Poverty, Inequality and Economic Growth | Economics

Moreover, growing inequality and poverty create various socio-political problems,

suet) as dissatisfaction and frustration among the poor, which often culminate in
disruption and civil war and destroy the social and political basis of economic
activities.

Income inequality among households is measured by the distribution of incomes

according to size (or level) of income per household. The distribution across
income-size classes is called ‘the size distribution of income’. The higher the
income share of high-income classes and the lower the share of low-income
classes, the more unequal income distribution is supposed to be.

In general, the size distribution of income is determined by both the distribution of

income between labour and capital assets (functional distribution) and the
distribution of assets across the income-size classes. However, in today’s
industrially advanced countries, assets owned by the employees are very
significant.

They own not only tangible assets, but also intangible assets such as knowledge
and skill accumulated through human capital formation. This is why changes in
income distribution in the process of economic development cannot be correctly
judged through the analysis of the functional distribution alone.

Indicators of Inequality:
Two standard measures of inequality are:
Lorenz Curve and the Gini Coefficient.

In Fig. 1 we show cumulative percentage distribution of household incomes (On

the vertical axis) corresponding to cumulative distributions of the number of
households (On the horizontal axis) ranked on the basis of household incomes
from the bottom to the top.
The Lorenz curve coincides with the diagonal line OB in the case of perfect
equality in which all the households receive the same income. At the other extreme
is the case of perfect inequality in which one household monopolises all the
income while the other households receive no income.

The Lorenz curve would follow the right angled line OAB. Thus the larger is the
gap between the area between the line OB and the Lorenz curve in the extent of
income inequality. The Gini-coefficient is measured by the ratio of the inequality
area to the area of triangle OAB. It measures inequality within the range from 0 for
perfect equality to 1 for perfect inequality.

Concepts and Measurement of Poverty:

Poverty refers to deprivation from certain basic things of life such as food, cloth,
decent accommodation, safe drinking water, health care and minimum educational
opportunities.

Poverty is of two types:

(i) Absolute poverty and

(ii) Relative poverty.

(i) Absolute Poverty:

It is expressed in terms of someone’s economic status relative to a certain absolute
level of economic welfare. It is defined as a status of a person whose material well-
being is below a certain minimum level treated as reasonable by the standard of
society to which he belongs.
The level of material well-being is commonly conceptualized as ‘the standard of
living’ which is measured by the aggregate market value of private goods and
services consumed by the person (not including public goods). By using the
yardstick poverty in a society is measured in terms of the number of persons whose
living standards are below a certain minimum, as well as their distances from the
minimum level.

(ii) Relative Poverty:

It concerns questions such as what percentage of total income is received by the
bottom 10% of households and how far their standards of living are as compared
with those of richer people. Relative poverty is essentially the problem of
inequality in income distribution.

Patterns of Changes in Inequality:

Simon Kuznets observed on the basis of historical data that inequality initially
increase with economic development. But at a later stage of economic
development, as affluence arrives in a modern mixed economy, inequality falls.
From this emerges the inverted-U hypothesis. The Kuznets’ curve shows growing
inequality at a low stage of development as is measured by the Gini- coefficient,
showed on the vertical axis, in Fig. 2.
It has been difficult to statistically confirm the inverted U-shape pattern by the
time-series data. But stronger support has been provided for the hypothesis on the
inter-country (cross-section) data.

Poverty and Economic Growth:

If inequality in income distribution, as measured by such indicators as the Gini-
coefficient, remains the same, increases in PCI are sure to reduce the incidence of
poverty. However, if inequality is bound to rise along the rising of the inverted- U
shaped-curve, low-income economies may have to experience an increased
incidence of poverty-when they begin to experience economic growth as measured
by increase in real PCI. As in the case of inequality, this relationship between
poverty and economic growth in the early stage of development can be confirmed
by cross-section data and not time-series data.

Fig. 3 (a) compares poverty index and average PCI. The upper section of this
figure represents a comparison in terms of the headcount index (HCI) as measured
by the percentage of poor people below the poverty line—set equal to one US
dollar—in purchasing power parity (PPP), whereas the lower section presents a
comparison in terms of the poverty gap index (PGI) measured by the sum of
differences in poor people’s consumption expenditures or income from the poverty
line.
However, in addition to the level of PCI, the distribution of income matters in
determining the prevalence and severity of poverty. The monotonically decreasing
trend in poverty corresponding to rise in PCI, as observed in Fig. 3 (b), indicates
the income-in-equalising effect of economic growth. However, large inequality due
to other factors might also have serious effect on the incidence of poverty.

