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This is to certify that the

dissertation entitled

THE IMPACT OF ECONOMIC GROWTH ON
THE DISTRIBUTION OF INCOME IN THE
LESS-DEVELOPED COUNTRIES

presented by

Abdollah Ferdowsi

has been accepted towards fulfillment
of the requirements for

Ph. D. Economics

degree in

 

 

N em.

' Major professor

Date August 12, 1982

 

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THE IMPACT OF ECONOMIC GROWTH ON THE DISTRIBUTION
OF INCOME IN THE LESS—DEVELOPED COUNTRIES

By

Abdollah Ferdowsi

A DISSERTATION

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Economics

1982

 

3

Q l \"5 o ~--.2’~?“

ABSTRACT

THE IMPACT OF ECONOMIC GROWTH ON THE DISTRIBUTION
OF INCOME IN THE LESSQDEVELOPED COUNTRIES

By
Abdollah Ferdowsi

The past three decades have been characterized by
an unprecedented and unexpected rate of economic growth in
many developing countries. Most developing countries focused
their attention on policies aimed at increasing the level of
output and they succeeded. The preoccupation with maximizing
the rate of output growth took precedence over the concept
of distribution of output among all segments of the
population.

The justification for growthvoriented policies is the
so-called Kuznets' Hypothesis. It suggests that in the
early stages of economic growth, the distribution of income
tends to worsen, while at the later stages market forces and
government's corrective action will improve the distribution
of income in favor of the poor. A great deal of skepticism
has been raised with regard to the inherent tendency and
ability of market forces and governments to reduce the
inequality in the distribution of income.

The main objective of this dissertation is to empirie

cally explore the relationship between income distribution

and different socio—economic and structural changes which
occure at different stages of economic growth. An
unprecedented technique of estimation is used, i.e. the
cubic spline function. The spline function is superior to
the other form of specification in a sense which allows a
curvature relationship between different variables.

Based on the empirical finding, a set of policies are
proposed to improve the distribution of income. It is
argued that there is no need for sacrificing economic growth
for an egalitarian distribution of income. By designing
and implementing economic and social policies, a better
distribution of income can accompany economic growth from
the start. It is also argued that any policy which attempts
to improve the distribution of income may prove impossible
to implement unless the poor develop sufficient consciousness
and organization to provide support for redistributive

policies.

TO MY PARENTS

ii

ACKNOWLEDGMENTS

There are so many great peOple whom without their
assistance and encouragement, it would be impossible to
complete a program of graduate study, and it is with great
pleasure that I take this opportunity to recognize and
acknowledge their invaluable contributions toward the
completion of this dissertation.

I must first express my sincere gratitude to
Professor Anthony Koo, Chairman of my dissertation committee,
for his invaluable advice and guidance throughout this study.
His willingness to devote immediate attention, prompt
responses, perceptive comments, and general encouragement
all made my work much easier.

The other members of my committee: Professors
Subbiah Kannappan, W. Paul Strassmann, and Edmund Sheehey
were also extremely helpful in providing technical advice,
insightful suggestions, and moral support.

Other faculty members also provided assistance.

In particular, Professor Daniel Suits, who stimulated my
interest in applied econometrics.

In addition, my special thanks to the members of my
family for their generous moral and financial support
throughout these years.

Finally, I gratefully acknowledge the invaluable
editorial assistance made by Monica Green and the expert

typing of the manuscript by Terie Snyder.

iii

TABLE OF CONTENTS

LIST OF TABLES.

LIST OF FIGURES

CHAPTER

ONE - INTRODUCTION

TWO - SURVEY OF LITERATURE

2.1 - Introduction. . . . . . . . . . . .

2.2 - Historical Presentation of. the Distribution
of Income .

2.3 - Income Distribution in the Process of
Economic Development.

2.” - Rise of Skepticism.

2.5 - Decomposition of the Gini Coefficient

2.6 - Conclusion.

Footnotes

THREE - DETERMINANTS OF INCOME DISTRIBUTION IN THE

PROCESS OF ECONOMIC GROWTH

3.1 — Introduction.
3.2 - Functional Distribution of Income Under a
Dualistic Economic Regime . . . .

3.3 - Distribution of Income and Education.
3.H - Inequal Distribution of Assets. . .
3.5 - Population Growth and Income Determination.
3.6 - Trade Policies and Income Distribution.
3.7 - Government Policies and Income Distribution
Footnotes

FOUR - EMPIRICAL EXPLORATION OF THE IMPACT OF

ECONOMIC GROWTH ON INCOME DISTRIBUTION.

”.1 - Introduction. . . . . . . . . . . . . .
u.2 - Method of Estimation. . . . . . . . . . . .
u.3 - The Estimation Results.

M. 3a - Per capita GDP and the Distribution

Income . . .
u. 3b - Rate of Growth Of GDP and Income
Inequality . . . . . . . . . . .
u. 3c - Dualistic Economic Development and
Income Distribution. . . . .

iv

PAGE
vi

vii

0101

13
31
3M
37

39

H2
H2

U3
51
56
58
6”
66

71

73
73
76
79
79
83

87

CHAPTER PAGE
FOUR - (cont‘d.) °

H.3d - Labor Share and Capital Formation. . . 9O
4.3e — Education and Income Distribution. . . 95
H.3f - Import-Export and Income Distribution. 100

n.3g — Indirect Taxes and the Gini
Coefficients . . . . . . . . . . . . . 103
u.u-General Equation. . . . . . . . . . . . . . . 106
Footnotes. . . . . 111

FIVE - POLICY IMPLICATIONS TO IMPROVE THE DISTRIBUTION

OF INCOME. . . . . . . . . . . . . . . . . . . 113

5. l-Introduction. . . . . 113

5. 2-Policy Intervention to Increase Labor Shares. 115

5. 3-Investment Policies and Income Distribution . 119

5.u-Capital Ownership and Inequality. . . . . . . 122

5.5-Policies to Promote Educational Level . . . . 126
5.6-Population Policies to Improve the Distribu—

tion of Income. . . . . . . . . . . . . 131

5. 7-Tax Policies for Mobilizing Resources . . . . 13H

5. 8-Conclusion. . . . . . . . . . . . . . . . . . 135

Footnotes. 137

APPENDIX . . . . . . . . . . . . . . . . . . 139

BIBLIOGRAPHY lu5

LIST OF TABLES

PAGE
TABLE 2.1 - Share of Ordinal Groups Over Long Periods . . 1“
TABLE 2.2 - Cross—Country Regression Model. . . . . . . . 25

vi

FIGURE

FIGURE

FIGURE

FIGURE

FIGURE

FIGURE

FIGURE

FIGURE

FIGURE
FIGURE
FIGURE
FIGURE
FIGURE
FIGURE

FIGURE

LIST OF FIGURES

PAGE

.1 — Distribution of Income at Different Level

of Percapita GDP. . . . . . . . . . . . . . 22
.2 - Skewness of the Lorenz Curve and its Relation

to Development. . . . . . . . . . . . . . . 30
.l - Industrial Labor Market Under Dualistic

Economic Regime . . . . . . . . . . . . . . us
.2 - Rate of Population Growth and Level of

Income. . . . . . . . . . . . . . . . . . . 60
.l - Piece-Wise Linear Relationship Between Gini

Coefficient and Per-Capita Income . . . . . 78
.2 - Piece-Wise Polynomial Relationship Between

Gini Coefficient and Per-Capita Income. . . 78
.3 - Estimated Gini at Different Per Capita Income 82
.H - Gini Coefficient and Percentage Rate of

Growth of Output. . . . . . . . . . . . . . 86
.5 - Urbanization and Gini Coefficient . . . . . 89
.6 - Labor Share and Gini Ratio. . . . . . . . . 92
.7 - Capital Formation and Gini Ratio. . . . . . 9h
.8 - School Enrollment Ratio and Gini Ratio. . . 98
.9 - Import and Estimated Gini Ratio . . . . . . 102
.10-Impact of Export on Gini Ratio. . . . . . . 10H
.1l-Indirect Taxes and Gini Ratio . . . . . . . 107

vii

CHAPTER ONE

Introduction

The past three decades have been characterized by an
unprecedented and unexpected rate of economic growth in
many deve10ping countries. Most deveIOping countries focused
their attention on policies aimed at increasing the level of
output and they succeeded. Between 1950 and 1975 the income
per capita in these countries rose by 3.9 percent per year
(including China). The preoccupation with maximizing rates
of output growth took precedence over the concept of
distribution of output among all segments of the population.

The justification for growth-oriented policies is the
so-called "trade-off" between economic growth and egalitarian
distribution of income. It has been suggested that redistri-
bution of income would lead to a smaller rate of growth of
income. On the other hand, if growth is given primary
emphasis, it creates a mechanism - higher productivity,
rising demand for labor and consequent higher wages — through
which the fruits of economic growth "trickles down" speedily.
In other words, growth-oriented policies suggest that it is
necessary first to build up the capital, infrastructure, and
productive capacity of the economy and the fate of the poor

should not be of great concern in the early stages of develOp-

ment.

The rational behind this justification is the Kuznets
hypothesis suggesting that in the early stages of economic
growth, the distribution of income tends to worsen, while

at the later stages it eventually will improve. The strong
implication of the Kuznets hypothesis is that inequality in
the distribution of income is a necessary condition for
economic growth and at the later stages, market forces and
government's corrective actions will improve the distribution
of income in favor of the poor. A great deal of skeptism,
supported by recent empirical data, has been raised with
regard to the inherent tendency, ability, and willingness of
governments to take corrective action to reduce the inequality
in the distribution of income. Landlords, politicians, and
other rich elites do not save and invest substantial pr0porv
tions of their incomes in the local economy. Much of their
incomes are spent on imported luxury goods, lavish mansions,
and foreign travels. Therefore, the growth—oriented
strategies are really an inaccurate justification for policies
which perpetuates the conditions of income inequality in the
developing countries.

V/Recognition of these facts make it essential to
reorient develOpment priorities away from preoccupation with
GNP growth and towards broader social objectives such as the
provision of health, nutrition, education, and finally more
equal distribution of income. Strategies designed to raise

the level of living and incomes of the poor not only contribute

to material well-being of the poor but also to higher
productivity and income levels of the society as a whole.

The main objective of this dissertation is to explore
the relationship between economic growth and income distribu-
tion. Chapter Two presents a review of the literature on
distribution of income and its pattern in the course of
economic growth in developing countries. It compares and
contrasts different schools of thought as they have appeared
in this field.

Chapter Three deals with the important socio—economic
and structural changes which occur at different stages of
economic growth. After identifying these changes, inherent
in the process of economic development it will be explained
how these changes affect the distribution of income. Chapter
Four concentrates on the empirical exploration of the impact
of different variables on the distribution of income. It
stressed that caution should be used in interpreting the
results obtained from cross~sectiOnal data and applying these
results to the long-term growth process for an individual
country.

High income inequality and substantial absolute poverty
may create the conditions for ultimate rejection of the
economic system by the frustrated masses and politically
explosive people. Chapter Five deals with the policies to
improve the distribution of income in favor of the poor. It
is shown that there is no need for sacrificing economic

growth to achieve an egalitarian distribution of income. By

designing and implementing economic and social policies, both
growth and distributional objectives can be achieved. Chapter
Five also advises that any redistributive policy necessarily
requires the political process that can generate more power
for the poor in the society. The achievement of political
power by the poor is a necessary first step toward a better

design and implementation of redistributive policies.

CHAPTER TWO

SURVEY OF LITERATURE

2.1 - Introduction

 

The issue of unequal distribution of income and
wealth in a society has been of concern to mankind for
centuries. This issue can be seen from a variety of
perspectives. This chapter offers a brief review of the
literature on the topics of income distribution and
economic development. Section 2 presents a historical
evolution of the distribution of income as it appears in
the literature. Section 3 deals with the pattern of income
distribution in the process of economic development. In
this section the literature on the Kuznets' hypothesis is
discussed. In Section N, the skepticism with regard to
the validity of the Kuznet‘s hypothesis is introduced.
Section 5 deals with the most recent approach to the
relationship between income distribution and economic
development, i.e., decomposition of the Gini coefficient.

Finally, section 6 offers a brief conclusion.
2.2 - Historical Presentation of the DiStributiOn of Income

The founders of classical economics were primarily

concerned with the functional distribution of income, i.e.

the distribution of income among the major factors of
production. The concept of unequal distribution was
considered only as a secondary issue.

The beginnings of abstract studies of distribution
were made by Physiocrats. Quesnay was mainly interested in
distribution between social classes i.e. "sterile" and
"productive" classes. Handicrafts and trades were considered
the sterile occupations while agriculture was thought to be
the only productive employment.1

In his Wealth of Nations, Adam Smith distinguished

 

a threefold classification of the factors of production—land,
labor and capital; and, naturally he distinguished three
shares: rent, wages and profit. He wrote, "the whole
annual produce...naturally divides itself into three parts,
and constitutes a revenue to three orders of people; to those
who live by rent, to those who live by wages and to those
who live by profit. These are three great, original and
constituent orders of civilized society. "2
Smith commented that pecuniary wages and profit could
be different according to the differences arising from the
nature of advantages and disadvantages of different employment.
But he pointed out that the other source of differences in
pecuniary wages and profit was due to the policy of EurOpe,
"which.no-where leaves things at perfect liberty":31
The-Ricardian law of rent, which is the first example

of the marginal method, defines rent as that portion of the

product which is paid for the use of the better quality or

powers of the soil. He argues that the rent of a given field
is measured by the surplus of its produce over that obtainable
with the same capital and labor from the poorest land in
cultivation.

Ricardo believed that wages were basically governed by
subsistence level with some allowances for rising standards
of living, a concept which he termed "natural price of labor".
As population increases, which is assumed is inevitable,
poorer soil is brought under cultivation. Consequently,
the rent will rise, wages remain at the "natural price of
labor" and profit will correspondingly decline.

In 1898 John Stuart Mill published his Principles of

Political Economy. In his book, he infused social and

 

institutional concepts in the theory of distribution. He
believed that unlike the law of production, those of
distribution are the matter of human institution solely and
"therefore depends on the laws and customs of society...
these laws are consequences of the fundamental laws of
human nature combined with the state of knowledge."u He
stated that law in general, and particularly laws relating
to prOperty, have profound effects upon the distribution

of income among persons.

Even though Mill modified the Ricardian schema by
infusing social institutions, his analysis of distribution
fundamentally was the same as that of other classical
writers. None of the classical economists were concerned

with economic equality itself. The main thrust of their

thinking appeared to be concerned with the distribution of

income among different factors of production.

The Utopian socialists of the early nineteenth century,
influenced by the events of the French Revolution, brought
the idea of economic equality to the attention of economic
theorists. They espoused a belief in the possibility of
a large reconstruction and reorganization of human society.
St. Simon advocated distribution based on a person's work
and reorganizing production by "the union of all instruments
of all labour in a social fund, which shall be exploited

5 I
Fourier favored a more complex system

by association."
of distribution which demanded a comfortable minimum income
to every person, including women and children more than five

years old.

In 1867 the first volume of Dasvxapital was published

 

by Marx. This volume contains the clearest exposition of

the Marxian system. As regards distribution, Marx

followed Ricardo's doctrines. He argued that the wages of
labor were determined by the amount of the necessities just
enough to maintain the labor force. Wages can never rise
above this subsistence level. But labor, Marx argues, creates
the whole value of the product, and receives only subsistence
wage. The difference is surplus value which is taken by

the capitalists.

Every increaSe in the laborer's efficiency,
every improvement in the means of production,
every new discovery of natural resources, every
addition to capital by way of saving, only increases
surplus value. It follows that economic progress,
while leaving the condition of the laborer as
miserable as ever, adds continually to the aggregate
of surplus value, that is to say, to the aggregate

income of the capitalist classes.6

As mentioned previously, classical economists also
dealt with the issue of inequality in the distribution of
wealth. To Smith, the differences in the nature of
employment were partly due to the absence of perfect liberty.
To John Stuart Mill it was the human institution, namely
the law of the inheritance of wealth, which led to unequal
distribution of income. And finally, Marx believed that
concentration of capital, due to rapid accumulation of
surplus, had to be blamed for income inequality in the
society. However, it only was after the arrival of the
"law of decreasing marginal utility" that it became possible
to analyze the economic and welfare effects of income
inequality.

Jevons7 introduced a principle which later was
called the law of diminishing marginal utility. The
principle postulates that income and wealth are subject to
diminishing marginal utility. From this principle arises a
great concept, namely the extreme wastefulness of large
inequality of income on economic welfare.

The quantity of happiness for a man, who already
has a great quantity of property in his possession, will
decline as he acquires additional units of prOperty. This
led Jevons to assert the great wastefulness of large
inequality of income from the point of view of economic
welfare. Ever since, it has been generally accepted that

total economic welfare is increased with more equal

10

distribution of income.

Another view on income distribution was suggested
by Pareto. He pioneered the study of distribution of income
between households without reference to social class to which
they belonged,the size distribution of income. From this
study, Pareto developed his famous law of distribution which
is known as Pareto's law. The law states that in all places
and at all times the distribution of income is given by a
mathematical formula. The formula is, log y = A -<xlog x,
where x is a level of income and y the number of persons
receiving an income equal to, or greater than x. Pareto
observed that the value of a is approximately equal to 1.5.
He concludes that inequality of income is a social
constant determined 137 forces beyond human understanding
and beyond human influence. InstitutiOnal changes and
egalitarian taxation cannot change this social constant.

