United States and conjectures that inequality was falling, beginning perhaps in the period before the first world war, after having risen during earlier periods. He argues that the distribution of income in agriculture is more equal than distribution of income in urban areas.

As development and urbanization proceeded, measured inequality overall should have risen. The new industrial system destroyed pre-industrial economic and social institutions. Dislocating effects and the “swarming” of population also increased inequality in addition to factors favoring maintenance or increase in the shares of top-income groups.

Subsequently the pace of industrial growth slackens and therefore the damaging effects of the transition becomes less severe.

The fall in total inequality is caused by the decline in inequality within urban areas. There was a rise in the income share of the lower groups within the non-agricultural sector of the population. An increasing proportion of the urban sector became “native” (born in the cities), which meant a better chance of organization and adaptation (increasing efficiency). The growing political power of the urban lower-income groups led to more adequate shares of the growing economy of the country.

Part (1c): The empirical findings on the shape of the relationship?

Kuznets says that no adequate empirical evidence is available for checking the conjecture of a long swing in income inequality. He also states that the phases cannot be dated precisely (although he has some suggestions…).

Part 2

Based on Selection VIII.A.2. in Meier & Rauch. (Written by Robinson.)

Part (2a): What is the Kuznets curve?

Robinson shows that overall income inequality follows an inverted U as the population is reallocated from one sector to another.

Part (2b): How can we explain such a relationship?

Robinson considers a two-sector economy. He then measures overall income inequality by the variance in the logarithm of income. (Since inequality is the dispersion in the income distribution, we can use the variance as a measure.)

Robinson focuses on between-sector inequality:

(i)All of the population in sector 1: between sector inequality = 0.

(ii)Some of the population migrates to sector 2: between-sector inequality positive.

(iii)All of the population in sector 2: between-sector inequality = 0.

Part (2c): Empirical findings on the shape of the relationship?

No findings mentioned by Robinson (only uses algebra).

Part 3

Based on Selection VIII.A.4. in Meier & Rauch. (Written by Higgins & Williamson.)

Part (3a): What is the Kuznets curve?

Once one controls for the so-called “cohort size effect” (explained below), the inverted U emerges, where inequality first rises and then falls as development (measured by worker productivity) increases.

Part (3b): How can we explain such a relationship?

The cohort size effect: Less developed countries have a smaller proportion of their labour forces in the peak earning ages, 40-59 (incomplete demographic transitions yield higher population growth rates). We see increasing inequality because of higher wages for the jobs for which the “high peak earning ages”-group is needed (scarcity  = wages  ). They control for this relationship to find the inverted U.

Part (3c): The empirical findings on the shape of the relationship?

The data they use covers 92 countries and four decades (the 1960s through the 1990s), yielding 600 annual observations. 19 countries contribute ten or more annual observations, permitting the analysis of inequality trends over time. They experiment with a number of alternative specification to check robustness. Their results provide considerable support for the hypothesis that inequality follows an inverted U as an economy’s aggregate labour productivity rises, when controlling for cohort size. (A higher fraction of the labour force in its peak earning years reduces inequality). Inequality is measured both by the Gini coefficient and as the ratio of income earned by the top income quintile to income earned by the bottom quintile (Q5/Q1). Cohort size has a consistent and powerful effect throughout.

Additional question: What does “joint significance” imply? Can we test this?

Here we’re looking at the joint significance of real output per worker and its square as explanatory variables (RGDPW and its square). When the author says that they are jointly significant at the 1% level it means that we reject the hypothesis of them both being 0 with 99% confidence. So, yes, this relationship can be tested (we use an F-test).

Problem 3

To answer the questions of problem 3, we can follow the arguments of Ghatak and Jiang. The optimal solution, according to Ghatak and Jiang, would be that the government taxes bequests of rich dynasties and then, to balance the government budget, redistributes the revenue to poorer dynasties with wealth lower than I (what is needed to become an entrepreneur). The goal is then to make as many individuals as possible able to start their own enterprises.

If everyone has equal wealth to start with (i.e. everyone is in a high-wage or subsistence equilibrium), this policy will of course have no effect.

The policy might, however, according to Ghatak and Jiang, have an effect in the case of a low-wage equilibrium. The policy would move everyone’s wealth closer to the mean. How large the wealth of the median person is (specifically, larger than or smaller than I?), determines whether there is a high- or a low-wage equilibrium. No matter what, the policy will increase the number of enterprises that are operated and hence raise total income.

Intuition:

In problem 3, we are supposed to look at the case when bequests are taxed at a flat rate t. A flat tax taxes all bequests at the same marginal rate. The collected resources are used for a flat transfer to every agent.

A (very!) simplified example may help to illustrate the intuition behind this idea: If we have two individuals, one earning 1000 dollars (”poor”) and one earning 10.000 dollars (”rich”) and they are both paying a flat tax rate of 10%, the first person pays 100 dollars and the second person pays 1000 dollars in taxes. These two tax-incomes are then put together and equal 1100 dollars from which the flat transfer is paid out. Since the rich have more, they also pay more in absolute terms when taxed at a flat rate (some people seem to forget this fact): A flat tax rate followed by a flat transfer is a way to redistribute income from the rich to the poor: the poor get access to the rich person’s resources.

An argument against this kind of taxation, when comparing to progressive taxation, is that money mean more when you have less to start with (differences in marginal value of income). Following this argument, a progressive tax rate is better because it makes sure that those who have better abilities pay the most. We might have the problem that, when moving from a progressive tax system, for the state to raise the same amount of money under a flat rate tax requires that the rich pay less and the poor pay more. Flat tax schemes weaken the redistributive effect of progressive taxation.