Causes of Inequality:
Statistical evidence does not give ample support to the inverted U-hypothesis
regarding changes in inequality with economic development. Yet, some factors are
likely to cause income distribution in developing countries to become less equal
and thus preventing poverty from being effectively reduced in the early stage of
their development.

The main causes are:

(i) Changes in Factor Shares:
In the early stage of development the income shares of capital falls and that of
labour increases. However, in all those countries where industrialisation starts late
there is, a general tendency to borrow capital-using and labour-saving technology.
Therefore, the share of capital is likely to rise further in today’s developing
economies than is observes from the histories of advanced economies.

This tendency has been aggregated by the adoption of policies by the developing
countries to promote highly capital-intensive basic and heavy industries such as
iron and steel, petrochemicals, heavy engineering, coal, oil, etc. which are of
strategic significance to such countries at the early stage of industrialisation.

The aim is to catch up with the advanced economies at maximum speed. For
achieving this goal, developing countries have frequently adopted policies
favouring large-scale industries based on capital-intensive technology at the
expense of small and medium enterprises based on labour-intensive technology—
by such means as import controls, rationing of foreign exchange, and overvalued
exchange rates.

(ii) Dual Economic Structure:

Many developing countries promote in which labour is an abundant factor large-
scale highly capital-intensive industries even at the early stage of development.
This gives birth to dual economic structures. In such economies wide gaps in
labour productivity and wage rate are found among large, small and medium scale
industries. Such dual economic structure is a serious source of inequality in today’s
developing countries.

To be more specific, only in the so-called ‘formal sector’—consisting of large

enterprises and government agencies—there is job security. Moreover, the wage
rates are high since workers are protected by labour laws. The entry to the formal
sector is closed to labourers in the informal sector, who make a living as
employees in small enterprises, casual labour on a daily basis, small traders and
self-employed manufacturers.

Due to such barriers to entry labour cost in large enterprises is high in spite of the
availability of cheap labour in the informal sector. So there is a strong incentive
among entrepreneurs in the informal sector to increase capital intensity by adopting
labour-saving technology. Consequently employment in the formal sector increases
much less than the increase in output and labour productivity.

So the income gap tends to widen cumulatively between employees in the formal
sector who can achieve a satisfactory rise in wages through collective bargaining
and labourers in the informal sector, who continue to live at or near the subsistence
level.

(iii) Income Difference between Agricultural and Non-Agricultural Sectors:

One major cause of growing inequality in the early stage of development is the
widening income gap between the farm and non-farm sectors. With the
introduction of modern industries in a traditional subsistence-based economy, there
emerges a major intersectoral difference in productivity. This difference tends to
widen as productivity in the modern industrial sector increases faster (due to
relative ease in borrowing technology) than that in agriculture at the early stage of
development.

One reason for growing farm-non-farm income gap in developing economies today
is the weak-labour absorptive capacity of the modern sector. This is mainly
attributed to the institutional factors that strengthen the dual economy structure by
encouraging the introduction of labour-saving technologies. Another reason is
growing pressure of population on farmland which reduces per capita land
availability. As a result, the law of diminishing returns starts operating quite early.
Achieving Equality:
(i) Taxes and Transfers:
Equality in the distribution of income and assets can be achieved with the adoption
of standard means such as progressive tax, inheritance tax (death duty/estate duty)
and a comprehensive social security system. However, these taxes and transfers are
not much effective for equalizing income distribution in developing economies
when the majority of the population remains engaged in self- employment and
casual hard work in agriculture and urban informal sector.

(ii) Agrarian Reforms:

Inequality in developing countries is also said to be connected with land reforms.
Such reforms aim at redistributing farmlands from landowners to tenants and
landless agricultural labourers. However, whether land reforms contribute to
increased agricultural productivity is not much transparent.

However, there is no denying the fact that the establishment of egalitarian agrarian
societies consisting of homogeneous small landholders increases social and
political stability which is essential for achieving rapid development.

On the other hand, land reform Acts have prompted landlords to adopt such
evasive measures as evicting tenants and hiring labourers to cultivate under
landlords’ direct management and planting trees in arable land to change the
latter’s classification. Such practices have made the labour power and managerial
abilities of tenants partly redundant.

(iii) Land Tax:

A potentially more effective policy instrument is taxation of land assets in
proportion to the asset value, called ‘land tax’. In developing economies today, the
frontiers of cultivation have been pushed to less productive land by population
pressure, resulting in increase in Ricardian differential rents. As a consequence, the
income gap between land-owing and landless people has been widening.