It is important to note that Pareto's law was based
only on statistical evidence and did not have an economic
reasoning. Modern theories have shown that income inequality
is not a social constant and can be varied at different
points of times and in different countries.

It was mentioned that social welfare would increase
due to the more egalitarian distribution of income. However,
this view has not gone unchallenged. The counter argument
states that these policies might have some unfavorable
effects on production because of its effect on saving.

In his book, Principles Of Political Economy, Sidgwick

 

11

argues that:
A more equal distribution would increase happiness.

It would, in short, be more economic. But it might
indirectly diminish happiness by causing a decrease
in saving, a decrease in efficiency of capital,
through its greater diffusion in small amounts, an
excessive increase in population and a check to the
growth of culture.

Edwin Cannan also acknowleged the extreme wastefulness of

inequality but he pointed out that the inequality provided

the motive force and the regulator for the existing

system. He suggested that it would not be advisable to

make the ideal distribution if it led to a considerable

fall in total production. He wrote that "the existing

inequality, regraded broadly, is in fact a necessary evil."9

The idea of inequality and its relationship to growth

prevailed until Keynes who gave an unexpected view. Keynes

accepted the view that richer people have a higher propensity

to save, meaning that poorer people have a higher pr0pensity

to consume. Thus, any redistribution of income from the rich

to the poor would reduce saving but increase consumption

and an increase in consumption would result in an increase

in total income through the multiplier. In concluding

notes on The General Theory, Keynes wrote:

 

Since the end of the nineteenth century,
significant progress towards the removal of very
great disparities of wealth and income has been
achieved...Many people would wish to see this
process carried much further, but they are deterred
by two considerations, partly by the fear of
making skillful evasions too much worthwhile and
also of diminishing unduly the motive towards
risk:taking, but mainly I think by the belief
that the growth of capital depends upon the
strength of the motive towards individual saving
and that for a large portion of this growth we

12

are dependent on the savings of the rich out of their

superfluity.10
And he goes on to show that there is not any contradiction
between growth and equality "up to the point where full
employment prevails, the growth of capital depends not at
all on a low propensity to consume but is, on the contrary,
held back by it."11 and "measures for the redistribution
of income in a way likely to raise the propensity to consume
may prove positively favorable to the growth of capital."12

After World War II, the attention again was focused

on increasing production per head through increasing saving

and investment in deve10ping countries. In his famous

 

article, Economic DeVelopment with Unlimited supplieS'gf
Labor, Sir Arthus Lewis argues that underdeveloped countries
cannot break the vicious circle because their capitalist
sector is too small. He continues by saying "if they had

a larger capitalist sector, profits would be a greater

part of their national income, and saving and investment
would also be relatively large."17 Lewis acknowledges

that the increase of the capitalist sector involves an
increase in the inequality of income, but he says that

mere inequality of income is not enough to ensure a high
level of saving. The argument turns against the egalitarian
distribution based on the rationale that policies leading
towards more equal distribution of income were considered

to be inconsistent with policies to promote economic growth.
The post-war period, mainly the 1950‘s and 1960's was

characterized as being a growthaoriented era. The

13

prevailing strategy was to increase the size of the pie first
and then to be concerned with its distribution. It was this
concern which focused the attention on income distribution
and its relationship to economic growth.

2.3 - Income Distribution in the Process of Economic
DeveloPment

 

 

Kuznets pioneered a study to determine the relation-
ship between distribution of income by size and different
stages of economic growth. He raised the question of
whether inequality in the distribution of income increases
or decreases in the course of a country's economic growth.
He exPlored those factors which determine the secular
level and trends of income inequalities. In his 1955

In

article Kuznets used the data for the United States,

England and Germany. He later expanded his data for other
countries in 1963.15
In 1955, he found that in the U.S., the shares of
the top 20% of the population declined from 5u% in 1929 to
us% in the years after the second world war, whereas the
share of the lowest 60% rose from 26 to 32%. The share
of the top 5% declined from 31 to 20%. In the United
Kingdom, the share of the top 5% of units declined from
H6% in 1880 to u3% in 1913, then to 33% in 1929, to 31%
in 1938 and finally to 2u% in 19u7. The share of the
lower 85% remained fairly constant, u1-u3%, between 1880

and 1913, but then rose to R6% in 1929 and 55% in 19M7.

(See table 2.1 on page 1n.)

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Following his expanded data for developed countries,
Kuznets concludes that the shares of the upper income .
groups have declined perceptibly and shares of the lower
income groups have risen somewhat. He cites that this
trend is somewhat more pronounced in the distribution
of income after taxes than the distribution of income
before taxes. He speculates that the inequality in the
size distribution of income has narrowed over time. Kuznets
acknowledges that there is not adequate data for the exact
turning point, however he identifies the early phases in
which inequality might have been widening, "from about
1780 to 1850 in England, from about 18u0 to 1890, and
particularly from 1870 on in the United States and from
the l8u0's to 1890's in Germany.16 For the narrowing
income inequality he cites that England's income distribution
started to become more equal in the last quarter of the
19th century. For the U.S. and Germany the turning point
was later than England's.

Kuznets made an attempt to explain these secular
trends in income distribution in the process of economic
growth- In doing so, he distinguishes between two groups
of forces in the long term that create increasing inequality
in the distribution of income before taxes (excluding
contribution by government). The first group, Kuznets
says, relates to the concentration of savings in the upperv
income brackets, "only the uppereincome groups save; the

total savings of groups below the tOp decile are fairly

16

close to zero."17 Further, Kuznets argues that the
cumulative effect of such inequality in savings would be
the concentration of an increasing proportion of income-
yielding assets in the hands of the upper groups--"a basis
for larger income shares of these groups and their
descendants."18
One phenomenon accompanying the economic growth is
the reallocation of labor from agricultural activities to
non-agricultural activities which Kuznets refers to as
industrialization or urbanization. The second group of
forces relates to this process. Kuznets contends that
the average per capita income of the rural population is
usually lower than that of the urban and inequality in
the percentage shares within the distribution for the
rural p0pulation is somewhat narrower than the urban
population. Operating with this simple model, he concludes
that "the increasing weight of urban population means an
increasing share for the more unequal of the two component
distributions...(and) if this is so, inequality in the
total income distribution should increase."19
After giving the explanation for forces that
create widening in income inequality, Kuznets attempts to
find the counteracting forces, i.e., forces that cause
for narrowing of income inequality in the later stages
of economic growth.

Onquroup of factors counteracting the cumulative

effect of concentration of savings, Kuznets asserts, is

17

legislative interference and political decisions. These
policies may be aimed at limiting the accumulation of
property through inheritance taxes or they may produce
similar effects indirectly, "by government-permitted or
induced inflation which reduces the economic value of
accumulated wealth stored in fixed-price securities or

other properties not fully responsive to price changes;

or by legal restriction of the yield on accumulated

property as happened recently in the form of rent controls

or of artificially how long—term interest rates maintained

by the government to protect the market for its own bonds."20
The reason which Kuznets offers for these legal and
political decisions are the changes in the old ideas of

the need for income inequalities as a source of savings for
economic growth.

The other group of factors offsetting the widening
of income inequality associated with the shift from
agriculture to industry is, Kuznets concludes, a rise in the
income share of the lower groups within the non—agricultural
sector of the population.

Classifying the factors that potentiate the increase
in the income share, Kuznets argues that the immigrant's
children, born in cities, are more able to take advantage
of a better chance for organization and adaptation. "The
growing political power of the urban lower-income groups
led to a variety of protective and supporting legislation,

much of it aimed to counteract the worse effects of rapid

l8

industrialization and urbanization and to support the claims
of the broad masses for more adequate share of the growing
income of the country."21

The data which is provided by Kuznets is not enough
to draw a definitive conclusion and he himself admits this
fact. However, since his work was the first systematic
study of distribution of income in the course of economic
growth, he made a great contribution to this field. This
classical study shows that the relative income inequality
increases in the early stages of economic growth, then
decreases in later stages of growth. This behavior is
known as Kuznets' hypothesis which has constituted an
intellectual school of thought. This work became a corner-
stone for future studies by other development economists
and a number of them have accepted this hypothesis.

In his 1960 article, Kravis attempted to test
Kuznets' hypothesis by using five different indexes of
income inequality. With the United States as the basis
of comparison, he shows that Denmark, Israel (Jewish
population only) and the Netherlands have less inequality
than the United States; in Great Britain, Japan and Canada
distribution of income is as unequal as the United States;
and Italy, Puerto Rico, Ceylon (now Srilanka) and El
Salvador have more inequality than the United States.

Based on this finding, he confirms that Kuznets' hypothesis
indicating greater inequality in underdeveloped countries

.than in developed countries.

19

He submits that even though the United States has
the highest real income it does not have the greatest degree
of equality. On the other hand, Japan has a per capita
income much lower than Italy or Puerto Rico, but it has a
relatively high degree of equality. Despite his finding,
he states that "there is a discernible tendency for
underdevelopment, low income and inequality to go hand in
hand and for develoPment, high income and relative equality
to be associated with one another."22
The reasons Kravis offers for the differences in
the degree of inequality are: 1) human characteristics
affecting economic performance relating to economic
motivation and to ability, 2) barriers to economic mobility,
either imposed by government or embedded in the mores of
the people, such as racial discrimination and social
structure, 3) economic structure which does not provide
for highly differentiated forms of work accompanied by
large income differentials, and u) social and political
organization.
Though Kravis uses a greater amount of empirical
evidence, data for ten countries, the sets of reasons
he believes lead to an inverted Uoshape relationship
between economic growth and income inequality are not
derived from his empirical evidence and they are overlapping.
This makes it difficult to identify the most crucial
factors affecting distribution of income in the course of

economic growth.

20

V/ Oshima, who was skeptical of Kravis's technique,
showed that inequality indexes used by Kravis led to
conflicting results about relative distribution of income.
He proposes a new technique to measure inequality. Based
on this measure he contends that the major determinant of
income dispersion is "the weight of the farm or rural sector
in the total economy. Other factors appear to be trivial."23
This is very strong and at the same time a naive conclusion.
There are many factors which affect the distribution of
income and these factors are more important in determining
the distribution of income than the weight of the rural
sector.

V, Paukert provided income distribution data for a larger
number of countries. His data was based on a modification
of Adelman's and Morris's.zu Paukert's data contains the
information about the share of personal preutax income
accruing to the lowest 20 percent of households, then to the
second, third and fourth quintiles, and finally to the
next 15 percent and to the t0p 5 percent. He uses two
measures of inequality; Gini ratio and the maximum
equalization percentage. Paukert arbitrarily divides the
countries into different groups according to their level
of gross domestic product per head as a proxy for economic
development. The first finding on the basis of his data,
Paukert observes, is "a sharp increase in inequality as
one moves from countries in the lowest income group to

those_in the $101—200 (in 1965 U.S. dollarsl group and a

21

further but less pronounced increase as one moves into the
$201—300 group. This group and the next ($301-500) represent
the peak of inequality. There is then a substantial reduc—
tion in inequality in the $501-1000 group, whose general.
level of inequality corresponds to that of the lowest
income group (under $100). As one moves further along the
developed path, to the $1000-2000 and to the above $2000
group, there is a clear reduction in the extend of
inequality."25
V/Considering the shares of different classes, Paukert
confirms Kuznets' conclusion that the income share of the
poorest classes in the least developed countries is higher
than developed countries; with an average of 7 percent in
the countries below $100 and 5.3 percent in those of $101-
200 group. He also shows that the share of total income
accruing to the t0p 5 percent is highest in countries in
the $201-300 and $301-500 group. These are countries with
the greatest inequality. Then from his finding, he
concludes that "the greater inequality in developing
countries is due primarily to the high share of income
received by the richest 5 percent of the population,"26
Using a graph to represent all of his findings, he plots
the mean Gini and mean shares of different groups against
mean income per capita. This graph is presented in Figure

2.1. Based on these findings, Paukert states that his

data "shows clearly that‘there~i§~an_increase in inequality

 

as countries progress from the below $100 level to the

\/’

22

 

   

 

 

1
4P
0 .5 H I E
G ’— GINI RATIO 1
i ----- nEP CURVE }
1 (3.1455 _ i
l
R I
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T 0.4 .. Luoz
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0 ............ n
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'201-300' '

501-10001'1000-2000l 2001 + I
GDP PERCAPIIA

Source: Paukert, Income Distribution," p. ll9.

belowlOOllOI-ZOO 301-500
Figure 2.1

DISTRIBUTION OF INCOME AT DIFFERENT LEVEL
OF PERCAPITA GDP

23

$101-200 and beyond." He believes that his work supports
Kuznets' hypothesis.

\/One flaw to Paukert's study is the technique which
is used to test the Kuznet's hypothesis. As it was mentioned,
Paukert uses the mean Gini, mean shares of income in each
group. This averaging technique ignores the dispersion of
observations among each group and causes a very neat
relationship between Gini and (HM) per capita. If this
technique is discarded, we can see a substantial variation
in inequality at each income level. For example, France
and some of the Latin American countries have a very high
level of inequality with regards to their level of incomes.
Even though he acknowledges that at each level of develop-
ment there are some countries whose income distribution is
in sharp contrast with the prevailing inverted U-shape
pattern, it seems he placed a heavy emphasis on per capita
income itself. Paukert raises the question of what those
factors are which attribute to the differences in inequality
and its changes in the course of economic development.

VThis question, however, is not answered in his article.

‘/ The answers can be so crucial that they might challenge the
nature of the inverted Unshape relationship between
inequality and economic growth.

In May 1976 Ahluwalia used a multiple regression
model to estimate a crossncountry relationship between
inequality and selected variables reflecting different

aspects of the develoPment process. In December 1976 he

2”

extended his previous study. In both articles he warns

that the relationships in his regression model are primarily
associational and they "do not establish causality." He
described them as "stylized facts; which can be observed,
but which then need to be explained by an appropriate
theory."27

Ahluwalia's regression model is based on a sample
of 60 countries including no developing countries, 1n
developed countries and 6 socialist countries. He estimates
different equations, where income shares of different
percentile groups are considered as the dependent variables
and the logarithm of per capita G.N.P. as independent
variables. The results of these estimations are shown in
Table 1-2 on page 25.

Based on this finding, he concludes that his study
supports the inverted U-shape pattern or Kuznets' hypothesis.
He argues that "income shares of all percentile groups except
the top 20 percent first decline and then increase as
per capita G.N.P. rises. Income shares of the t0p 20 percent
display a corresponding opposite pattern."28

Ahluwalia admits that the true relationship between
inequality and development is very complex and it depends
on a number of processes of structural changes that occur
in the process of development. He suggests three different
variables that affect the degree of inequality in the
process of development and then he uses regression models

by including these variables. Ahluwalia argues, as Kuznets

25

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26

did, that one aspect of the development is the shift of
population from the traditional agricultural sector to the
modern sector. Then he speculates thattidtsprocess leads
to an increase in relative inequality in the early stages
of deveIOpment} But in the later stage, as the modern
sector expands, it absorbs higher amounts of labor and
causes the income differential between the two sectors to
narrow.

Improvements in the quality of human resources,
Ahluwalia asserts, provides another mechanism to decrease
income inequality. Faced with the lack of data on the skill
structure of the labor force, he uses the literacy rate
and the secondary school enrollment rate as right hand side
variables approximating the investment in human capital.
After estimating this equation, Ahluwalia finds that
"improvements in literacy have a beneficial impact on the
income share of the lowest H0 percent while the secondary
school enrollment rate has a beneficial impact on the
income share of the middle #0 percent, probably reflecting
the exclusion of the lower income groups from access to
schooling."29

The third factor affecting the long run pattern of
income equality, Ahluwalia proposes, is the demographic
factor. He argues that the population growth has an
important effect on income equality by prolonging "the
phenomenon of surplus labor in the sense that a large
proportion of the work force remains locked into low income

employment in the traditional or informal sector of the

27

30 The estimated equations based on the cross-

economy."
section shows substantial support for his hypothesis that

the rate of growth of population has a significant impact

on income inequality. He shows that this rate of growth

has a negative effect on the income shares of the lower and
middle groups, but a positive effect on the tOp 20 percent
income share.

After establishing and explaining the secular relation—
ship between level of economic development and income
inequality, Ahluwalia investigates the short term relation-
ship between growth and inequality. He speculates that
there are some economic factors associated with a high
rate of growth in the short run, i.e. factor market
disequilibria due to the economic expansion. These
disequilibria, Ahluwalia argues, cause significant income
differentials. He points out that these disequilibria
are stronger with a high rate of economic growth.

He tests the relationships between income inequality
and rate of growth by using a regression model. The
results obtained from this regression model shows no evidence
confirming that a faster rate of growth leads to greater
inequality. The interesting policy implication that
Ahluwalia suggests is to emphasize increasing rate of growth
to pass the transitional period of severe inequality as
quickly as possible. He explains: "higher growth rates
accelerate this transition without necessarily generating

‘greater inequality than can be expected given the structural

28

characteristics of the economy at each level of development."31
But in the same page he questions his own finding and states
that it is naive to draw such a sound relationship between
inequality and the rate of growth. He gives two contradictory
examples: "the experience of Brazil, where the high growth
was accompanied by worsening relative inequality...The
experience of Taiwan, where substantial growth has taken
place with an actual reduction in income inequality."32
V; It seems that Ahluwalia fails to recognize the
effect of other structural factors affecting the inequality
of income during a rapid economic growth. In spite of the
above two contradictory examples, he insists that his
cross section results show no systematical relationship
between higher inequality and a faster rate of growth. His
statement implies that he truly supports the idea of a
faster rate of growth for passing the transitional stage
of inequality.

