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Development Economics
Inequality and Development
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Why is inequality a concern?
• Inequality may be of interest for functional reasons.
– The presence of inequality affects the way in which an economy works and
prevents (or perhaps promotes!) some other goal that we are interested in.
• There is good reason to believe that the functional aspects of inequality
are far more acute for developing countries than for their economically
developed counterparts
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Why is inequality a concern?
• Generally, we assume that social welfare depends positively on the
level of income per capita but negatively on poverty and negatively on
the level of inequality.
• Effects of (extreme) poverty on inequality is obvious.
• There are three reasons why inequality may be bad for the society.
• First, extreme income inequality leads to economic inefficiency.
– This is partly because at any given average income, the higher the inequality, the
smaller the fraction of the population that qualifies for a loan or other credit.
– Moreover, with high inequality, the overall rate of savings in the economy tends to
be lower, because the highest rate of marginal savings is usually found among the
middle classes.
• Rich people spends on luxury, jewellery, capital flight etc. 5-3
Why is inequality a concern?
• Furthermore, inequality may lead to an inefficient allocation of assets. High
inequality leads to an overemphasis on higher education at the expense of
quality universal primary education, which not only may be inefficient but is
also likely to beget still more inequality in incomes.
• High inequality of land ownership—characterised by the presence of huge
latifundios (plantations) alongside tiny minifundios that are incapable of
supporting even a single family—also leads to inefficiency because the most
efficient scales for farming are family and medium-size farms.
– The result of these factors can be a lower average income and a lower rate of
economic growth when inequality is high.
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Why is inequality a concern?
• The second reason: extreme income disparities undermine social
stability and solidarity.
• Also, high inequality strengthens the political power of the rich and
hence their economic bargaining power.
– Usually, this power will be used to encourage outcomes favourable to
themselves.
– High inequality facilitates rent seeking, including actions such as
excessive lobbying, large political donations, bribery, and cronyism.
• Finally, extreme inequality is generally viewed as unfair
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Inequality, Income and growth
• The Kuznets inverted U-shaped hypothesis
– Kuznets curve: A graph reflecting the relationship between a country’s
income per capita and its inequality of income distribution.
• Kuznets (1955) is the earliest attempt to correlate the presence of
economic inequality with other variables such as income.
– Because of data limitations, Kuznets used the ratio of the income share of
the richest 20% of the population to that of the poorest 60% of the
population as a measure of inequality.
– The comparison was carried out between a small set of developing
countries—India, Sri Lanka and Puerto Rico—and a small set of developed
countries—the United States and the United Kingdom.
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Inequality, Income and growth
• The ratios turned out to be 1.96 (India), 1.67 (Sri Lanka), and 2.33
(Puerto Rico), as opposed to the values of 1.29 (United States) and
1.25 (United Kingdom).
• These values are indicative of the possibility that developing
countries, in general, tend to possess higher degrees of inequality
than their developed counterparts.
• A later study by Kuznets (1963) that used data from 18 countries, a
mixture of developed and developing countries. provided further
support for this possibility.
• Simon Kuznets suggested that in the early stages of economic
development (growth), the distribution of income will tend to worsen;
only at later stages will it improve. 5-7
Inequality, Income and growth
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Inequality, Income and growth
• The Tunnel Effects of inequality (Hirshman and Rothchild, 1973).
– the tolerance for inequality in income distribution along the path toward
economic development.
– If growth and equity in income distribution are considered to be the two
principal objectives of the process of economic development, the
development strategy has to be devised by keeping in mind the social and
political context.
– If, given the social structure, the tunnel effect is weak (i.e., tolerance for
inequality is low), a strategy of “grow first, distribute later” is unlikely to
meet with success.
– Even with strong initial tunnel effects, the development process may be
frustrated if ruling groups and policy makers are insensitive to the erosion
of these effects over time. 5-9
Inequality, Income and growth
• Kuznets did not specify the mechanism by which his inverted-U
hypothesis was supposed to occur.
• However, explanations as to why inequality might worsen during the
early stages of economic growth is always related to the nature of
structural change.
– Early growth may, in accordance with the Lewis model, be concentrated in
the modern industrial sector, where employment is limited but wages and
productivity are high.
– Alternatively, returns to education may first rise as the emerging modern
sector demands skills and then may fall as the supply of educated workers
increases and the supply of unskilled workers falls.
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Income and inequality: Uneven and compensatory
changes (cont.)
• Types of income growth: When a country experiences an increase in
per capita income, the change might stem roughly from three sources.
– First: those changes that occur on an everyday basis: people accumulate
wealth, acquire skills, exhibit steady gains in work productivity, and so on.
– Second source of change is inherently uneven: some sectors (such as
engineering, software design, or accounting) take off, and there is a
frenetic increase in demand for individuals with these skills. The economy
as a whole registers growth, of course, but this growth is highly
concentrated in a relatively small number of sectors.
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Income and inequality: Uneven and compensatory
changes (cont.)