The equalising effect of land tax would be especially large if increased rent
incomes could be taxed and used as a source for public investment in irrigation and
agricultural technology development in order to counteract population pressure.
The tax revenue would achieve a very high pay-off in promoting both growth and
equality if allocated to the promotion and strengthening of general education.
However, effective land taxation requires establishment of a land registry system.
Once the system is completed the government will be able to continue raising a
stable tax revenue at moderate administrative cost without distorting agricultural
production incentives.

By using such tax revenue it is possible to adopt modernisation measures including

education, research and physical infrastructure—such as roads and potts. The land
registry system reduces the cost of land transactions and greatly facilitates
mobilisation of credit for long-term investment, using land as collateral.

So establishment of the land taxation system should represent a high pay-off

investment opportunity for developing economies to promote both efficiency and
equity. Yet few developing economies have intre-shed land tax, partly because of
the huge initial investment required and partly because of strong opposition from
landlords and open powerful groups in rural areas even though high land tax could
be less harmful to such countries than distortive taxes such as excise duty and
export duty.

(iv) Policy Change:

The policy bias towards promoting infrastructure of capital-using technology
should be corrected to prevent capital’s share from rising sharply in developing
countries.

(v) Adjusting Borrowed Technology:

A major effort must be devoted to adjust borrowed technology to the underlying

resource endowment in developing economies. Since the technology being used in
advanced economies was developed as an optimum (minimum cost) technology
under the condition of low capital cost relative to labour cost, reduction in both
production cost and capital’s relative share can be achieved by adjusting it in the
labour- using direction.

(vi) Altering Dualistic Economic Structure:

The government should stop intervention into market such as means import
licensing and foreign exchange allocations that favour large- scale enterprises.
They should also make necessary endeavours to assist small and medium
enterprises through development and diffusion of appropriate technology and
 provision of technical and managerial know-how, including market information.
Laws and regulations for the protection of labourers may be applied relatively
loosely but as widely as possible to reduce segmentation of the labour market
between the formal and informal sectors.

(vii) Promoting Progress in Land-Saving Technology:

Due to strong pressure of population on land, an extremely rapid rate of progress in
labour-saving technology is required to prevent labour productivity in agriculture
from falling faster than that in industry. It is possible to achieve this type of
technological progress only by adequately exploiting the potential of science-
based agriculture.

However, the potential cannot be realised without major public investments in

farmers education, agricultural research, irrigation, roads and other infrastructures.
Whether developing economies eager to achieve rapid industrialisation allocate
their limited budget to make investment for agricultural development will have a
decisive effect on the trend in income distribution.

The focus should be on improving the quality of life of the poor through
redistribution of income in their favour. The importance of delivering social
services to the poor for improving the quality of their lives cannot be over-
emphasised.

Does Economic Growth reduce Relative Poverty?

Economic growth will reduce income inequality if:

1. Wages of the lowest paid rise faster than the average wage.
2. Government benefits, such as; unemployment benefits, sickness benefits and pensions are
increased in line with average wages.
3. Economic growth creates job opportunities which reduce the level of unemployment.
Unemployment and lack of employment are one of the biggest causes of relative poverty.
4. Minimum wages are increased in line with average earnings.
5. Progressive taxes redistribute income. Progressive taxes such as higher rates of income tax will
take a higher percentage of income from the rich; this can be used to fund social spending, such
as health care, education and welfare benefits which help to reduce income inequality.
Businesses survive because of consumption by the population. If there is high income
and wealth inequality, and widespread poverty, there is then low consumption by a
high percentage of the population.

Economic performance is a function of the circulation of money in the system. A

company hires workers, buys raw materials and manufactures products, then sells the
products. There is money movement in all these. The salary earned by the workers is
then used for buying food, homes, services, etc. If you stash away the money you earn
under your pillow, that’s good for you in terms of building up your nest egg for a rainy
day, but it doesn’t do the economy at large much good.

A rich person will spend more money in absolute terms than a poor person. But, the
poor person is likely to spend a higher percentage of his income because his income is
not high, and alot of it goes into buying basic necessities such as groceries. There’re
more poor than rich people. When aggregated, poor people drive up consumption more
so than rich people.

The above explains why economic slowdowns, economic recessions are hard to manage.
The population at large is hesitant to consume, preferring to save money in case the
situation gets worse, e.g. they are retrenched by their employer. But, if consumption is
low, then business activity is low, and it feeds into economic slowdown worsening it. It’s
counterintuitive for people to ‘spend themselves out of the recession’. Sometimes, the
government steps in to increase public spending such as building major infrastructural
works