Charles Wright33 questions the estimated results
obtained by Ahluwalia using the same technique as Ahluwalia
used, but he omits the socialist countries from the data.
He shows that when socialist countries are omitted, there
exists a considerable doubt to believe an inverted Uvshape
relationship between growth and inequality. Wright
concludes that institutional structures and government
policies are the main determinant of relative inequality
in every country.

Kakwaniau uses an unusual and interesting way to

29

test the Kuznets' hypothesis. His methods are purely
technical and he does not give any explanation for the
inverted U-shape relationship between growth and equality.
He uses two Lorenz curves; Lorenz curve I is skewed toward
(0, 0) and Lorenz curve II is skewed toward (1, 1). It is
obvious that the income share of the bottom 20 percent is
larger with Lorenz curve I than Lorenz curve II. And the
shares of the upper 20 percent is also greater with Lorenz
curve I than with Lorenz curve II (BG and BH respectively).
By considering these results, it will be obvious the
intermediate group has a smaller income share with Lorenz
curve I than with Lorenz curve II. This is illustrated in
Figure 2.2.

In the process of economic development, when the
share of the intermediate income group rises, one expects
that the shape of the Lorenz curve changes from one skewed
toward (0, 0) to one skewed toward (1, l). Kakwani
proposes that "Kuznets' hypothesis will be sufficiently
established if it can be shown that the Lorenz curves for
the developing countries are, in general, skewed toward
(0, 0), whereas the Lorenz curves for the developed countries
are skewed toward (1, l).35

In order to measure the degree of skewness of a

Lorenz curve, he uses the following equation:
a 8
n = an (/2-n)

where: n is the length of the ordinate of a point on the

30

 

 

 

 

(0.1) ' (1.1)
C B
-- -n

I

T n - I

I! g

I
———-a

|

I

’ I

I

I

I

I

0 I . - I
o A
(0.0) 20% 80% (1.0)

Source: Kakwani, "Income Inequality," p. 383.

Figure 2.2

SKEWNESS OF THE LORENZ CURVE
AND ITS RELATION TO DEVELOPMENT

31

Lorenz curve and the egalitarian line and n is the distance
of the ordinate of n from the origin along the egalitarian
line.

If <1 = B Lorenz curve is symetric; skewed toward
(0, 0) if a > B , and if a < 8 then it is skewed toward
(1, 1). He estimates the value of a and B for fifty
countries and he shows that the ratio of 0/8 is greater than
unity (a > 8) for all develOping countries or countries
with Lorenz curves skewed toward (0, 0). But for most
developed countries a/g ratio is smaller than one (a < 6),
indicating that Lorenz curves are skewed toward (1, 1).
Based on his finding, he concludes that "this observation
supports Kuznets' hypothesis that the income share of the
middle group is higher in the developed than in the

develoPing countries."37

\/2.u - Rise of Skepticism

 

One implication of the inverted Uvshape relationship
is the nature of a trade off between equality and economic
growth- Specifically, the worsening of inequality is
inevitable in the early stages of economic growth, and then
in the later stages, the fruit of economic growth will
automatically trickle down to the poor. Also government
may take an active role to correct the distribution of
income in favor of the poor (as Kuznets pointed out). The
inverted U-shape hypothesis implicitly accepts that in the

poor society inequality can be eliminated only through

32

increased production. But the growth experience in most of
the developing countries has revealed that the fruits of
growth have been concentrated in the modern sector of the
economy reinforcing inequalities in income, assets and
power. At the same time the modern and industrial sector
has not been able to absorb the rapidly growing labor force
from the agricultural sector (as Lewis anticipated).

After failure of growth-oriented strategies to
achieve an equitable society and to reduce poverty, new
strategies have been proposed. These new strategies are
concerned with achieving more equality in distribution
of income, with growth regarded as a necessary but not a
sufficient condition.

Stewart and Streeten are among those skeptical of
growth-oriented strategies. They claim that government
intervention, which was considered to be used to correct
the distribution of income is in fact in favor of the
upper-income groups rather than the poor. The reason which
they offer is that government is comprised of the elite
who are reluctant to take actions to correct the distribution
of income. They write, "The elite, against whom redistri0
butive measures must be aimed,ftum1the personnel who
administer the measures. They capture the machine and
render it ineffective."38

They also argue that modern technology which is
used in developing countries leads to inequal distribution

of income. Modern technology needs a highly skilled

33

personnel, and efficient, disciplined and literate
workers. In order to achieve these standards, public and
private expenditure must be concentrated on the modern
sector. Meanwhile, an unequal distribution of income is
required for generating market for the goods produced by
modern technology, i.e. goods produced for consumers with
high incomes.

By considering these factors, Stewart and Streeten
refute the existence of an inverted Uvshape relationship.
They conclude that "the high-growth policy thus tends not
only to generate inequalities, but also to establish
positions of power that make it extremely difficult to
combat these inequalities by government redistribution
policies."39 So they demand more direct actions to reduce
inequality of income in the developing countries. They
present a list of direct strategies to alleviate poverty
and to reduce income inequality.

They assert that progressive taxation of income
has not been successful to correct inequality, so they
suggest a policy for redistribution of existing assets.
Redistribution of assets, they argue, includes policies
of land reform, spread of ownership or nationalization of
industries, and greater access of educational and health
services to the poor. But they acknowledge that this
strategy is a radical one and "it does not normally form
part of the advice given to existing governments."1+0

The other strategy which they present is called

314

redistribution through growth. This strategy was originated
by I.L.O., then was modified by Chenery and Ahluwalia.ul
Chenery and Ahluwalia collaborated to construct a model
which incorporated the distributional objectives into
develOpment strategy. Their strategy is simply to transfer
the extra income resulting from growth to the poor. Chenery
and Ahluwalia assert that this strategy can achieve
substantial improvements in pattern of concentration of
assets and a considerable potential for raising the income
of the poor. This form of redistribution involves the
transfer of investment resources to low-income groups,
providing the poor with a source of income. This strategy
does not reduce the overall G.N.P. because "it means a

lower rate of growth of incomes at the upper end, and a
higher rate of growth at the lower end, without any absolute

~u2
. . fl
reduct1on of 1ncome.

2.5 - Decomposition of the Gini CoeffiCient

 

Perhaps one of the most interesting approaches to
detect the relationship between economic growth and income
distribution is the decomposition of Gini ratio. This
approach was fruitfully used by John Fei, Gustav Ranis and

Shirley Kuo.”3

Their purpose was to set out a methodology
for the decomposition of family income inequality by
distinguishing among different components of family incomes

and their change in the process of economic development.

As the measure of inequality, they chose the Gini

35

coefficient. They also assumed that the total income
pattern of n families, Y = (Yl, Y2...Yn) have been comprised
of different income components. For simplicity they assume
that income of families are composed of wage, property
income and transfer income. And consequently overall
inequality measure, Gy, can be decomposed into the various
sub Gi (i.e. Gw indicates the inequality in wages among
families).

In order to estimate overall inequality, they use

the weighted sum of the factor Ginis:
Gy = c G(Yl) + ¢ G(Y2) + ¢ G(Yr)
l 2 . ... r .

and pi can be defined as the distributive shares and is
calculated as:
¢. = %; and § 0i = 1

1
The above formula simply states that total family income
inequality, Gy, is the weighted average of the factor
Ginis G(Yi). Depending on how G(Yi) affects the overall
inequality, they distinguish among the different types of
income components.

They argue that type one income, prOperty income, is
distributed less equally than total income (G1 > Gy). Type
two income is distributed more equally than total income
(G2 < Gy)' Wage income is considered as a type two income.
They consider transfer income as type three income.

The important feature of type three is its role to

36

narrow the inequality of income. As they point out "a
large welfare budget (a large 0T) will certainly contribute
to the overall equality rather than inequality,"uu so a
negative sign has to be attached to ¢TG(YT).

They also recognize the phenomenon of urbanization
in a dualistic economy i.e. reallocation of labor from
agricultural sector to industrial sector. They argue that
if agricultural income is distributed more equally than
total income, the phenomenon of urbanization will contribute
(to a higher inequality of total income. But if agricultural
income is distributed less equally than total income, its
declining share would result in the equality of total
income.

They apply their model to Taiwan. Its economic
structure was characterized by labor surplus dualistic
economy. They point out that though Taiwan's family
distribution of income in the 1950's was unfavorable to
the poor, that distribution has improved substantially
during two decades of rapid growth, The factors involved
in this process, they assert, were a combination of
activities to correct the distribution of income in urban
and rural sector. In the rural sector these policies
included agricultural reforms, rapid spread of secondary
crops, rural industrial activities, reducing rent payments
and more labor intensive cropping patterns. In the urban
sector, they assert "that urban income inequality cannot

decline very much until after the turning point."‘u'5 By

37

turning point, it is meant the end of surplus labor. In
urban sector the policies have to be concerned with the
rapid absorption of labor by using more labor intensive
technology.

Decomposition of overall inequality into factor
components is a very useful method in detecting the source
of income inequality and introducing policies to improve
the distribution of income. The use of the method requires
details and comprehensive data on different components
of family incomes. The lack of data in most develOping

countries hinders the application of this method.

2.6 - Conclusion

 

In concluding, it will be helpful to classify
different schools of thought as they appeared in this field.
The classical economists were concerned with the distribution
of income among workers, capitalists, and land owners.

It was the prevailing approach until the beginning of the
[present century. Around this period, Pareto suggested the
size distribution of income. His statistical studies

led him to assert that the inequality of income was a
social constant determined by basic economic and social
forces and this inequality could not be influenced by:
differing national institutions and government policies.

Kuznets (1955) pioneered a study which.negated
Pareto's law. In his study, Kuznets developed a dynamic

relationship between distribution of income by size and

38

different stages of economic growth. Based on provided

data, he concluded that income inequality is not constant,

as Pareto suggested, but it would increase in the early
stages of economic growth, then decrease in later stages.
This behavior in income inequality at different stages of
economic growth is termed Kuznets' hypothesis and constituted
a new intellectual school of thought. After this study,
there have been a large number of studies that have accepted

”6 This hypothesis

Kuznets' hypothesis as a general law.
implies that the worsening of inequality is inevitable in

the early stages of growth and then at the later stages,
inequality will narrow down. This hypothesis implicitly
accepts that in the poor society income inequality can be
eliminated only through increases in production. It was

this behavior in income inequality which led some development
economists to emphasize the growth«oriented strategies with

the presumption that an equitable society can be achieved

automatically.

FOOTNOTES

CHAPTER TWO
FOOTNOTES

1Hugh Dalton, Some Aspects of the Inequality of
Incomes in Modern Communities (London: George Routledge and
Sons, Ltd; New York: E.P. Dutton and Co., 1920) p. 38.

 

2Adam Smith, The Wealth of Nations, ed. Edwin Cannan
(New York: The Modern Library, 1937) p. 52.

3

 

Ibid, p. 99.

uJohn Stuart Mill, Principles of Political Economy,
2 Vol., Vol. 1 7th ed. (London: Longmans, Green, Reader
and Dyer, 1871) p. 250.

5Thomas Kirkup, History of Socialism, 5th ed. rev.
(London: A. and C. Black, 1913) p. 28. ‘—

6

 

Dalton, Some Aspects of the Inequality, p. 81.

7Jevons admits that he was not the first person to
bring the subject of marginal utility. It had been already
discovered by J. Benthan in his writing about "principles
of utility".

8Dalton, Some Aspects of the Inequality, p. 100.

gEdwin Cannan, "The Division of Income," Quarterly
Journal of Economics, (May 1905) p. 368. if

10John Maynard Keynes, The General Theory of Employ—
ment, Interest and Money, First Harbinger ed. (New York:
Harcourt, Brace, and World, Inc., 196”) pl 372.

ll

 

 

 

Ibid, p. 373.

12Ibid.

13W. Arthur Lewis, "Economic Development with Unlimited
Supplies of Labor;VThe Manchester SChoOl, 22 (May 195%)
pp. 139—192.

 

39

NO

31Idem, "Inequality, Poverty and Development," p. 337.

321bid, p. 337.

33Char1es L. Wright, "Income Inequality and Economic
Growth: Examining the Evidence," The Journal of Developing
Areas (October 1978) pp. #9.

3D'Nanak C. Kakwani, Income Inequality and Poverpy:
Methods of Estimation and Policy Applications (New York:
Oxford University Press, Published for World Bank, 1980).

35

 

 

Ibid, p. 383.

36Kakwani imposes several restrictions on the formula:
But R.H. Rasche, J. Gaffney, A.Y.C. Koo and N. Obst show
that these restrictions are inadequate. Even with imposing
these restrictions, Gini coefficient might be greater than
one. For further details see Rasche, Gaffney, Koo and Obst,
"Functional Forms for Estimating the Lorenz Curve," Michi an
State University, Econometrics Workshop Papers No. 7706,
(February 1978).

37

 

Kakwani, Income Inequality, p. 385.

38France Stewart and Paul Streeten, "New Strategies
for Development: Poverty, Income Distribution and Growth,"
Oxford Economic Papers 28 (November 1976) p. 391.

39

 

Ibid, p. 393.

1+01131-1, p. 395.

l“I'Montek S. Ahluwalia and Hollis Chenery, "A Model
of Distribution and Growth," in RediStribution with Growth,
ed. Hollis Chenery et a1., (London: Oxford University Press,
3rd Printingm 1976) pp. 209-235.

 

2Stewart and Streeten, "New Strategies," p. 395.

uaJohn E. Fei, Gustave Ranis and Shirley Kuo, "Growth
and the Family Distribution of Income by Factor Components,"
Quarterly'Journal 0f Edenomics (February 1978) pp. 17053.

 

””Ibid, p. 18.
usIbid, p. 37.

6Sherman Robinson, "A Note on the U-Hypothesis
Relating Income Inequality and Economic Development,"
American Economic Review (June 1976), p. #37.

 

91

luSimon Kuznets, "Economic Growth and Income
Inequality," American Economic Review, HS (March 1955),
pp. 1—28.

15Idem, "Quantitative Aspects of Economic Growth of
Nations: VIII. Distribution of Income by Size," Economic
DeveloPment and Cultural Change (January 1963, Part II),
pp. 1-80.

16

 

 

Idem, "Economic Growth and Income Inequality,"
p. 19.

17Ibid, p. 7.

18Ibid.

19Ibid, p. 8.

2oIbid, p. 9.

21Ibid, p. 17.

22Irving B. Kravis, "International Differences in the
Distribution of Income," The Review of Economics and
Statistics (November 196077p. 909.

 

 

23Harry T. Oshima, "The International Comparison of
Size Distribution of Family Income with Special Reference to
Asia," The Review of Economics and StatistiCs (November 1962)
p. 0H2.

2‘I‘Irma Adleman and Cynthia Taft Morris, An Anatomy
of Patterns Of Income Dietribution in Developing Nations,
Part III of the final report (Grant AID, Northwestern Univer-
sity, 1971).

25Felix Paukert, "Income Distribution at Different
Levels of Development: A Survey of Evidence," International
Labor Review 108 (August—September 1973), p. 116.

26

 

 

 

 

Ibid, p. 120.

27Montek S. Ahluwalia, "Income Distribution and
Development: Some Stylized Facts," American EconomiC'Review
66, No. 2 (May 1976) p. 128.

28Idem, "Inequality, Poverty and Development,"
Journal of Development EccncmicS 3 (December 1976) p. 309.

2g“Idem, "Income Distribution and Development," p. 131.

30

 

Ibid, p. 132.

CHAPTER THREE

DETERMINANTS OF INCOME DISTRIBUTION IN THE
PROCESS OF ECONOMIC GROWTH

V’There are many factors which affect the distribution
of income and its pattern during the course of economic
develOpment. To investigate the relationship between growth
and income distribution, the best point of departure is the
recognition of the main characteristic of an underdeveloped
economy, that is, the socio-economical and structural changes
which occur at different stages of economic growth. After
identifying these changes, the second step will be to find
how these changes affect income distribution.

These main characteristics include a broad selection
of variables that attempt not only to describe different
aspects of a developing country, but also the trend in the _
distribution of income during the course of development.

In Section 2 of this chapter, a dynamic production
function is introduced. The production function explains
the functional distribution of income between laborers and
capitalists under a dualistic economic regime. In Section 3,
the relationship between the distribution of human capital
and income is considered. In Section u, the concentration
of holdings of physical capital and its impact on income

is analyzed. In Section 5, there is a discussion of the

92

H3

population growth and change in its age structure. Section
6 deals with the external aspects of the economy. The
impact of trade policies on internal terms of trade and
employment will be discussed. Finally, Section 7 is
concerned with the government policies in attempting to
achieve the distributive justice in the economy.

3.2 - Functional Distribution of Income Under a Dualistic
Economic Regime ‘

 

Perhaps one of the most observable characteristics
of many underdeveloped countries is the coexistence of a
overpopulated agricultural sector and a rapidly growing
modern or industrial sector. This phenomenon has been termed
"dualistic development" in the literature. The agricultural
sector is characterized by widespread disguised underemploy-
ment with a high rate of population growth. In this sector
the traditional techniques of production are being used.
The industrial sector, on the other hand, enjoys advanced
technology which is usually the result of foreign investments.

