8 May 2017

Inequality: A necessary evil or a real problem?

Charlotte writes:*

In 2006, Uganda experienced a record growth rate of more than 10 percent. Although we may be happy with this result, it is wise to consider that whilst this was happening, Uganda scored around 0.5 on the Gini Index, meaning that it was suffering from high levels of income inequality. Furthermore, it ranked 152th on the Human Development Index, suggesting that its population had low levels of development (i.e., low life expectancies and levels of education). I ask myself: Is economic growth paired with high inequality acceptable for a country?

Many scholars would say yes – to them, income inequality is seen as the necessary-evil to economic growth. A belief, which is grounded in a misguided trust in the existence of the Kuznets curve. The thought behind this idea, is the belief that entrepreneurs would not invest in an economy, if there are no prospects for “large financial rewards”. In this view, income inequality is needed as it creates the opportunity for the rich to get richer. Equality will, at some point, follow.

Yet, some scholars are starting to disagree with this line of thinking, as they realize that inequality can be expensive. To see why, let’s first carefully distinguish economic growth from equality. Economic growth measures the overall economic well-being of a market by tracking changes in a country’s GDP. Equality, on the other hand, looks at the distribution of resources, which are not necessarily material. Equality would also take into account, for instance, healthcare and education, which are excluded from a country’s GDP.

An emerging strand in literature is arguing, that this underlying inequality can harm the economic growth it, arguably, set into motion. A recent IMF study [pdf] found, in fact, that whilst an increase of 1 percent in income of the bottom 20 percent of people in a country, would lead to a 0.38 percentage point higher growth in the next five years, that same income increase of the top 20 percent would lead to a 0.08 decline in economic growth. The mechanisms at play are threefold. It is argued, that income inequality ((1) leads to political and economic instability with reduced investment as a consequence, (2) negatively affects the social consensus needed to deal with shocks, and (3) harms the poor’s access to healthcare and education, thus undermining human capital potential and labor productivity [pdf]. Therefore, non-inclusive growth can make a country’s growth spell unsustainable [pdf]. The underlying details to economic growth, which GDP does not reflect, thus matter.

In Uganda, we can clearly see the problems of non-inclusive growth. The economic growth in Uganda was largely driven by the expansion of some sectors of the economy, such as industry and services, whilst agriculture was mainly left behind [pdf]. However, it is exactly this sector that employs about 75 percent of the Ugandan population. This has meant that only a small part of the population is benefitting from economic growth. As a consequence, Uganda has experienced large political and economic instability, resulting in negative consequences to economic growth, such as capital flight [pdf]. It thus seems of little surprise that from 2006 onwards, Uganda’s economic growth has been inconsistent, going from high peaks to economic declines.

Bottom line: Economic growth may be a popular goal to strive for, but if it is not inclusive, then it can do more harm than good as large parts of the population are left behind. The resulting costs can make economic growth unsustainable.

* Please comment on these posts by students in my growth & development economics course. It really helps if you highlight unclear analysis, alternative perspectives, better data, etc.