Jimmy Norström Erik Nilsson Income Inequality Jimmy Norström Erik Nilsson

Why should we study income inequality? It’s relationship to poverty. - If income is distributed more unequally, more people will live in poverty for any level of average income. Effects on economic growth. - Hypothesis states that income inequality will be good for growth in rich countries and bad for growth in poor countries.

How do we measure income inequality? Two commons ways to look at income inequality. Divide the population into several equal-sized groups and measure how much each group earns.

How do we measure income inequality? Divide income into equal-sized groups and measure how much of the population falls into each group.

The Gini coefficient Takes on a value between 0 and 1 and tells the degree of income inequality in a country. To construct the Gini coefficient one first calculates what fraction of the total income the poorest 1 % of households earn. Then the same fraction for the poorest 2 % of households, and so on, up to 100 %.

The Gini coefficient When then graph these values we get a Lorenz curve. The Lorenz curve is curved because of inequality.

The Gini coefficient If there was no inequality the Lorenz curve would be a straight line (Line of perfect equality). The Gini coefficient is the area between the “Line of perfect equality” and the Lorenz curve divided by the total area under the “Line of perfect equality. The Gini coefficient is between 0 and 1. The higher the coefficient the higher the degree of inequality.

Kuznets Curve Kuznets hypothesized that as a country developed, inequality would first rise then later fall. The theory implies that if we graph the Gini coefficient as a function of GDP per capita, the data would show an inverted-U shape. This is the Kuznets curve.

Sources of income inequality People in an economy differ from each other in ways that are relevant to their income. - Human capital (both education and health) - Geography (city or countryside, provinces) - Ownership of capital - Luck

Effect of income inequality on economic growth Four channels through which inequality affect economic growth has been hypothesized. The accumulation of physical capital The accumulation of human capital Government redistribution policy Sociopolitical instability

Effect on the accumulation of physical capital Saving rates tend to rise with income The higher the level of income inequality - that is, the higher the fraction of total income earned by rich people - the higher the total savings will be. Through this channel, inequality have a positive effect on economic growth.

Effect on the accumulation of human capital Poor households tend to forego human-capital investments that offer relatively high rates of return. In this case, a distortionfree redistribution of assets and incomes from rich to poor tends to raise the quantity and average productivity of investment. Through this channel, inequality have a negative effect on economic growth.

Effect on government redistribution policy A greater degree of inequality—measured, for example, by the ratio of mean to median income—motivates more redistribution through the political process. Typically, the transfer payments and the associated tax finance will distort economic decisions. For example, means-tested welfare payments and levies on labor income discourage work effort. In this case, a greater amount of redistribution creates more distortions and tends, therefore, to reduce investment (in the transition to the steady state)

Effect on government redistribution policy The rich may prevent redistributive policies through lobbying and buying of votes of legislators. The lobbying activities would consume resources and promote official corruption and tend accordingly to hamper economic performance. Therefore, inequality can have a negative effect on growth through the political channel even if no redistribution of income takes place in equilibrium.

Effect on sociopolitical instability The threats to property rights deter investment. (revolution) The participation of the poor in crime and other antisocial actions represents a direct waste of productive efforts. Through this channel, inequality have a negative effect on economic growth.