In the process of economic growth as output per capita
increases, it has been observed that output per capita in the
industrial sector increases at a rate much higher than the
output per capita in the agricultural sector.1 This uneven
rate of growth in two sectors can be explained by the
differences in income elasticity for agricultural products
and industrial products. Income elasticity for food and
other agricultural products are very low, whereas the inverse

is true for industrial goods.

nu

As average income increases, the percentage change
in demand for agricultural products is less than the percen-
tage increase of income. Correspondingly, the percentage
change in demand for industrial products is greater than
‘the percentage change in income. This phenomenon causes
more demand for industrial products and less demand for
agricultural products. Since demand for factors of production
is derived demand, the differences in output demand lead to
a rapid increase in demand for labor in the industrial
sector. The agricultural sector will supply the greatest
part of this labor to the industrial sector.

The movement of the labor force from the agricultural
sector to the industrial sector due to structural change in
final output can be shown by a very simple graph. The
graph.only presents the demand for labor in the industrial
sector under the assumption of the dualistic economy with
unlimited supply of labor (at least up to a certain level of
employment). In Figure 3-01, the wage rate is measured on
the vertical axis and the level of industrial employment
on the horizontal axis.

Demand for labor is downward sloping, reflecting the
law of diminishing marginal product. The most important
feature of this sector under the assumption of unlimited
supply of labor is the labor supply curve. The supply of
labor is perfectly elastic up to Lc and beyond LC it is
upward sloping. The horizontal portion of labor supply
reflects the rapid increase of labor from the agricultural

\/ to the industrial sector. This prevents the institutionally

US

>

 

 

 

 

 

'— ..-—-0--.

Figure 3.l

INDUSTRIAL LABOR MARKET UNDER
DUALISTIC ECONOMIC REGIME

96

determined wage rate (Wi) to increase up to LC, where the
unlimited supply of labor is eliminated.2 In the industrial
sector, firms maximize their profit by employing labor where
marginal revenue product of labor (demand for labor) is

equal to the institutional wage rate. If demand for labor

is DlL’ then the amount of employment will be Ll° Since

wage is constant, this level of employment leads to the
surplus or profit of WNA, and total wage income of OWALl.

The amount of surplus will be the main source of investment
and capital accumulation in the industrial sector. In the
next period, this surplus will be added to capital stock
which leads to a greater demand for labor (D2L) and the

labor employment of L2. The new employment level will create
ABMN amount of surplus which results in a higher amount of
investment and capital accumulation. This continuous process
of reinvesting surplus and increase in capital stock causes
continuous shifts in demand for and increase in employment
of labor. As it is shown, the agricultural sector has
constituted the main source of labor supply to the industrial
sector.

\J’The allocation of labor from the agricultural sector
to the industrial sector has established a pattern of
industrialization in the process of economic develoPment.
This pattern is common to many dualistic developing countries.
In order to investigate how this pattern or structural
change affects income distribution, a dynamic production
function for the industrial sector is used. This production

function can be specified as:

97

Q = f(1<, L, t).

The above production function shows a technological
relationship between output and inputs. As it is revealed
by the production function, the essential factor inputs
in the industrial sector are labor (L) and capital (K). t
shows the increase in output due to improvement in technology

over time. Q represents the quantity of industrial output.

Assumptions:

 

a. The production function is homogeneous of degree
one, continuous and twice differentiable.
h. K and L take non-negative magnitudes, and their

marginal productivities are positive, i.e.

029.
fL 6L>o, f

II
9218
V
O

K

c. The law of diminishing return is applied to

both factors:

fLL < 0 , fKK < 0

d. The rate of change of fL with respect to a change
in K is equal to the rate of change of fK with respect to L,

i.e.

e. It is assumed that labor and capital are purchased

in a competitive market, so

w =, fL and r = fK

'48

Definitions:

 

In the outset it will be convenient to define the
concepts which are used throughout this section.
a. R is defined as the rate of technological progress

and it is measured as:
91
Q0

where Qt is output at time t, and Q0 is output in time zero.

R :

b. The nature of the bias in technological progress
can be defined in terms of the Hick's concept of factor

saving (using) biasedness and is represented as:

if B = 0 Hick's neutral technological progress and if B > 0,
capital using (labor saving) technological progress.
c. Labor and capital share can be defined, respec-

tively, as

Lf
¢ = ~5E
L
¢ : KfK
K Q
Then homogeneity of degree one implies that 0L + 0K = l

(Euler's Theorem).

d. Elasticity of substitution between capital and

labor is
o = foL
QTKL

Proportional time change and rate of growth in marginal

u9

physical product of capital and labor can be specified, in

 

terms of B, R, and 0L as: (Proof in Appendix to Chapter 3.)
f
jft = R + ¢L B
K
f
TEE = R-(l-0L)B
L
f a f (1.-¢ )
K L k L L k
__ : - o_ _: .. .. + c...
fK R+¢LB a k,fL R (1 0L)B a k

and finally rate of growth of national income can be derived

as

= R + (l - )

two-

WHVo
...

rue-

¢L
Since the wage receivers are in the lower income
bracket, any factor which increases labor share will change
the distribution of income. Therefore, in order to investi—
gate the functional distribution of income under this
dualistic model we turn our attention to labor share and its
rate of growth in the process of economic growth. In order
to see how the labor share can be affected we have to
distinguish between two developmental phases, i.e. when
labor is still in excess supply or prior to and after the
point when surplus labor has been fully absorbed into
productive employment. Before this turning point, there
exists a horizontal supply curve of labor to the industrial
sector signifying the prevalence of a constant real wage.

will be zero, so the

SIS}!

This constant wage implies that

growth of labor share over time can be written as:

50

..l". : ii + if. .. é
“b1. w L Q
or
L — _ _ _ E
32- - R (l ¢L) k

decreases

P6169 '

So long as the unlimited supply of labor exists
as R (rate of technological progress) and %-(rate of capital
deepening) increases. The other implication of this phase
is the capital share will increase. The decrease in labor
share and increase in capital share will contribute to
deterioration in the distribution of income.

After the turning point, 3 is not equal to zero, so

the growth of labor share will change to

¢ 0
L .. .1. E
¢L
When the supply of labor is no longer perfectly elastic, E—
L

increases if the nature of technology is labor using
(B < 0) and the elasticity of substitution between labor
and capital is less than unity (0 ‘< 1). One of the
implications of the above model is a rapid growth of employ—
ment due to_the rising profit share and capital accumulation.
This process is significantly related to the nature or bias
of technological progress.

v/The above model is also capable of explaining the
Kuznet's hypothesis. Rapid growth of employment in the
industrial sector leads to a shift in pOpulation from the

agricultural to the nonnagricultural sector. It is sound

51

to speculate that the inequality of income in the rural
sector is much less than the inequality in the urban sector.
The increase in the relative weight of the urban p0pulation
(more unequal income) in comparison with the total population
will lead to a higher overall inequality in distribution

of income.

At the same time the increase in urbanization has a
significant effect in increasing political participation
and political power of the urban low income groups. The
political participation will lead to legislation aiming
toward the provision of equal opportunities and educational
institutions. These steps lead to increase in income share

of urban migrants and low income residents.

3.3 - Distribution of Income and Education,

 

The prevailing framework to investigate the effect
of education on income distribution is the human capital
model. Based on this model, education is treated analogous
to physical assets. Investment in oneself is considered as
a source of productivity and growth and so it influences the
stream of individual earning. All economists acknowledge
that level of education can influence the level of income.
However, effect of education on the size distribution of
income as an equalizing factor has been subjected to a
great deal of controversy. The source of the controversies
is the different assumptions made on the dependency or
independency between the level of schooling and the rate of

return to it. For instance, according to Chiswick, "The

52

higher the average level of schooling in a region, the
greater the inequality of income in that region."3 Other
authors, namely Marin and Psacharopoulos” criticized
Chiswick's assumption of independency between the level of
schooling and the rate of return to it. They claim that
there is a negative correlation between rate of return and
the level of schooling and they hypothesize that education
has an equalizing effect on income distribution.

To find the direction of the effect of education
on the size distribution of income, the Chiswick's (1968)
approach is discussed. The use of this approach is very
convenient because it related a measure of education to a

measure of income distribution. The model has been

specified as:

Ln (Ysi) = Ln (Y0) + ri Si + Ui (3.3.1)

where: Y personal income after Si years of investment

Si in schooling;
Y0 5 average income with zero level of schooling;
pi 5 rate of return of schooling;
Ui 2 error term.

By making the assumption that all income beyond Y0 is due
to investment in human capital,5 the above expression will
be:

In (Ysi) = Ln (Y0) + ri Si (3.3.2)

and by taking variances of both sides, one can associate

the level of income inequality to the level of education.

53

l. Var (Ln Y.) = Var (r.S.) (3.3.3)
1 1 1

The variance of the logarithms of income is commonly
used as a measure of income inequality. So, the above
expression in this case shows that the income inequality
is a function of the variance of education and the rate
of return to it.

The source of the controversy lies on the expansion
of the Var(rs): namely whether r and s are independent or
not, Var(rs) results to two different expressions.

If ri and si are independent, (the assumption which
Chiswick makes), then the variance of a product of two

independent random variables is:

Var(riSi) = 52 Var(si) + S2 Var(ri) + Var(si) Var(ri)
(3.3.H)
and expression (3.3.3) can be expanded as
Var(LnYi) = 52 Var (Si) + 82 Var(ri) + Var(si)Var(ri)
(3.3.5)

All of the variables on the right hand side of (3.3.5) are
positive, so equation (3.3.5) implies that the variance of
the logarithms of income (relative inequality) is positively
related to the level of education. In other words, if r and
s are assumed to be independent, then the increase in the
level of education increases income inequality.

One implication of this model, which.Chiswick himself
mentions, is that the change in distribution of schooling in

the process of economic growth could lead to a more unequal

5U-

income distribution. The assumption of dependency between

r and s is rather an unrealistic one. If human capital is
treated as any other productive assets, then if its supply
increases, the rate of return to it will decrease. This
negative relationship is very strong in developing countries
where the access to education is limited and there is an
unequal distribution of schooling. In these countries
income differential between skilled (educated) and unskilled
(uneducated) is very great. The major part of this income
differential is due to the fact that at low levels of
development and unequal access to education, supply of highly
educated and skilled individuals is very inelastic, if not
perfectly so, and these individuals receive quasi-rent for
their scarce abilities. Unlike other forms of physical
assets, the scarce abilities of these individuals cannot be

confiscated. The provision of educational institutions

which facilitate the equal access to education

will lead to elimination of this quasinrent, and consequently,

the earning differential due to this factor will narrow down.
As it is suggested above, the rate of return to

education declines for two reasons. First, the values of

the rates of return are inversely related to the educational

level for each individual. For instance, Psacharopoulos

has shown that the average social rate of returns to

inVestment in education are 25.1 percent for primary and

only 13.5 percent for secondary level, a decline of 11.6

55

percent.

The second reason for a decline in rate of return
to education can be related to the increase in the numbers
of educational institutions which facilitate the easy access
to education. ‘As it was mentioned earlier, an unequal
access to education will lead to a quasi-rent received by an
elite group. So, there might exist a negative relationship
between rate of return to investment in education and the
provision of educational institutions as reflected by
enrollments at different educational levels.

The inverse relationship between rate of return and
provisions of new educational institutions to create equal
distribution of schooling is very crucial in establishing
the relationship between education and income distribution
in the process of economic development. It is evident8
that there is a close relationship between increase in the
level of per capita G.N.P. and the increase in the enrollments
at different educational levels. At the earlv stage of
economic growth, there is not equal access to educational
institutions, and as a result there is a significant wage
differential and a high inequality in distribution of
income. At the later stage, enrollments at different
educational levels increases. This increase in enrollment
leads to the elimination of quasi—rent and consequently

to a lower degree of income inequality.

56

3.9 - Inequal Distribution of Assets

 

In most deve10ping countries, the distribution of
physical assets shows considerably more inequality than the
distribution of income. The inequality in the ownership
of assets will still result in more inequality in the
distribution of income received to their owners. In these
countries, the differences between the income accruing from
privately owned assets are the main sources of overall
inequality.

The greater degree of inequality of income from assets
can be explained by fragmented financial markets in these
countries. The wealthier peeple have better access to and
better information about the financial system. With better
information and larger assets the investors can assume risk
and consequently a higher average return will accrue to them.
This fragmented financial market tends to discriminate against
the predominant traditional sector of the economy.9

The concentration of physical assets and hence the
receipt of property incomes has a very significant effect on
the size distribution of income. How the distribution of
physical assets changes in the course of economic growth
depends, partially, on the change in the saving rates in
various incomquroups. The accumulation of physical assets
is positively correlated with the amount of savings, and
since the amount of savings is likely to be higher among
the wealthier people than among the poor, the distribution

of physical assets will not change in favor of the poor.

57

Although the income is the main determinant of saving,
there are other factors which can affect the people's
willingness to save. One of these factors is the improvement
in the financial institutions which create easy access to
the saving and credit markets. Also the improvement in
these institutions will increase the public's confidence and
trust in their integrity. As the per capita income increases,
the governments of developing countries are able to insure
all the funds deposited into financial institutions and
this increases the public's confidence. The rate of saving
is highly responsive to these institutional improvements.
This aspect of economic development is a very encouraging
process which facilitates capital accumulation for the low
income groups.

Perhaps one of the most important components of
wealth.in rural areas of developing countries is land. In
the rural sector, agricultural land accounts for a large
proportion of the total wealth. And it is usually the most
significant determinant in the distribution of income and
power. In these countries the large landowners often
dominate both financial institutions and government. It is
evident that the countries which have less income inequalities
in the process of economic growth are characterized by-a
fairly even distribution of land in rural areas.

The change in the distribution of land depends on
radical land reform which changes the prevailing structure

of land ownership to improve the distribution of land and

58

income.

3.5 - Population Growth and Income Determination

 

Population growth can and does affect the distribution
of income. This effect can be examined by exploring how
economic growth affects population growth through changes
in the pattern of death rates and birth rates. For the
purposes of the following discussion, poPulation growth is
defined as the difference between birth rate and death rate.

Historically, it has become evident that in the
earlier stage of economic growth both birth and death rates
are very high and consequently there is a low rate of
population growth. As the level of income rises, public and
private health services become more available and affordable.
Also, the introduction and practice of preventive medicine
causes the death rate to fall. Birth rate, however, starts
declining long after the decline in death rates. This
pattern has been termed as "the demographic transition".

The decline in the death rates and the lag in birth rates
is the most conspicuous and major cause of the acceleration
and high level of population increase in the early stages
of economic growth.

Although the relationship between income level and
decline in death rates if fully understood, the decline in
birth.rate is not so obvious. The decline in birth rate
can be explained by the process of change in economic and
social structure such as increase in income, urbanization,

industrialization, and education. Several explanations

59

have been given for the pattern of birth rates in the
process of economic growth. They are as follows:

a. Children as productive agents: In the rural

 

agriculture, the children provide a significant amount of
labor to the family. Their benefit will exceed their low
cost, due to the extended family system. But as urbanization
proceeds, children become less valuable, as productive
agents, and birth rate consequently falls.

b. Old age securities for parents: In the absence

 

of social welfare, the parents may expect their children

to support them in their old age. The introduction of old
age pension and retirement payment might decrease the need
for children for this purpose and consequently a decline in
birth rate.

c. The perpetuation of the family: An optimum

 

number of children might be desired due to the importance
which is placed on perpetuation of the family. Based on this
theory, a decline in infant and child deaths leads to the
decline in the number of births necessary to assure the
optimum number of children that will grow to parenthood.

The above arguments explain why birth rates will fall
after the initial decline in the death rates. The lag
between these two rates leads to a significant increase in
the rate of population growth. So far, a demographic
pattern has been established during the process of economic
.growth; high rates of birth.and death in the earlier stage,
then decline in death rate due to provision of public and

private health services. There is a consequent decline in

PERCENTAGE GROWTH RATE

 

60

PER CAPITA INCOME

Figure 3.2

RATE OF POPULATION GROWTH
AND LEVEL OF INCOME

61

the birth rate at the latter stages of economic growth.

Two important aspects of this pattern have to be
noted. First, the decline in death rates is more conspicuous
in the younger age groups. This difference in mortality
rate leads to the extremely young population which includes
a large proportion of children below the working age (15
years old). In other words, the ratio between the number
of economically inactive and active persons will increase.
Second, there are differentials in birth rates and death
rates within the country. In the early stage of economic
growth, when the birth rate begins to drop, this reduction
is likely to be evident first among families in the modern
occupations and in the upper income brackets. But the high
birth rate still continues among families in rural areas
and lower income brackets. This differential in birth
rates leads to inequality in size of households, as measured
by number of persons. Families in the lower income bracket
are larger in size and families in the Iqumui income bracket
are smaller in size.

After establishing the pattern of population growth
during the course of economic growth, and considering the
important aspects of p0pulation structure, it can be
explained how this process affects the distribution of
income in a country. The relationship between the
population growth and functional distribution of income was
first discussed by Multhus and Ricardo. They argued that

increase in population would force wages to stay at the

62

level of bare subsistence. This theory was frequently referred
to as "the iron law of wages". Increase in population would
raise the rent in the national income in the expense of
profit. As it was seen in the first section, the population
growth would prolong the existence of unlimited supply of
labor and would delay the level of employment where wage
rate starts to increase. As it was argued in the same
section, the change in labor share as a result of population
growth depends on the rate of growth of capital, the
substitutability of capital and labor for one another, and
the biasedness of technology. There are a number of mechanisms
through which the population growth can influence the size
distribution of income. One of these mechanisms is the impact
of population growth on the accumulation of physical and
human capital. As it was mentioned, rapid rate of population
growth changes the age structure of the population. This
phenomenon increases the ratio of dependents to adult members
of the labor force, thereby increasing the consumption by
a larger number of children. The result is a lower saving/
income ratio. The reduction in saving will lead to
reduction in capital accumulation for households. By assuming
the fertility differential among rich and poor families, the
population growth will enhance the concentration and ownership
of physical capital.

