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ISET Economist Blog

A blog about economics in the South Caucasus.

Beyond Fairness and Envy: The Economic Effects of Income Inequality

Why should we care about income inequality? According to Nobel Prize laureate Joseph Stiglitz and Harvard economist Jason Furman, “greater inequality leads to more political instability, and greater political instability leads to lower growth” (“Economic Consequences of Income Inequality”, Federal Reserve Bank of Kansas: Journal Proceedings, 1998, pp. 221-232). Consequently, even if one does not care about income inequality directly, there may be reason to care about its indirect effects.

In their article "Income Distribution, Political Instability, and Investment" (European Economic Review 40, 1996, pp. 1203-1228) Italian economists Alberto Alesino and Roberto Perotti empirically investigate the connection between inequality, political instability, and economic prosperity. They apply econometric techniques to the data of 71 countries (measured in the years from 1960 to 1985) and capture political instability by constructing “an index which summarizes various variables capturing phenomena of social unrest”. Specifically, the authors elicit the connection between the income of the middle class (defined to be the total income of the third and fourth quintiles of the population), socio-political instability, and investment activity. They find that “socio-political instability depresses investment” and that “a rich middle class reduces socio-political instability”. As a wealthier middle class implies more equality in the distribution of income, their findings confirm the hypothesis that inequality is bad for prosperity.


THE LEAKY BUCKET

This view is in stark contrast to the classical economic paradigm that people in a market economy should be allowed to reap the fruits of their activity without being forced to share them with others. The situation is often compared to a leaky bucket: yes, a government can take away income from the rich, but it has to pay a price for that, which comes in form of reduced overall economic output. Allegorically, the bucket in which the money is carried from the rich to the poor has a leak – the total size of the pie depends on how we divide it.

The argument rests on the assumption that in their economic conduct, people are incentivized primarily by material rewards. If one takes away (some of) these rewards, they will exert less effort.

Obviously, there is some truth to this point. Consider a society where taxation and redistribution ensures that everybody has exactly the same income. Why should people in such a society get up early in the morning, work hard, be creative, and do unpleasant tasks? As the income would be the same anyway, people might be tempted to sleep long, procrastinate unpleasant tasks, and “have a cushy job”, as the Americans say.

Arguably, socialist economies like the Soviet Union were suffering from this problem. The core of the problem was that Soviet citizens were reluctant to show initiative and come up with good ideas as those would help the collective, not themselves. As a result, few factories produced consumption goods that were really desirable. For example, a car could only be acquired after long waiting times, and when finally it was delivered, it had a low quality and looked clumsy.

This lack of attractive goods aggravated the problems of socialist countries to incentivize their people, leading to desperate attempts to resort to negative incentives (forced labor, punishment of alleged low-performers) and non-monetary rewards like badges and titles (“worker of the year”, “Order of Lenin”). This was hardly effective, however, as most persons find it much better to simply become rich than to become worker of the year.

On the other hand, in some economies in Europe, primarily in Scandinavia, the governments engage heavily in redistribution. Even though more than fifty percent of those economies are run by the state, people enjoy high incomes and excellent quality of life.


WHAT ABOUT GEORGIA?

After the collapse of the Soviet Union, Georgia experienced high income inequality. The Estonian economist Anneli Kaasa estimated the Gini coefficient to have been 0.36 in 1992 and 0.58 in 1996 (“Factors Influencing Income Inequality in Transition Economies”, University of Tartu Working Paper, 2003).

The Gini coefficient is the foremost index of inequality used in economics. It ranges from 0 to 1, with higher values indicating more inequality. The Scandinavian countries have Gini coefficients around 0.25; the USA, arguably the most inequitable among all high-income countries, 0.45; Georgia currently about 0.41. A value of 0.58 corresponds to countries like Angola and Haiti today.

The chart shows the income distribution in Georgia according to Geostat. As can be seen, the average total income received by top 10% of the population is very high compared to what other members of the society earn. An average member of the top 10% income recipients earns about 16 times more than an average member of the lowest 10%.

Taking the stand that stark inequality is detrimental to economic prosperity, in particular in a society that is vulnerable to political unrest (unlike the USA, which has a stable democratic political system for centuries), the question is what are the sources of inequality in Georgia and how can it be reduced. I will discuss these questions in next week’s Khachapuri Index. 

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Guest - NP on Tuesday, 04 February 2014 13:24

Any information about: 1) the average income of the top 1% of the population? ; 2) the distribution of Wealth (stock) rather than the distribution of incomes? Inequality in the distribution of wealth is usually much larger.

Any information about: 1) the average income of the top 1% of the population? ; 2) the distribution of Wealth (stock) rather than the distribution of incomes? Inequality in the distribution of wealth is usually much larger.
Guest - NP on Tuesday, 04 February 2014 13:32

P.S: I think a pie chart showing the share in total Income of the different deciles would have been more telling :) (It would appear very clearly - at first sight - that the cumulative incomes of the top 10% of the distribution are larger than the cumulative incomes of the bottom 60% of the distribution)

P.S: I think a pie chart showing the share in total Income of the different deciles would have been more telling :) (It would appear very clearly - at first sight - that the cumulative incomes of the top 10% of the distribution are larger than the cumulative incomes of the bottom 60% of the distribution)
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