– Finally, there are those changes that are “compensatory” to the second: as
the growth spurt manifests itself in high incomes in some sectors, the
incomes spread through the economy as demands for all sorts of other
goods and services rise.
• At any point in time, it is likely that some combination of all three
phenomena is at work.
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Income and inequality: Uneven and compensatory
changes (cont.)
• The inverted-U would be a theoretical possibility if it is more likely that
– uneven changes occur at low levels of income,
– whereas compensatory changes occur at higher levels of income.
• A basic feature of economic development is that it involves
– large transfers of people from relatively poor to relatively advanced sectors
of the economy, a “dual economy,” where economically backward and
progressive sectors coexist and development proceeds by the advanced
sector feeding on the backward sector for resources to propel its own
growth.
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Income and inequality: Uneven and compensatory
changes (cont.)
– Technical progress initially benefits the (relatively) small industrial sector
and be biased against unskilled labor
– industrialization itself brings enormous profits to a minority that possesses
the financial endowments and entrepreneurial drive to take advantage of
the new opportunities that open up.
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Acemoglu on Kuznets curve
• Acemoglu (2002) provides a political economy theory of the
Kuznets curve.
– When development leads to increasing inequality, it can lead to political
instability and force democratisation on political elites.
– Democratisation leads to institutional changes which encourage
redistribution and reduces inequality.
– However, development does not necessarily lead to the Kuznets curve.
Development may be associated with two types of non-democratic paths.
• Autocratic disaster (high inequality and low output)
• “East Asian Miracle” (low inequality and high output).
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Empirical Evidence of the Kuznets Curve
• Ultimately, Kuznets hypothesis is an empirical phenomenon.
• Two ways to do that empirically.
– For an individual country using time series data (rrquires long time series)
– Use cross-sectional data
– Panel data
• One of the early studies is Paukert (1973)
– Use data from 56 countries divided by income categories, and Gini as a
measure of inequality.
•
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Empirical Evidence of the Kuznets Curve
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Empirical Evidence of the Kuznets Curve
• Paukert (1973)
– First, there appears to be a relationship between inequality and GDP of the
kind predicted by Kuznets
– However, the variation within a particular category is certainly far from
negligible (third column).
• A large dataset also support Paukert’s (1973) argument (next
slide).
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Empirical Evidence of the Kuznets Curve
• Ahluwalia (1976) analyzed a sample of sixty countries: forty
developing, fourteen developed, and six socialist, with GNP figures
measured in U.S. dollars at 1970.
– found support for the Kuznets Curve in developing countries
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Empirical Evidence of the Kuznets Curve
• Deininger and Squire (1998): Using a high-quality panel dataset of income
distribution, they found no consistent evidence supporting a universal Kuznets
Curve. Their analysis showed that inequality often remains stable or increases
even at higher income levels, suggesting institutional and policy factors play a
stronger role.
• Barro (2000): Estimated a non-linear relationship between inequality and
growth using a broader dataset. While some evidence of a Kuznets-type curve
was found, the results varied significantly across regions and were sensitive to
data and econometric specification.
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Empirical Evidence of the Kuznets Curve
• Country-Level Time Series Evidence
• Fields (2001): Argued that while some countries (e.g., South Korea, Taiwan)
followed the Kuznets trajectory, others did not, indicating the non-universality of
the curve. Historical inequality patterns were shaped by policies, structural
changes, and demographic transitions.
• Londoño and Székely (2000): Using Latin American data, they challenged the
Kuznets hypothesis, noting that inequality remained persistently high despite
economic growth, largely due to poor education systems and labor market
rigidities.
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Empirical Evidence of the Kuznets Curve
• Cornia, Addison, and Kiiski (2004): Analyzed inequality trends in the 1980s–
90s and attributed rising inequality to globalization, liberalization, and
weakened redistributive mechanisms.
• Piketty (2014) and Milanovic (2016) questioned the long-term decline of
inequality postulated by Kuznets. Piketty shows that inequality can rise again in
advanced economies, challenging the idea that capitalism naturally corrects
inequality in its mature phase.
• New inequality metrics and better data (e.g., World Inequality Database)
reveal that top income shares have increased even in advanced economies,
casting further doubt on the Kuznets curve's universality.
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Empirical Evidence of the Kuznets Curve
• Methodological Issues and Critiques
– Many early studies relied on cross-sectional data, which cannot capture
dynamic within-country processes.
– Income inequality measures (like Gini coefficients) suffer from
comparability issues across countries and time.
– Causality is hard to establish: does development reduce inequality, or does
inequality hamper growth?
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Empirical Evidence of the Kuznets Curve
• The empirical literature reveals mixed support for the Kuznets Curve.
• While some countries historically followed the hypothesized path, many others
diverged due to:
– Varied institutional arrangements
– Policy differences
– Global economic forces (e.g., globalization, technology)
• Modern studies increasingly emphasize the role of politics, institutions, and
global capital flows over purely developmental stages.
• Thus, while the Kuznets Curve remains a valuable empirical issue even after
70 years of its introduction, it does not offer a universal law of inequality and
development.
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