The increase in dependency ratio can also affect the
expenditure on education for each child. It has been noted

that there is an inverse relationship between the size of

63

family and the amount spent on education per child.10 The

decrease in amount expended on education will impede the
improvement in the education of children in low income
bracket, and consequently leads to the expansion of the
supply of unskilled workers relative to the supply of better
trained and educated workers, thus increasing skill-unskilled
wage differentials.

Population growth and fertility differential can lead
to a higher degree of inequality if the basis of income
distribution is changed from income per household to the
income per person. Kuznets (1976)11 suggests that there is
a negative correlation between size of family and per person
income. The fact that the upper income classes have smaller
family size and the lower income classes are characterized
by large family size, makes it essential to distinguish
between size distribution of income among households and
among persons. The inequality in the distribution of income
will be much higher if the per person income is used as a
basis for calculating the inequality indicators.

In summary, the pOpulation growth contributes to a
deterioration of income distribution in the early stage of
economic growth. In the later stage, as population growth
slows down, it is expected to have a smaller degree of

income inequality.

6‘4

3.6 - Trade Policies and Income Distribution

 

The foreign trade policies as well as the domestic
policies can affect the income distribution. The impact of
these policies on income distribution can be examined by
investigating how these policies affect the internal term
of trade and employment.

Most of the LDC's have appealed to import substitution
in pursuing their industrialization. Especially since the
second world war, industrialization strategies have been
setting up industries to produce goods that were previously
imported. These strategies have been implemented by
governments through protective tariffs and controls. The
justification for these protective measures is the learning
time needed for the new domestic industries to establish
themselves. Temporarily shielding young domestic firms
from the severe competition afforded by more mature and
therefore more efficient foreign firms will give the infant
industry a learning time to develop and become more efficient.

VI The protection of infant industries aiming at the
establishment and development of manufacturing industries
can affect the distribution of income in several ways.

a. Dietorting the internal term 0f trade. By keeping
out low-cost foreign—made products, it hurts the farmers by
raising the prices they pay for domestically manufactured
goods and depresses the prices they receive for their
products. In other words, the import substitution policies

which.cause the ratio of manufacturing prices to agricultural

65

prices to be higher than the world markets, redistributing
income from agriculture to industry. For example, S.R. Lewis-1'2
has estimated that distribution of income from farm price
distortion (due to protection) amounted to $500 million per
annum of income from farming to manufacturing in Pakistan
over most of the 19503. The same redistributive effect has
been confirmed by other authors for a number of countries.13
The distribution of income from farmers (which are in lower
income brackets) to manufacturers (which are in higher
income brackets) will contribute to a deterioration of

income distribution.

b. Encourgging‘capital intensiVe‘techniqpe. Since

 

most of the import-substitution projects are relatively
capital intensive, the pursuit of this policy encourages

the capital intensive technique. Too much emphasis on
protection will also discourage the export industries.
Conversely, exports from developing countries are relatively
labor intensive. So wide resort to import substitution

will aggrevate the problem of unemployment, and thus
intensify the inequality in the distribution of income.

c. Monpp01y poWer. The protection system may also

 

lead to monopoly power for those manufacturers who have
obtained the import license for essential inputs of the
protected industries. By preventing the competition, the
monopolists are able to charge higher prices for the
previously imported consumer goods and thus reap monopoly

rent at the expense of the consumers.

66

In general, the main conclusion is that import
substitution industrialization has contributed to a
deterioration of income distribution. How the distribution
of income due to this factor changes over time depends on
government policies to provide Opportunities for promoting

exports and employment.

3.7 - Government Policies and Income Distribution

 

\/The pursuit of growth-oriented strategies in most of
the developing countries has ignored the ethical standards
concerning what is an equitable or just distribution of
income. The emphasis on these strategies leads to an
environment inefficient to create equal opportunities to
acquire income-generating skills. The realization of these
facts has led to the conclusion that distribution cannot be
left to the free interplay of different forces.

Most governments, in an effort to equalize income
distribution, tax the rich, provide public goods, and transfer
income to the poor. These are the main instruments by
which to change the distribution of income to satisfy the
equity objectives of economic growth.

To get precise measurement of the redistributional
effects of taxes, two main aspects have to be considered.
First is the structure of the tax system and second, it is
necessary that the burden assigned to an individual
actually be borne by the individual and not be shifted to
others. The first aspect is concerned with the progressivity

or regressivity of a tax system. A tax system is defined to

67

be progressive when the average rate of tax rises with
income. 0n the contrary, a regressive tax system is when
the average rate of tax falls with rising income. Personal
income tax which is levied on taxable income is progressive
in effect as well as in structure. The sales and excise
taxes are as a whole regressive. The question of progress-
ivity or regressivity of the property and corporate income
taxes are difficult and controversial. The reason for this
difficulty is the incidence of these types of taxes. The
overall progressive tax system tends to reduce the inequality
of income.

In order to determine the redistributive effect of
the tax system on the distribution of income, it is also
necessary to know how the tax burden is allocated among the
individual taxpayers; which is the second aspect of government
taxation. Some taxes can be shifted among various parties
in the economy. It is, therefore, necessary to locate the
final resting place of the major types of taxes.

With regard to the personal income tax, the incidence
falls entirely on the individual upon whom the tax is levied.
In the case of corporate income tax, Gillespielu suggests
that two thirds of thd corporate profits tax is borne by the
owners and one third is shifted forward to consumers.

Sales or excise taxes will generally be shifted to
the consumer through higher product prices. The amount of
the shift in this case depends on the elasticities of supply

enui demand for goods and services upon which the tax is

68

imposed. With regard to the prOperty taxes, it is necessary
to distinguish between two kinds of properties. In the case
of land and owner-occupied residences, the tax is borne by
the owners. On the other hand. taxes on rented property

can be shifted wholly or in part from the owner to the tenant
in the form of higher rents.

As it has been noted that each country employs a
variety of taxes. Some of these taxes are progressive,
whereas other are regressive. The structure of the tax
system as a whole for distributional policies is very
important, because only progressive tax systems will reduce
the inequality of income distribution.

V/In underdeveloped countries, the traditional taxes
are excise and sales taxes. Although these types of taxes
are regressive in their nature, they are economically and
administratively feasible to levy and collect. An income
tax, which is progressive, can be administered effectively
only if financial records are kept and the economy is
predominantly a money economy. Also, political institutions
must be such that collection of taxes levied on economically
powerful individuals is possible. In the lowest income
countries, the peOple in higher income groups are too
powerful politically to permit even moderate rates of taxation
to be levied against them. In these countries, the tax
actually collected is likely to be regressive, because it
can only be collected from low and middle income salary

earners o

69

In the lowest income countries, the only tax system
which is economically and administratively feasible is
indirect taxes. Only in the later stages of economic
development, as economic complexity produces more financial
records, will the newer forms of direct taxes, (corporation
and personal income taxes, which are more progressive in
their nature) become increasingly important. The ratio of
direct to indirect taxes is less than unity in the early
stages of economic develoPment, and then will gradually
rise again as the country becomes more and more industrial.15
Government tax policies are only a part of the picture.
In order to determine the redistributive effect of the
government activities on the distribution of income, the
study must take into account the public expenditure side
too. Since in most of the developing countries the tax
system tends to be roughly regressive, or at most prOportional,
in its overall effect, the overall progressivity of govern-
ment policies depends on the overall progressivity of
government expenditures.

The very nature of government expenditure makes it
difficult to measure precisely the manner in which its
benefits are distributed among individuals and institutions
in the society. However, transfer income and welfare
programs have clear redistributive effects. Transfer
payments and welfare programs provide funds to dependent
and handicapped and compensation to the unemployed.
Gillespie16 presents an interesting chart in which he shows

Ll

70

how the government expenditures have been allocated among
different income brackets. It reveals that government
expenditure on education, social security, health and
housing are regressive, i.e. allocation of expenditure on
each income group decreases as the level of income increases.
The regressive nature of government expenditure assures that
overall there is some net redistribution effect to decrease
the inequality of distribution in income.

Although the provision of welfare programs can change
the distribution of income, governments of underdeveloped
countries cannot raise the revenue they need through direct
taxes on the profit of corporations and personal incomes.

In pursuit of welfare programs, these governments have to
appeal to indirect taxes; and this is a discouraging fact as

far as the distributional objective is concerned.

FOOTNOTES

 

CHAPTER THREE
FOOTNOTES

1For a good reference on this matter, see Simon
Kuznets, Modern Economic Growth (New Haven and London: Yale
University Press, 1976i.

2The turning point on the labor supply at LC is called
"commercialization point" by John Fei and G. Ranis, Develo -
ment of the Labor Surplus Economy (Homewood: Irwin, 1969)
p. 22.

 

 

3Barry R. Chiswick, "The Average Level of Schooling
and the Inter-Regional Inequality of Income: A Clairificationfl'
American Economic Review (June 1968) p. 500.

”Alan Marin and G. Psacharopoulos, "Schooling and
Income Distribution," Review of EconOmiCs and Statistics 58
(August 1976), pp. 332—337.

5Ability and motivation can be a source of income
differential, besides the level of education, but these
factors have a very small effect on earnings. For a detailed
study see Z. Griliches and W.M. Mason, "Education, Income and
Ability," Journal Of POlitical Economy, Part II (May-June,
1972).

 

 

 

6For the original work on expansion of this equation,
see Leo A. Goodman, "On the Exact Variance of Products,"
American Statistical ASSociation Journal (December 1960), pp.
708-713.

7G. Psacharopoulos, Return to'Education:‘An Inter-
national Comparison, (San FranciSco and Washington: Josser-
Bass Inc., 1973).

 

 

 

8For instance, see Frederick H. Harbison and C. A.
Megers, Education, Manpower and Economic Gr0wth (New York:
McGraw Hill, 196HYT

 

9For a good discussion on the relationship between
concentration of wealth and income see especially charter
two in James Meade, Eff1c1encypiEqual1_y, and the ownership
of Property (Cambridge, Mass.: Harvard University Press,
1965).

 

 

71

72

10This point is shown by the use of a simple
regression model in Luiz Kogut and Carlos Geraldo Langoni,
"Population Growth, Income Distribution and Economic Develop-
ment," International Labor Review 111 (April 1975) p. 327.

11Simon Kuznets, "Demographic Aspects of the Size
Distribution of Income: An Exploratory Essay," Economic
Development and Cultural Change 25 (October 1976) pp. 1-90.

12J.P. Lewis, Pakistan: Industrialization and Trade
Policies (London: Oxford University Press for O.E.C.D.,

19705, p. 1u3.

13See for instance, Ian M.D. Little, Tibor Scitovsky,
and Maurice Scott, Industry and Trade in Developing Countries
(Paris: Oxford University Press for O.E.C.D., 19707, p. 93.

1MW. Irwin Gillespie, "Effect of Public Expenditures
on the Distribution of Income," in Essays in Fiscal
Federalism, ed. Richard A. Musgrave, (Washington, D.C.:
The Brookings Institution, 1965).

15For the empirical finding on the percentage of
direct and indirect taxes in total taxation in the process
of economic development, see Harley H. Hinrichs, A General
Theory of Tax Structure Change During Economic Development,
(Cambridge, Mass.: Harvard Law School, 1966).

16

 

W. Gillespie, "Effect of Public...", p. 139.

CHAPTER FOUR

EMPIRICAL EXPLORATION OF THE IMPACT OF ECONOMIC
GROWTH ON INCOME DISTRIBUTION

”.1 - Introduction

 

In order to empirically investigate the relationship
between the distribution of income and the process of
economic growth, one needs to have information on long-term
trends on different socio-economic characteristics of the

individual countries. But there is a paucity of time series

data on distribution of income and other important aspects
of economic performance, even for developed countries. The
lack of time series data on these important variables is
a serious constraint in empirical investigation. The lack
of data on long-term trends makes it essential to look
for other sources of data; namely, the application of
cross‘sectional data. In estimating the relationship from
this type of data, one makes an implicit assumption that
ith country's socio—economic characteristics would be
exactly the same as the jth country after a certain time lag.
This assumption implies a basic homogeneity among
countries. The homogeneity among countries is an invalid
assumption, simply because socio—economic characteristics

of the underdeVeloped conntries are totally different from

73‘

7”

those of developed countries at the beginning of their.
industrialization. These differences can be summarized as
follows:

a. There exists a lower agricultural land per
capita and a higher man/land ratio in developing countries
today than existed in the presently advanced countries.
Statistical evidence on the ratio of agricultural land to
the male workers in agriculture shows the ratios of 1.2
workers per land unit for the United States, 3.0 for the
Soviet Union, 31.0 in India, and 73.0 in Egypt.1

b. Agricultural productivity in developing countries
today is lower than it was in the advanced countries in
their pre-industrialization stage. This is probably largely
due to the higher density of population settlement and the
greater pressure of p0pulation on land. The lower
agricultural productivity in turn leads to lower per capita
income in the agricultural sector of the developing
countries.

c. There is a much higher population growth in the
underdeveloped countries today relative to that in the
pre-industrialization phase of the now developed countries.
One implication of high population_growth.is that the
proportion of children under age of 15 is almost oneehalf
of the total population in these countries. The higher
dependency ratio in turn implies that a greater amount of
resources is required to feed, clothe and educate the‘

young, therefore reducing saving and the availability of

75

resources for.productive investment.

d. Most of the now-advanced countries began
industrialization after a long period of political indepen—
dence, whereas most of the underdeveloped countries are
beginning development after decades of political inferiority
and colonial status. This factor leads to a political
environment which is insufficient to promote political
participation for the majority of the population. The lack
of interest in political participation leads to weakness
in the social and political structure of underdevelOped
countries.

e. In underdeveloped countries today, there is a
greater degree of dualism and a higher degree of inequality
than there were in the presently advanced countries in their
pre-industrialization stage.

The above comments very briefly highlight some of
the important economic and political characteristics of
the underdeveloped economies today in comparison with the
developed countries in their pre-industrial phase. Therefore,
these differences hinder the comparability of crossvsectional
data for drawing a stable relationship between income
(distribution and economic growth for a single country when
cross-sectional data are used. A country committed to a
policy of more equitable distribution of income and wealth
favors laws to regulate economic activities and ownership of
physical and human capital and consequently has a more equal

distribution of income acrOss different stages of economic

76

growth, whereas a country whose government is unwilling to
take redistributive measures has a higher degree of
inequality regardless of the level of economic growth.

\/ It is again emphasized that in interpreting the
results obtained from cross—sectional data, one has to be
aware of the danger of drawing inferences from cross-sectional
comparisons and applying these results to long-term growth
processes for an individual country.

By keeping in mind the shortcomings of the cross-
sectional data, this chapter proceeds as follows: in
section 2, a brief introduction to the method of estimation
is presented. In section 3, the impact of different
variables on the Gini coefficient is estimated by using the
spline function. One equation is estimated for each
variable to explore the impact of that particular variable
on the distribution of income. Section ”, on the other hand,
presents estimates for a more general equation, relating
the Gini coefficient to all the variables in a single

equation.

”.2 - Method of Estimation

 

The conventional wisdom of the relationship between
income distribution and the process of economic growth, as
measured by per capita product, has been the inverted
U-shaped hypothesis, originated by Kuznets. This hypothesis
states that the inequality in the distribution of income

first increases in the early stages of economic growth and

77

then in the later stages it improves. In other words, any
measure of income inequality follows a particular trend
within a certain range of per capita products, but follows
a different trend beyond that range.

To test the inverted U-shaped hypothesis by using
the regression model, the potential specification which
reflects the change in patterns of income inequality could
be the piecewise technique. The regression equation can

be specified as:

where i is various countries and 008 and y are coefficients
to be estimated, Gi is the Gini coefficient measuring the
inequality of income distribution and furthermore 0 < G < 1.
Y is per capita gross domestic product, Di is a dummy
variable whose value is 1 for all observations such that

Y < Y S Yi and is zero, otherwise. 8 is the disturbance

i-l ‘
term.
For the inverted U-shaped pattern the above

regression can be simplified and illustrated as shown in
Figure 0.1, But the piecewise technique reflects a linear
relationship with a constant slope in some range of Y and

a different constant slope elsewhere. The constancy in
slopes is a serious disadvantage in showing the pattern of
income distribution in the process of economic growth. The

alternative is to fit a piecewise polynomial relationship

between these two variables. The piecewise polynomial

78

 

 

GINI
l l
l l
I I
l l
!
! l
I l
I
I
l I
I I
' I
I
l J. v
Y0 Y1 Y2
Figure 4.1
PIECE-WISE LINEAR RELATIONSHIP BETNEEN
GINI COEFFICIENT AND PER-CAPITA INCOME

GINI

 

 

 

Figure 4.2

PIECE-WISE POLYNOMINAL RELATIONSHIP BETWEEN
GINI COEFFICIENT AND PER-CAPITA INCOME

79

technique is called spline function.2 Any degree of poly—
nomial could be employed, but in this chapter only the
cubic polynominal is used. The general form for the

regression model for the cubic polynomial is:

f 2 3 k- 3
+b Y+b Y +b Y + Iki(Y-Yi) Di+€i

G=b
0 1 2 3 121

where all the variables are defined as before and k is
the number of knots.

