Last week I discussed the economic consequences of inequality. Contrary to a traditional tenet of economics, empirical research has shown that inequality may have adverse economic consequences. Inequality increases the risk of political instability in a country, posing a threat to investments due to the fact that political unrest is highly detrimental to the profits made from any economic activity. Therefore, foreigners will bring less capital into a country when the risk of instability goes up, and even local investors will move their money over the borders and invest it elsewhere.

Under the assumption that inequality is rather vice than virtue, the question is what can be done to reduce it. The classical way, namely taxing income and property (usually even with progressive tax rates), and then redistributing the revenues to the disadvantaged members of society, is hardly feasible in a low-income country like Georgia. Low taxes are needed for stimulating investments and general economic activity – they are one of the few factors that increase our competitiveness with more developed economies.

Are there other ways to approach the problem? Yes, there is a more sophisticated approach. By identifying the sources of inequality, i.e. those kinds of income that strongly influence overall inequality, one can use subsidies, taxes, and other measures to increase or decrease those kinds of income that have the highest impact on overall inequality. In what follows, we will discuss this method.

WHERE DOES THE INEQUALITY COME FROM?

For identifying the sources of inequality, one can compute the Gini index for different income groups separately, as proposed by Robert I. Lerman and Shlomo Yitzhaki (“Income Inequality Effects by Income Source: A New Approach and Applications to the United States”, Review of Economics and Statistics 67, 1985, pp. 151-156).

The method of Lerman and Yitzhaki was applied to Georgia in a paper by Ruslan Yemtsov of the World Bank (“Inequality and Income Distribution in Georgia”, IZA Discussion Paper 252, 2001). Yemtsov compares the distribution of income of self-employed people with the distribution of total income and finds out that the self-employed are a major source of income inequality.

This result of Yemtsov is not surprising, as the self-employed category comprises individuals who are in very different economic situations. There is the smallholder farmer who grows some tomatoes and cucumbers mainly for his own consumption, the architect who hardly makes ends meet, the independent lawyer earning an average income, and the freelancing Tbilisi IT specialist who maintains the servers of large companies for $100 per hour. All these are self-employed.

Based on GeoStat data, I have done a similar analysis with 2009 and 2011 data. I have looked at the inequality of different income types (given in the first column of the table below), and, most important, I have computed how an increase of income of a particular type by 1% would affect the overall inequality in Georgia. The resulting numbers represent “percentage of the Gini coefficient”, difficult to interpret by itself but nonetheless providing a good indicator where we would have to start if the goal was to decrease inequality.

The table has a clear message. In 2011, one could reduce inequality (measured by the Gini coefficient) by almost 10% if one would increase the income of transfer recipients by 1% (transfers are made up of pensions, social benefits, scholarships, payments from relatives, and remittances). Likewise, one could reduce inequality by about 5% if in-kind farm income would go up by 1%.

At the same time, one could decrease inequality by almost 12% if one would take away 1% of the salaries of hired non-farm income recipients.

INCREASING PENSIONS AND SUBSIDIZING TOMATOES

Assuming that the Gini coefficient is what we are interested in when we speak about inequality, we could decrease inequality relatively easily by increasing transfers, e.g. pensions and social assistance benefits. As the calculations show, small changes can already have considerable impacts (of course, before implementing such a policy, one would have to redo the analysis with data that includes the pension increase from 125 to 150 lari that took place last year).

Similarly, one could enhance equality by subsidizing in-kind farm income, paying a farmer some tetri for each tomato in excess of its market price or setting up import barriers (if disguised in a smart way, both measures would not conflict with WTO restrictions). If the in-kind income generated through smallholder farming would increase in value, inequality would go down more than proportionally.

So without introducing a full-blown social welfare state and without explicit redistribution programs, the ideas of Lerman and Yithaki devise a way how to get the Gini coefficient down. It has to be stressed again that this only makes sense if one agrees that the Gini coefficient captures relevant inequality, which is currently the consensus in economics.