The graphical representation of the spline function
is shown in Figure ”.2. The points corresponding to Y1 and
Y2 are called "knots". The use of spline function gives
more flexibility to the estimated regression model for
variation in the rate of change in the slope of the curve
within an interval; the property which the linear piecewise
technique did not have. So the spline function is superior

to the other form of specification in a sense which allows

the curve to twist in order to fit the data more closely.

”.3 - The Estimation Results

 

”.3.a - Per capita GDP and the Distribution Income

The object of this part is to test the empirical
basis for Kuznet's hypothesis; that inequality tends to
increase in the early stage of economic growth and improves
in the later stages. An index of income inequality which
is used in this chapter is the Gini coefficient and it is
estimated for the households with the national coverage.

Gini coefficient has been obtained from a compilation of

80

available cross-country data undertaken by the World Bank's
DevelOpment Research Center and reported in Jain (1975).3

One summary measure of the level of economic growth
has been per capital GNP of each country. The use of
cross-sectional data requires international comparisons
among these countries. The method used to compare per
capita GNP has been to take the per capita GNP estimate for
each country in its own currency and to convert them all
to a common currency by means of the exchange rate between
currencies. However, the use of exchange rates to compare
the per capita GNP of two countries at different income
levels systematically understates the per capita GNP of the
lower income countries.”

To have a better measure for international comparisons
of gross products, purchasing-power parities of currencies
provides a better way of making international comparisons.

The data on per capita gross product, based on purchasing-
power parities, is taken from a recent study sponsored by the
statistical office of the United Nations.5

After establishing a consistent set of data, the
relationship between income distribution and level of economic
growth can be explored by fitting a spline function. Since
it is expected that there is a turning point in inequality
somewhere in the middle range of per capita income, four
knots are used at Y = $”00, Y = $800, Y= $1200, and Y = $1600
(expressed in 1970 U.S. dollars). The estimated equation is

as follows: (the numbers in the parenthesis are

81

3':
T—statistics)

c; = .11+ .oouy,- .114 (10>'”y,2+ .19 (1o>’7y,3

(.”6) (1.71) (-1.96) (2.16)

— .18(10)'7 (Y-800)3Dl, + .55 (10)“8 (Y-800)3D2,,

(-2.”l) (2.98)

- .25 (10)’8 (Y-1200)3 D , + .145 (10)‘9 (Y-1600)3 Du

3
(-1.19)* (1.17)

(R2 = .37, F = 5.13)

(7,59)

This estimated equation confirms the inverted U-shaped
hypothesis at the level of per capita GDP of $1000 and Gini
coefficient of .583. If the maximum inequality corresponds
to Y = $1000, then the numbers of knots can be reduced to
two; at Y = $800 and Y = $1200. The new estimated

equation with smaller numbers of knots is:

G = .58 - .12 (10)’2Y+ .25 (10)-5Y2*- .1” (10)"31'3

(”.”) (-1.6) (2.1) (2.37)

+ .23(10)'8 (Y-800)3Dl, - .82(10)'9 (Y-l200)3D2*
(2.5) (2.8)

(R2=.3l, F = 5.66)

(5,61)
The estimated equation is illustrated in Figure ”.3. As

it is seen, the graph confirms the inverted U-shaped

 

coefficients with asterisk are significant at .05
level or better.

82

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83

hypothesis. As the level of per capital GDP rises, the
inequality in the distribution of income worsens; it reaches
to its highest degree at per capita GDP of 1000 dollars.
After this level of GDP, the Gini ratio declines rapidly

and reaches to its minimum of .365 and stays the same as

GDP per capita increases.

”.3b - Rate of Growth of GDP and Income Inequality

The relationship between income distribution and
economic growth is essentially a long-term relationship.

It may be useful to explore how the degree of inequality

is affected by the rate of growth of output. The developing
countries have shown a respectible average growth rate of
approximately 6.1 percent between 1960 and 1977. The average
annual growth rate among all developed countries during this
same period was approximately ”.9 percent. So one can

expect that the rapid economic growth in the developing
countries leads to rapid capital formation and through its
accelerator effect causes expansion of income and employment.
On the other hand, a stagnant level of per capita income
which is reflected in a slow process of innovation leads

to a gradual increase in unemployment and a steady decrease
in income share among the lower income levels.

So a rapid rate of economic growth, it is expected,
leads to a better distribution of income while slow rate
leads to a deterioration of distribution of income. To
investigate this relationship empirically, a spline

regression model is estimated. The dependent variable is

8”

the rate of growth of GDP over the six year period. The

estimated equation is as follows:

G = .68- .28 RG+ .082 (RG)2 - .006 (RC3)3 + .0088 (RG- 5)3Dl
(1.5) (-.78) (.98) (-1.1) (1.19)

2 _ _
(R - .30, Fu,u7 — 5.15)

The estimated equation is shown in Figure ”.”. The graph
shows an inverted U-shaped relationship between the Gini
coefficient and the rate of growth of GDP. The maximum
level of inequality is reached where the rate of growth of
GDP is 5.9 percent. Beyond this rate of growth, the
distribution of income starts improving.

One probable reason for the deterioration of the
distribution of income can be found in the existence of lags
in factor mobility across sectors. High rate of growth may
lead to the over—utilization of labor and capital in some
sectors, causing a bottleneck or skill shortage in these
sectors. The skill shortage in turn leads to significant
income differentials for the owners of these highly demanded
skills.

When rate of_growth of GDP is considered as an
explanatory variable, the regression equation does not take
into account the rapid population growth in developing
countries. Although developing countries have a high rate
of growth of GDP, these countries also have a high rate of
population growth, the average rate of population growth is

about 2.1 percent per year in developing countries compared

85

with population growth rates of 0.7 percent per year in the
industrialized world. To consider this factor, another
spline function is estimated. The explanatory variable is

per capita rate of growth. The estimated equation is:

0 = .07 + .9” (PRG) - .51 (.PRG)2 + .88 (PRG)3
(-.19)(l.36) (-1.26) (1.19)

- .092 (PRG- 2.0)301+ .oous (PRG — ”)3D2

+ .0025 (PRG- 5.0)303
(.195)

- 2 _
F(u,53) — 5.02 R - .27

Figure ”.” shows the estimated equation. When the per
capita growth rate is regressed on Gini coefficient, Gini
coefficient increases and reaches to its peak level at per
capita rate of growth of 1.6. Beyond this rate, it
continuously declines. The very small range of worsening
income inequality again can be contributed to the factor
market disequilibria.

By looking at the estimated coefficients in both
equations, it is apparent that none of them is significant.
But R25 are significantly different from zero at 0.01 level.
This case often occurs in spline function when there is
only one explanatory variable. The problem is that though
the explanatory variables as a group can explain the
dependent variable well, the effect of each variable

separately cannot be estimated with any reasonable degree of

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87

precision. This problem occurs usually in cases where the
explanatory variables are highly intercorrelated; which is
the case in the spline function. The right hand side
variables all are different forms of a single variable. It
should be emphasized that the problem in this case is
essentially a sample phenomenon. Lack of sufficient
information in the sample does not permit accurate estimation
of the individual parameters. One solution to this problem
is to get more data if it becomes available.

”.30 - Dualistic Economic Development and Income

Distribution

In the process of economic growth, it has been
observed that output per capita in the industrial sector
increases at a rate much higher than the output per capita
in the agricultural sector. This unequal development slowly
draws people from the low income agricultural sector to the
industrial sector. This process creates a mechanism which
leads to an increase in relative inequality in the early
stages of urbanization and improvement in the distribution
of income in the later stages.

For the empirical inquiry on the association between
overall inequality and rural-urban migration, one needs
information on inequality within each sector and percentage
of p0pulation in each seCtor. The lack of data on these
variables makes it essential to use some other proxy
Variables which somehow capture some aspects of this process.

The explanatory variable which is used here is the share of

88

the urban population in relation to the total population.
The measure of overall inequality is the Gini coefficient.

The estimated spline equation is:

2 3

Gini = .” + .OO”8UPOP -.21(10‘)-3 UPOP + .”l(10)-5UPOP

(3.35) (.25) {—.23) (.3”)

- .ll(lO)uu(UPOP--3O)3Dl+.3(1.O)-I+(UPOP--6O)3D2
(-.68) (1.1)

2 _ -
R - .27 F5,u5 - 3.”3

where UPOP is share of urban p0pulation in total population.

It is evident that, as it was for the GDP growth
rate, although the explanatory variables as a group can
explain the dependent variable, which is reflected in
significant R2 at .01, the effect of each variable separately
cannot be estimated with any reasonable degree of precision.
Again the solution to this problem is to obtain more data
on urbanization and Gini.

The estimated equation is shown in Figure ”.5. The
graph shows an inverted U-shaped association between
urbanization and overall inequality. The maximum overall
inequality is reached when the share of urban population
equals 51 percent. Beyond this point, the overall inequality
improves.

The perverse effect of migration on overall inequality
can be explained by the differences in the inequality of
income distribution between these two sectors. As Ahluwalia6

has shown, the inequality of income in the rural sector is

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much less than the inequality in the urban sector. The
increase in relative weight of the more unequal sector in
total population will lead to a higher overall inequality
in distribution of income.

A plausible reason for the improvement in the overall
inequality at the higher urbanization can be explained by
increase in political participation and political power of
the urban low income groups. The political power will lead
to legislation aimed toward the provision of equal Opportun-
ities and educational institutions. These steps tend to
improve the distribution of income in favor of the urban

migrants and low income residents.

”.3d - Labor Share and Capital Formation

The labor—surplus, dual-economy model of development,
discussed in the first section of Chapter Three, implies
that a high rate of growth in the modern sector would create
a high rate of demand for relatively unskilled labor. The
engine of the rapid growth in the modern sector is the
continuous reinvestment of surplus output. The rapid capital
accumulation, in turn, absorbs increasingly large numbers of
workers and ultimately increases the share of labor in total
output. Since the wage receivers are in the lower income
brackets, any factor which.increases labor share will change
the distribution of income.

Therefore, in order to investigate the pattern of
the distribution of income under the dualistic model, two

explanatory variables are used. These are the labor share

91

and capital formation as a percentage of GDP. Two spline
regression equations are estimated. The explanatory
variable in the first equation is the labor share and in the
second equation, the explanatory variable is the capital
formation. Gini coefficient is the dependent variable in
both equations.

When the labor share is regressed on Gini coefficient,

the estimated equation is:

0 = -l.8” + .18 1.9, - .0098 (LS)2* + .38 (.10)"* (LS)3*

(-l.97)(2.”3) (-2.31) (2.13)

- .13 (10)"3 (Ls-50)3Dl
(-.75)

2

R = .3” F = 6.38

”,”9
where L3 is the labor share.

Figure ”.6 shows the estimated equation. As it is
observed, there is an inverted U-shaped association between
labor share and the overall inequality. The maximum
inequality occurs when the labor share is equal to 32.5
percent. Beyond this point, as the labor share increases,
overall inequality decreases continuously. Although it is
expected that the distribution of income improves as the
labor share increases, a plausible explanation cannot be
offered for the worsening distribution of income at the
lower labor share. It can be speculated that the lower labor

share is associated with a smaller percentage of the labor

force in the industrial sector versus the agricultural and

92

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informal sectors. The smaller percentage of labor force
in industrial sector of the urban area, in turn, is
associated with lower political power to demand for better
work conditions, higher wages and at the extreme, for more
equal distribution of existing assets.

For the second spline regression, capital formation
is used as the explanatory variable. The estimated

equation is:

G = 2.6— .38KF+ .022 (.KF)2 - .142 (10)-3 (KF)3
(1.72)(-1.u1) (1.u3) (-1.u9)

+ .59 (10)‘3 (KP -20)3Dl
(1.7”)

R = .28 FH,H9 = ”.95

Figure “.7 shows the association between capital
formation and Gini coefficient. The striking feature that
this graph shows is the significant impact of capital
formation on improving the distribution of income. An
increase of 20 percent in capital formation, as percentage
of GDP, has caused a significant drop in Gini ratio (from
.59 to .31).

In the absence of time series data for a single
country, it is very difficult to pinpoint the causes of
this association between capital formation and Gini ratio.
If capital and labor are complementary inputs, and the
capital invested is in labor intensive techniques, then one

can easily explain this pattern. The use of cross.seCtion

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data does not shed light on the complementariness between
capital and labor if the capital has been invested in more
labor intensive techniques. In general, it seems that
capital accumulation has served not only as the engine of
growth, but also as an equalizer for the distribution of
income. Capital accumulation appears to have been invested
in the more labor intensive sector and is perhaps the only

source of job creation.

H.3e 0 Education and Income Distribution

In the analysis of education and income distribution,
education is considered as a source of productivity and
growth and so it influences the individual's earning.
However, effect of education on the size distribution of
income as an equalizing factor has been a source of
controversy. Some authors believe that improvement in the
educational characteristic of the population provides a
mechanism which operates to promote income equality, while
other authors claim that there exists a negative relation—
ship between education and income inequality.7

To find the direction of the effect of education on
the size distribution of income, the impact of educational
level (as measured by school enrollment ratios) on Gini
coefficient is examined. Three equations are estimated;
the first equation relates Gini coefficient to primary
school enrollment ratio. In the second equation, secondary

school enrollment is used as the explanatory variable and

96

total school enrollment is regressed against the Gini
coefficient in the third equation.
The estimated spline model relating the primary

school enrollment ratio and Gini is as follows:

G = -71.9 + 7.‘+ (.PSBR) - .25 (PSER)2 - .0028 (PSER)3

-.ou (.03) (-.019) (.013)

- .68 (10)”7 (PSER--20)3Dl - .0029 (PSER-80)3D2

(-.32(10)'5) (-.19)

-3 3
+ .11 (10) (PSER-H0) 03
(.198)
R2 = 008 F 073
° (6,59) °

where PSER is primary school enrollment ratio.

By looking at the low values of t and R2 it is
apparent that neither R2 nor any estimated coefficient is
significant. Based on this result, it is concluded that
there is not any association between primary school
enrollment ratio and the Gini coefficient. One plausible
reason for this lack of association can be contributed to
the very low rate of return for the persons with completed
primary education compared with persons with no education.
Also, universal primary education has become a more feasible
goal and more primary education is provided on a universal
basis.

On the other hand, when the secondary school

enrollment ratio is regressed on G, an inverted Uvshaped

97

pattern is observed. The estimated equation is:

G = .62 - .009 (8338),, + .33 (10)”? (SSER)2,.,
(6.”) {-1.98} (2.21)

- .68 (10)"1‘l ($83103, + .85 (10)” (SSER -20)31)l
i:

(2.36) (2.”8)

- .18 (10)” (SSER—u0)3D2*

{-2.63)

2 - -
R - .31 F5,53 - u.88

where SSER is secondary school enrollment ratio.

The estimated equation is shown in Figure u.8. As
it is seen, distribution of income worsens when there is
low level of enrollment. The basic reason for this perverse
effect of formal education in income distribution is the
significant income differentials between those who are able
to complete secondary education over others who have only
completed part or all of their primary education. The
income differential can be as high as 300 to 800 percent.8
As the enrollment ratio increases, the income differential
as a quasi-rent for an elite group will decline. There
exists a negative relationship between income differential
and educational level, reflected by the enrollment ratio.
The lower income differential between high school graduates
and others with no education or primary education might
contribute to the decline in the Gini coefficient.

In the third equation, the explanatory variable is

98

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the total primary and secondary school enrollment ratio. The

estimated equation is:

G = 3.2 - .28 TSER* + .89 (10)'2 (TSER)§
(2.51)(-2.28) (2.91)
-0 3 -u 3
- .82 (10) (TSER)* + .87 (10) (TSER-u0)*Dl
(02.98) (2.57)
R2 - 31 F - 8 21
' ' 0,88 ’ '

where TSER is total school enrollment ratio.

The estimated equation is illustrated in Figure “.8.
As it is observed, there exists a U-shaped pattern between
Gini ratio and TSER. The reason for this pattern is the same
as mentioned for the secondary school enrollment ratio and
Gini coefficient. The difference between TSER and SSER
with respect to the Gini coefficient is that the maximum
level of inequality corresponds to the TSER to 59 percent
compared with SSER of only 23 percent. Also, the maximum
points on these two curves differ, i.e. the maximum point
on SSER is .51, but is is .SHS on the TSER. Beyond the
TSER of 5H, the Gini ratio falls continuously, a feature
which is not present for the SSER.

In brief, it can be concluded that the very low level
of enrollment ratios leads to the significant income
differential for an elite group and causes more inequality
in the distribution of income. As the primary and

secondary education are provided on a universal basis (as

100

reflected by increasing school enrollment ratio), the income
differential will decline and consequently the distribution

of income improves.

n.3f - Import-Export and Income Distribution

As it was discussed in Chapter Three, the foreign
trade policies affect the distribution of income. One of the
most widely used trade policies is the import substitution
strategies. This policy has a very detrimental effect on
traditional primary exports and income distribution. In
order to encourage local manufacturing through the importa-
tion of cheap capital and intermediate goods, foreign exchange
rate has to be artificially overvalued. Overvaluation has
the effect of raising the price of exports and lowering the
price of imports in terms of the local currency.

The net effect of import substitution policy is to
encourage capital—intensive techniques of production and
penalizing the traditional primary exports. In terms of its
income distribution effects, the outcome of import substitu-
tion policy is to penalize the small farmer and the self~
employed at the expense of improving the profits of the
owners of capital. 80 import substitution has the effect of
taxing agricultural goods in the home market and discouraging
agricultural exports. This in turn worsens the distribution
of income by favoring the urban sector and the higher—
income groups while discriminating against the rural sector
and the lower income groups.

An empirical exploration of the impact of trade

lOl

policies, namely import substitution strategies, on the
distribution of income requires elaborate data on the change
in the structure of imports and exports due to these
strategies. In the absence of this data, the explanatory
variables are the percentage of import in GDP (which is
called the degree of Openness) and the percentage of export
in GDP. In the first equation, the amount of imports as a
percentage of GDP is regressed on Gini coefficient. The

estimated result is:

G = 9.39-2.8M*+.3O Mi- .01Mi+ .01 (14—10): 01

(2.H8) (—2.38) (2.”1) (-2.u3) (2.“6)

-3 3
— .58 (10) (M—20)* 02

(—2.69)

2 _ _
R _ .23 85,”, - 2.89

where M is the percentage of import in GDP.

The estimated equation is shown in Figure 9.9. Figure
H.9 demonstrates that there is not any specific pattern
between Gini coefficient and the increase in import as a
percentage of GDP. The curve is characterized with the
recurrent ups and downs for the estimated values of Gini
ratio. Gini ratio falls dramatically between the 7.0 to
7.5 percentage range and it rises sharply and then falls
again. Its lowest point corresponds to 22.5 percentage of
import in GDP. Beyond this range, rises again and reaches
its peak and falls for the third time. Based on this

behavior, it is difficult to draw any inferences on the

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103

association between the degree of Openness and the Gini
coefficient.

For the second equation, export (as the percentage
of total GDP) is used as the explanatory variable. The

estimated spline regression is:

G = .31 - .007 x - .01 (10)"2 x2 + 10 (10)"3 x3
(1.8) {-1.11) (-1.35) (1.51)
- .21 (10)’3 (x-20)3 D1 + .18 (10)‘3 (x-30)3 02
(-1.62) (1.91)

R = .12 F = l.Ml

where X is percentage of export in GDP.

It is evident that neither R2 nor any of the estimated
coefficients are significant at any reasonable level. So
it can be concluded that statistically there is not any
association between Gini ratio and increase in the export
as the percentage of GDP. The behavior of estimated Gini
ratio when it is graphed against export is illustrated in
Figure ”.10. It is characterized with recurrent ups and
downs. It has to be kept in mind that, in this case,
neither R2 nor any estimated coefficient are significant,

2

while in the case of import both R and estimated coefficient

are significantly different from zero.

9.32 - Indirect Taxes and the Gini Coefficients
Each county employs a variety of taxes for the

mobilization of resources to finance public expenditures.

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Some of these taxes are progressive, whereas others are
regressive. For instance, personal income and property

taxes are progressive and excise and sales taxes are
considered to be regressive. The structure of the tax system
as a whole for distributional policy is very important.

Only progressive tax system will lead to a more equal
distribution of income.

In the underdeveloped countries, lack of administra-
tive capability and the absence of well-organized money
economy make it extremely difficult to collect personal and
especially property taxes. These countries have to rely
on the more traditional taxes, i.e. sales and excise taxes.
Although these types of taxes are regressive in their
nature, they are economically and administratively feasible
to levy and collect. In order to explore the impact of
these taxes on income distribution, a spline regression
equation is estimated. The explanatory variable is the
indirect taxes as a percentage of GDP. The Gini coefficient
is the dependent variable in this equation. The estimated

result is:

2 3

G = 1.98 - .51T + .057 T 0 .21 (10)“2 T

(2.16) (01.56) (l.u8) («I.HB)

- .3 (10)"2 (T-10)3 D1

(l.u8)

2 _ 0
R - .10 Pu,09 - 1.81

where T is the indirect tax as the percentate of GDP.

106

Figure ”.11 shows the above estimated equation. It is
observed that there is not any specific pattern between

Gini coefficient and increase in indirect taxes. Gini ratio
falls sharply and almost stays the same within 8.0 and

19.0. Beyond this range, it rises continuously. Considering
the T statistics and R2, it is found that there exists no
statistical association between Gini ratio and indirect

taxes based on the cross sectional data used in estimating

the above equation.

9.0 - General Equation

 

So far, the estimated equations have related the
Gini coefficient to one single variable as the explanatory
variable. In this section, a more general econometric
equation is presented. In this equation, the impact of all
the variables on Gini coefficient is estimated. The general

form of the equation is as follows:

G = f{Y, Y2, RPG, PRG, AGAC, TSBR, UPOP, GOV, KP, LS,

X,M, T}

where G, the dependent variable, is the Gini coefficient.

The level of development is measured by per capita income Y
and its square form Y2. RPG represents the annual average
rate of population growth for the six year period. PRG is
the per capita rate of income growth of GDP. AGAC represents
the share of agricultural output in total output and UPOP

is the urban population as the percentage of total population.

These two variables demonstrate the relative position of the

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rural sector. GOV, KF, T respectively, represent the
government expenditure, capital formation and indirect taxes
as the percentage of GDP. Labor share is shown by LS and X
and M are percentage of export and import in GDP.9
OLSQ technique is used to estimate the equation.

The estimated result is shown below (T ratios are in

parentheses).

G = .39 + .2 (10)"3 Y* - .92 (10)’7 Y: + .091 RPG*

(1.63) (2.01) (-2.03) (2.06)

- .022 PR0, + .33 (10)2AGAC - .57 (10)"3 TSER
(-3.02) (1.2) (-.67)

+ .81 (10)”3 UPOP - .13 (10)"280v + .27 (10)’2KR

(.921) (-.23) (.71)

+ .38 (10)“2x - .19 (10)"2M - .5 (10)”3T

(1.56) (.66) (-.l2)

- .58 (10)”: L8
(3.3)

2 - -
R - .71 F13,u0 - 7.78

The estimated coefficient for Y is positive and for

Y2

is negative and both are significant. The estimates
indicate that inequality first increases and then decreases
as per capita income increases. Rate of population growth

contributes to more inequality in the distribution of

income. This effect is reflected by the significant and

109

positive estimate for RPG variable. On the other hand,
per capita rate of growth has a significant effect on the
Gini coefficient. PRG has an equalizing impact on income
disparities. Although total enrollment ratio improves the
distribution of income, the estimated coefficient is not
significantly different from zero (negative sign but very
low 3 ratio). The same result can be observed for the
government expenditure. Increase in urban population and
share of agricultural output in total output results in more
income inequality but neither of these estimates is
significant.

The interesting result Of this general equation is the
estimated coefficient for capital formation. When only KP
was regressed on Gini coefficient, it was observed that KP
had a significant equalizing effect on the distribution Of
income. But in the general equation KF has a positive sign
and it is not significantly different from zero. Labor
share, on the other hand, has a very strong equalizing impact
on the distribution of income. This strong effect is
indicated by very high 3 statistics.

The estimated equation also shows that increase in
export as percentage of GDP contributes to higher inequality
and increase in degree of Openness leads to lower inequality,
though neither of the estimated coefficients is significant.
The negative sign of the estimated coefficient for indirect
taxes indicates that increase in indirect taxes results in

less inequality; but again 3 statistics shows that this

110

estimate is not significantly different from zero.

In brief, it can be said that some of the estimated
coefficients in the general equation are consistent with
the previous results estimated from single variable
equations. For instance, the inverted U-shaped hypothesis
is confirmed both in the general equation and spline
function. Also, PRG is found to act as an equalizing
factor in both general equation and spline function. But
there are also inconsistencies between results estimated
from the general equation and the spline functions. KF has
very strong equalizing effects in the spline function, but
in the general equation it has positive sign; meaning more
capital formation results in more income inequality.

One important point about the general equation
which has to be emphasized is the low t statistics for some
of the estimated coefficients. The obvious reason is the
existence of the multi-collinearity. In the general
equation, there is strong interrelationships among the
independent variables, and it becomes difficult to estimate
their separate effects on the dependent variable. For
instance, there is strong intercorrelation between per
capita income and school enrollment ratios. After using
Y and Y2, adding TSBR does not have significant effect on
the Gini coefficient. The unexpected wrong signs for the
estimated coefficient in thegeneral equation can also be

explained by the existence of multicollinearity.

FOOTNOTES

CHAPTER FOUR
FOOTNOTES

lSee Kuznets, Economic'Gr0wth and Structure: Selected
Essays, (New York: WIW. Norton and CO. Inc., 1968) p. 179

 

2For further analysis of spline function see Daniel
R. Suits, Andrew Mason, and Lou Chan, "Spline Functions
Fitted by Standard Regression Method,"‘The‘RevieW\of
Economics and StatiSticS 60 (February 1978) pp. 1327

 

 

38. Jain, The'Size'Distribution’Of'Income: ‘A
Compilation of Data, (Baltimore: John Hopkins Univérsity
Press, for the World Bank, 1975). This book offers the
richest compilation of data on distribution Of income for
the largest number of countries.

”For the detailed explanation of this matter, see
Everett Hagen, The Economics Of Development, (Homewood,
Illinois: Richard D. Irwin, Inc., Revised Edition, 1976)
p. 13.

5The data on real domestic product and shares of
gross domestic product devoted to private and public
consumption and investment for over 100 countries and the
method of estimation can be found in Robert Summer, Irving
B. Kravis, and Alan Heston, "International Comparisons

 

 

 

Income and Wealth (March 1980), pp. 19-67. To the best of
my knowledge, no author has used purchasingvpower parities
in this context.

6Montek S. Ahluwalia, "Income Inequality: Some
Dimensions of the Problem," in“RediStribution'With‘Growth,
ed. Hollis Chenery et. a1., (London: Oxford University E
Press, 3rd Printing, 1976) p. 21, Table 1.9.

 

7See Chapter Three of this dissertation.

8Michael Todaro, “Economic'Develqpment‘in'the Third
World (New York and London: Longman, Second Edition 1981)
p. 312.

9The data on per capita rate of growth, percentage of
agricultural output in total output, government expenditure,
capital formation, labor share, percentage of export and

 

111

112

import in GDP, and indirect taxes as a percentage of GNP
have been taken from the Yearbook of National Account
Statistics (various years), United Nations. The information
on rate of population growth and share of urban population
in total population are from The DemOgraphic Yearbook
(various years), United Nations. Data on school enrOllment
ratios are from Unesco, Statistical Yearbook (various

years).

 

CHAPTER FIVE

POLICY IMPLICATIONS TO IMPROVE THE
DISTRIBUTION OF INCOME

5.1 - Introduction

 

The second half of this century has been character-
ized by unprecedented rates of economic growth in many
developing countries. Most developing economies focused
their attention on policies which were geared to increase
the level of output, and the concept of distribution of the
output itself was ignored. However, the skepticism
regarding the spillover effects of economic growth to all
segments of the p0pulation has been raised.

One justification for growth-oriented policies is
the so-called "trade-off" between economic growth and
egalitarian distribution of incomes. It has been suggested
that these two ends are contradictory and that a redistri-
bution of income would lead to lower investment as a portion
of income and thus a smaller rate of growth of income. On
the other hand, if growth were given primary emphasis, the
fruits of this growth would eventually trickle down to all
segments of population.

In this chapter it will be shown that there is no

need for sacrificing economic growth for an egalitarian

113

119

distribution Of income. By designing and implementing
economic and social policies, a better distribution of
income can accompany economic growth from the start.

One important point about redistributive policies,
which has to be mentioned, is the reluctance of the
economically powerful and the lack of administrative
capability to change the status quo. The distribution of.
income is closely determined by the distribution of
political power. Redistributive measures that alter the
current distribution of income are against the interests
Of the politically powerful who are supposed to administer
these measures. By this view, it is reasonable to argue
that these politically powerful elite are reluctant to
take action to correct the distribution of income.

Any redistributive policy necessarily requires the
political process that can generate more power for the poor
and disadvantaged in the society. In most cases, the
political power is more important than scanty command over
economic resources.1 The achievement of political power
by the poor is a necessary first step toward a better
design and implementation Of redistributive policies. As
the level of education and political awareness of the lower-
income groups increase, they become more conscious of their
political rights and easily are mobilized in the defense
of these rights. The political conscience of the lower-
income group will lead to a variety of protective and

supporting legislations which are aimed at improving the

115

distribution of income in favor of them. Considering the
above stated concern regarding lack of political power

and its relationship to redistributive policy, the chapter
proceeds as follows: Section 2 is concerned with the
choice of different measures to promote labor share. In
Section 3, investment policies and their relationship with
income distribution is introduced. Section 9 explores how
changes in capital ownership and changes in pattern of
capital accumulation can be used to change the pattern of
income distribution. In Section 5, it is argued that
educational expansion is considered to be an important
factor in improving the distribution of income. Section 6
is concerned with the distributional impact of pOpulation
policies. Section 7 shows how the tax policies can be used
to not only increase revenue but to improve the distribution

of income. Finally, Section 8 offers a brief conclusion.

5.2 - Policy Intervention to Increase Labor Share

 

As it was shown empirically, the increase in labor
share improved the overall inequality in the distribution
of income. Policy intervention in the labor market aimed
at promoting greater absorption of labor is an apprOpriate
policy. The easy policy for the greater absorption of labor
is the low-wage approach. This policy attempts to keep the
modern sector wages at a low level. Low wages not only
encourage rapid absorption of labor in the modern sector,

it also leads to a high profit, high saving economy and

116

consequently to a higher rate of economic growth.

Yet policies directed at lowering the relative price
of labor are unsuccessful approaches to income redistribution
in deve10ping countries. These policies neither increase
labor share nor are they equitable. The impact of lowering
real wages on labor share can be illustrated in a two-factor
economy with unemployment. The decrease in real wages is
expected to produce some increase in employment and an
increase in output. But since the elasticity of substitu-
tion between labor and capital is less than unity2 the share
of wages in total income will actually fall. Under these
circumstances, the distribution of income has worsened;

i.e. capitalists are better off and workers previously
employed suffer an absolute decline in income. Against

these two changes, there is an increase in income in the
previously unemployed group which represents a distributional
gain.

As it was argued, the low-wage approach, although
increasing employment, does not improve the distribution Of
income. SO some other policies are needed to not only
increase the level of output and employment but also to
improve the distribution of income. The policy approach
has to be related mainly to factors influencing the demand
for labor. SO the emphasis must be aimed at the use of
more labor-intensive production and technology. The high
rate of labor utilization can be attained only by choosing

a product mix which is labor-intensive in character or by

117

adopting a technology which permits the substitution of
labor for scarce capital and fertile land.

Unfortunately, modern technology adopted by the
less-developed countries requires labor and materials
similar to those in the developed economies for which it
was designed, so that new products and processes are not
suited to the demand patterns and factor endowments of the
underdeveloped countries. The transplanted technology
requires highly skilled workers and efficiency. For the
required standards of skill and efficiency, the private and
public expenditure must be disproportionately concentrated
on the workers of modern industries. This has an important
implication for distribution of income. The income
distribution problem is worsened by the fact that the
adopted technology used Often imposes heavy demand not only
for physical capital but for human capital for a small
portion of the labor force. The requirement for high skills
on the part of labor increasesintra-labor'inequality and
creates quasi-rent for a privileged and small group of
workers.

The choices of an appropriate technique Of production
that makes increasing use of the unskilled labor (the most
absundant resource) is essential to increase employment
and equality in the distribution of income. But since
many existing labor-intensive techniques have low productivity,
the use of these techniques may create a potential trade-off

between growth and income distributional objectives. SO

118

the scope for implementing redistributive and growth
strategies depends not only on the use of labor-intensive
techniques but on a steady rate Of technological improvement
and innovation in these techniques and also promotion of
products, which are labor—intensive in character.

It is simply a realistic recognition of the fact
that research efforts in developing countries are unlikely
to be focused on improvement and innovation in labor-
intensive techniques. The recognition of this fact
necessitates direct actions by the governments to expand
the indigenous research capabilities in relevant areas.

The indigenous research may place emphasis on production
and marketing problems of particular commodities suitable
for labor-intensive production or plant breeding programs
aimed at the increase and development Of crops grown by
small farms.

Another policy to discourage the over use of
unsuitable imported technology is to eliminate the under-
valuation of foreign currency in order to make the imported
technology very expensive. Since the manufactured exports
are usually more labor-intensive than import substitutions,3
the removal of the bias against export in favor of many
import substitution policies can be expected to increase
labor demand and gross domestic product in the long run.

Governments also can increase the demand for labor by
reducing labor costs to employers without lowering the wages

paid to the workers. These policies can be implemented by

119

provision of labor subsidies or abolition of payroll taxes.
But provision of subsidy payments or tax credit involves

a cost to the government budget and these costs must be
compared with the resulting increase in employment. If
there is a large degree of substitutibility between labor
and other factors Of production, there will be a significant

increase in employment and the policy will be successful.

5.3 - Investment Policies and Income Distribution

 

In the previous chapter, it was shown that investment
had a significant effect on the distribution of income.

It will be plausible to place a heavy role on investment
but the investment must take place in a manner which serves
the income distribution objectives very effectively. The
investment must be consistent with the resource endowment
of the economy.

Almost all developing countries have a variety of
policies aimed to encourage investment in the manufacturing
sector. In almost all instances, the incentives are in
terms Of exemptions from company taxes or imposition of
explicit or implicit subsidies arising from low interest
rates, exchange rate undervaluation or imported capital
equipment, and incentive schemes. It is correct to say
that in most developing countries all incentive schemes
favor the use of capital at the expense of labor. The
worse effect of these incentives on employment growth and

income distribution is when the choice of techniques and

120

choice of sectors are affected by these policies. The
problem in most underdeveloped countries is capital market
fragmentation. Under this condition, the investment
incentives cause a difference in the availability of capital
between sectors. The capital is underpriced in the modern
sector and it is overpriced in the market facing the
traditional and agricultural sector. This in fact penalizes
employment growth of unskilled workers, discourages the use
of domestically produced inputs and discriminates relatively
against small-scale manufacturers who use more labor-
intensive techniques. In the agricultural sector, too,
small farms have unequal access to subsidized inputs. The
availability of cheap credit to large farms has encouraged
labor-displacing mechanization. The lack of availability
of credit for labor-intensive sectors (farmers and urban
small producers) demands an apprOpriate policy action which
ensures equal access to credit for these sectors. There is
strong evidence that capital-output ratios and capital labor
ratios are higher among large firms than small firms. For
instance, according to Squire,u the small scale producers
use four to ten times more labor per unit of fixed
investment than the larger firms. So, removing discrimination
against small producers and a more deliberate policy of
ensuring access to credit for them can increase employment
and improve the earnings of the self-employed.

In addition to the lower capital—labor ratios in

small scale manufacturing, there is also higher value added

121

per unit of capital in this sector. Promoting small scale
manufacturing not only serves to improve the distribution
Of income but also is conducive to growth. In this case,
there is no trade-off between growth objectives and
distributional Objectives.

There are several measures suggested to encourage
small manufacturing units. These measures consist of
elimination of special incentives, such as cheap foreign
exchange and subsidized credit that only favors large
firms and the establishment of agencies.that advise small
firms on technical matters about production and marketing.
Measures which improve the credit allocation mechanisms
and reform the interest rate structure are very important
for promoting the small scale manufacturing units and
consequently promotion of employment.5

One important point about incentive systems is the
impact of tax exemption on the rate of investment. If tax
exemption has no effect on the rate of investment, then the
government foregoes tax revenues and the investors gain
with no change in investment. The foregone government
revenue matters if the government supplements the foregone
income through other taxes, e.g. payroll taxes, that penalize
employment growth. Under the above stated condition, the
policy implication is the imposition of a tax on capital
and other types of capital-based tax rebates. These
policies shift income from high—income groups to the

Vgovernment budget.

122

To summarize briefly, the investment-incentive
packages almost always favor large scale manufacturing in
the modern sector. Small scale and indigenous activities
that fit the resource endowment of the economy are
neglected or discouraged by these policies. This, in turn,
decreases the Opportunities for income-earning activities
that can reach a significant segment of the labor force
and contributes to inequality of income. TO serve the
growth objective and distributional objective, the policy
package has to promote investment Opportunities and

technical advice for small scale indigenous activities.

5.9 - Capital Ownership and Inequality

 

Resource prices and utilization levels for each
type of productive factor (labor and capital) give the
functional distribution of income. In some cases, for
designing policy packages to improve distribution of income,
the knowledge of size distribution of income is very
important. In order to translate the functional distribution
into size distribution, one needs to examine the distribution
Of income-earning factors among households.

In most underdeveloped countries, the main cause
of the very unequal distribution of personal income is the
very unequal and highly concentrated patterns of asset
ownership and human skills. It follows that to reduce
inequality, the policies must be designed to focus on

directly reducing the concentrated control of assets. The

123

most radical approach to changing the concentrated patterns
of physical assets involves the redistribution of directly
productive assets to lower income households to raise
income levels of these households. In predominantly
agricultural countries, land redistribution might be the
most effective instrument in reducing inequality in the
distribution of income. The impact of land redistribution
on productivity and distributive justice deserves emphasis.

Country studies undertaken by the FAO and the World
Bank to analyze the relationship among size of holding,
concentration of land and productivity, indicate that a
smaller average size of holding and a lower concentration
of land ownership are associated with an increase in output
per hectare.6 In a systematic analysis of the differences
between large farms and small farms in six Latin American
countries, it was found that output per hectare was three
to fourteen times greater on the small farms than on the
large farms.7 The important implication is that reduction
in either the size of holdings or the concentration of land
ownership need not be associated with a reduction in output
per hectare. On the contrary, it is found that output per
hectare is likely to be higher. In broad terms, land
reform not only eliminates the possibility of trade—offs
between growth and distribution, but it serves to improve
both objectives.

Land reform also has a significant role in providing

employment in rural areas. Evidence exists that the use of

129

labor per hectare is inversely related to the size of
holdings. The studies previously mentioned indicate that
manpower per hectare of agricultural land is significantly
correlated with the size of the holding, i.e., the larger
the holding, the smaller the labor input. The extreme
poverty of many who live on the land and the increasing
pressure on the land through population growth demands an
urgent widespread land reform to raise productivity and
income in agriculture and, at the same time, to provide
more employment.

Perhaps more intensive use of labor is the main
reason why small farms are more productive than the large
farms. Inputs other than labor also have to be used
intensively on small farms. Therefore, existence of the
organizations providing for both the supply of necessary
inputs such as credit, fertilizer, seeds and marketing are
crucial in a post-reform period. 80 it is necessary for
the government to devise package policies to provide
OOOperatives, agricultural development banks, special credit
institutions and marketing facilities.

One important point on feasibility of land reform
which is directly related to political factor is worthy of
mention. The concentration of land ownership is usually
the most significant determinant of political power in some
of the developing countries. A meaningful land reform
program will seldom be implemented unless there are shifts

in political power. The successful land reform experience

125

of Kenya, Japan, and the Republic of China indicates that
in these countries there was a change in governments that
favored drastic changes in political and economic structure.

In brief, land reform can be consistent with all
the goals of economic deveIOpment; it increases productivity,
increases employment and provides a better distribution of
income. However, sustained increases in output depends on
complementary investments and follow up policies. The
most important of these policies is organization and
provision of the necessary inputs and the marketing of
production.

Real land reform is an effective policy to change the
concentration of land ownership in the rural areas. In the
urban areas, the distribution Of real estate and financial
assets is more skewed than the distribution of farm land
in the rural areas. In countries with a substantial and
prosperous industrial urban sector, urban prOperty reform
and progressive taxation on urban wealth have to accompany
the land reform. Land reform by itself may not decrease
the inequality of the distribution of total wealth in
these countries as a whole.

Land reform and prOperty reform can be considered as
the redistribution of the existing assets. In addition
to the redistribution Of existing productive assets,
governments can change the pattern of accumulation in the
economy. If lack Of ownership or access to particular 1

types of assets is the main reason for low levels of incomes,

126

the governments can build up these assets by redirection
of the pattern of investment in the economy.8 One possible
policy to change the pattern of accumulation is to provide
equal access to the financial markets for the lower income
groups. The fragmented financial market in deve10ping
countries discriminates against the people in lower income
brackets. The other policy is to subsidize formal and
nonformal education by the governments. Accumulation of
human capital through formal and nonformal education, in
turn, leads to a higher income level.

In brief, some form of asset redistribution, whether
the existing assets or dynamic redistribution seems to be
a necessary condition for any significant reduction of

income inequality in most less developed countries.

5.5 — Policies to Promote Educational Level

 

Unlike land reform which is a direct attack on
patterns of the concentration of land ownership, the
extension of education to the poor results in the creation
of new human capital. The justification for provision of
education on a universal basis is twofold. First, as it
was argued in Chapters 3 and 9, concentrated patterns Of
human skills are as important a cause of income inequality
as the concentration of physical assets. The increase in
educational level and equal access to educational
institutions lead to more equal distribution of income.

The second justification of providing education is

127

its substantial effect on labor productivity and higher
economic growth. For instance, Psacharopoulos has
estimated that the contribution Of education ranges on the
average between 11 percent (for advanced countries) and 15
percent (for less developed countries) of the observed rate
of growth. When the contribution of education is
disaggregated by educational level, it is found that, on the
average, primary education contributes 96 percent of the
total educational contribution to the rate Of growth,
secondary education 90 percent and higher education 19
percent.9

Considering the impact of education on income
distribution and economic growth, the policy implication
is that public policy should aim to promote and deveIOp a
more equal pattern of distribution of human capital. It is
a popular policy because there is not any trade—Off between
economic objectives and distributive justice. Furthermore,
there is less restrictive political constraints upon
implementing educational policies compared with other direct
redistributive actions.

It should be pointed out that the provision of
education per se will not contribute to a better distribution
of income if it is not provided on an equal basis for the
whole population within the country. Educational
institutions are generally provided in urban areas and
educational levels are higher for urban than rural families.

This unequal access, in turn, leads to the higher average

128

income levels of urban families. For instance, in Columbia,
which is one of the most advanced Of the less develOped
countries, nearly sixty percent of the rural schools

offer no more than the first two grades of primary school;
only six percent have facilities to Offer a four-year '
primary sequence.10 It appears that the productivity and
income benefits of formal education and training accrue
mainly to persons living in urban areas. SO if education

is to contribute to more equal distribution of income, it
has to be provided on an equal basis.

Up to now, the discussion has been concerned
primarily with the equal access to educational Opportunities.
The other important question on the provision Of education
is which level of education has to be mostly emphasized
in deve10ping countries. As previously stated, primary
education makes the greatest contribution to economic growth
and it has the highest social rate of return in developing

countries.11

On the cost side of providing different levels
of education, in the less developed countries the annual
per-student expenditures on the secondary and particularly
on higher education are proportionately much higher than in
the more advanced countries. Thus in the less develOped
countries students in higher education receive relatively
high benefits in the form of public expenditure toward
education. The emphasis and consequent subsidizing of

higher education can be detrimental to the distribution of

income especially if the students in higher education come

129

from the richer families.

In most developing countries, the private rate of
returns to investment in higher education are higher than
social rate of returns and little is gained by subsidizing
the students from a high income class. Thus, in these
countries it might be advantageous to curtail the public
financing of higher education and shift greater proportion
of its cost to the beneficiaries or their families. At the
same time, loans (repayable at a later time by the students
from future earnings) can be Offered to the students of the
poorer families. However, this approach requires an efficient
administration to channel the funds only to the needy
students.

In brief, it can be concluded that the provision of
primary education on a universal basis not only has the
largest impact on economic growth but also the public
financing of primary education actually redistributes
income from the richer families to the poorer families
without strong political resistance.

In addition to formal education, nonformal education
also can be provided to promote productivity of labor. The
nonformal education consists of programs such as provision
of basic literacy and numeracy, or agricultural extension
services with the purpose of extending knowledge of agri—
cultural processes to farmers. Other programs aimed to
promote agricultural productivity are occupational educations

designed to deve10p particular knowledge and skills such as

130

animal husbandry, adaptation of new technologies and
improvement of agricultural output. One kind of nonformal
ecucation which is not directly related to production is
family and community improvement education. Family improve-
ment education is designed primarily to promote knowledge

on subjects such as health and nutrition, child care, home
improvement and family planning. Though the family improve—
ment education may not increase the output immediately,

it can improve the quality of living of the poor and in the
long run raise the life expectancy and mental development

of future generations which can be an important factor to
the increased productivity of the labor force.

In the absence of any evidence, it is difficult to
assess the impact Of nonformal education programs on income
distribution. If these programs are concentrated on the
subsistence farmers and the underemployed, it may be the
only means to provide competent peOple to gain access to
higher income and higher level jobs in the economy. One
shortcoming of nonformal education is that it does not Offer
degrees, diplomas, and certificates. The degrees might be
considered the essential means of entry to positions of
wealth and power. Although it can be argued that nonformal
education is not as powerful as formal education in the
improving of the distribution Of income, it may be the only
available learning opportunity for large proportions of the

population in many developing countries.

131

5.6 - Population Policies to Improve the Distribution of
Income -

As it was estimated in Chapter Four, population growth
has a very significant disequalizing effect on the distribu-
tion of income. There are several mechanisms through which
the rapid growth of pOpulation may generate income inequality.
The first mechanism is through the effect of population
growth in increasing the supply of labor relative to other
factors of production. This process, in turn, restrains
the growth Of real wages and increases underemployment.

The other mechanism is the decrease in per person income
within families, since there is an inverse relationship
between size of family and family income. The per person
income in poor families, which are characterized by larger
family size, causes a much higher inequality in the size
distribution of income.

The rapid rate of population growth also has an
adverse effect on economic development. The mechanism
through which population growth can affect the economic
develOpment can be summarized as follows.

First, the high rate of population growth leads to a
higher dependency ratio. In a society characterized with
a high rate of growth of pOpulation, there is higher demand
for resources to feed, clothe, house, educate and equip the
increasing numbers of the non working population. The lack
of resources for these purposes will impede the improvement

of the quality of labor force and consequently lead to a

132

lower labor productivity. Second, higher growth of
population and therefore higher dependency may cause a
decline in the savings rate and so lead to less investment
and slower growth in total output. The higher the pOpulation
growth, the more investment will be required to maintain

the average capital stock per worker, leading to lower rate
of increase in capital per worker and thereby halting the
productivity growth.

The adverse effect of population growth on income
distribution and economic growth, therefore, suggests that
a fertility reduction is a desirable policy. Also, there
will not be any sacrifice of economic growth to improve
the distribution of income. The important characteristic
of any population policy in developing countries has to be
a policy which is simultaneously cheap, safe, certain and
above all, simple and acceptable to the general public.

In general, population policies aimed at reducing fertility
can be divided into two basic categories: persuasion and
coercion.

a. Persuasion: The government can try to persuade

 

peOple to have small families. This can be done through
communication media Or formal and nonformal education to
encourage couples to reduce fertility and to promote the
ideal of a small family. For this policy to be effective,
government has to provide information on different
contraceptive methods and costs and benefits of having

children. Lack of awareness about the benefits and costs

133

of children may affect the fertility decisions. Persuasion,
through informing couples about the costs and benefits, in
this case, is a desirable population policy.

b. Coercive Policies: The government can attempt

 

to force peOple to have smaller families. This can be done
through legislation to raise the minimum legal age for
marriage or required abortion for pregnancies after a
certain number of children. The coercive population policies
are not very pOpular because they are not only morally and
politically unacceptable but also they require administrative
power to enforce the imposed legislations. For instance,
Todaro argues that the defeat of Indira Gandhi's government
in the election of 1977 was largely due to the popular
backlash against the government's forced sterilization
program and her return to power in 1980 was due to her
commitment to ease the coercive birth control policies.12
The population policy which influences the demand
for children is perhaps the most effective policy. As was
mentioned in Chapter Three, the demand for children is
categorized as children as productive agents, children as
sources of Old age security, and to perpetuate the family
roots. Establishment Of Old age social security provisions
and minimum age child labor laws can influence the family
size, even though these policies are not considered as
population policies. Also they can increase the direct and
indirect costs of children by the raising of school fees

and the elimination of subsidies for secondary and higher

139

education. Promotion of labor force participation by

women will increase the indirect costs of children in terms
Of foregone income of the mother during the child bearing
period. It has to be noted that these policies primarily
influence the urban population and have no strong effect

in rural areas.

In brief, the governments of developing countries have
to formulate and implement pOpulation policies that fit the
economic, cultural, and religious characteristics of the
particular countries. Persuasion of these policies is
important because any measure that reduces fertility would
substantially increase per capita income. Lower fertility
also can affect the total output by increasing capital
accumulation and productivity of labor. In addition to
its effect on total and per capita output, the lower rate
of growth of population also contributes to improvement of

the distribution of income.

5.7 - Tax Policies for Mobilizing Resources

 

Any distributionally oriented development policy must
secure sufficient financial resources to be successful. This
is implied in the case of wage-subsidy, subsidizing formal
or nonformal education, and transfer of investment to the
poor. The major source of financing these policies
traditionally has been the direct and indirect taxes. In
addition to raising resources for the distributional policies,

tax systems can be an effective means of improving the

135

distribution of income. Only direct and progressive
taxation of both income and wealth can serve to raise funds
and improve the distribution of income. Lack of
administrative capability and the absence of a well-organized
money economy restrict the scope for expanding the role of
direct taxes in developing countries. In addition, in most
Of these countries, governments Offer all sorts of tax
exemptions and concessions to commercial corporations.
Even in the absence of tax exemptions, lack of administrative
power makes it very easy to evade taxes on corporate profits
and personal incomes. Under these circumstances, instead
of increasingly progressivity, a government should expand
the financial records Of corporations and individuals
because increasing progressivity of direct taxes, without
having any financial record, simply leads to tax evasion.
Due to difficulties with regard to direct personal
and corporate profit taxes, most of the deve10ping countries
rely on indirect taxes. The largest single source of public
revenue in these countries is derived from the taxation of
import, export and excise taxes on domestic products.
These indirect taxes which individuals and corporations
pay indirectly through their purchase of commodities are
economically and administratively feasible to assess and
cxollect. Under these circumstances, the obvious tax policy
is; the increase the progressivity in the indirect tax
articucture, while securing the maximum tax revenue.

In order to maximize the tax revenue, several

136

economic principles need to be considered. First, the
commodity should be imported or produced by a relatively
small number of firms so that tax evasion can be controlled.
Second, the commodity should have a high income elasticity
and low price elasticity so that as income rises, more tax
revenue will be collected. For the distributive objectives,
progressivity of the indirect tax structure can be increased
by the different tax rate among consumer classes. Higher
tax rates can be imposed on commodities with higher income
and lower price elasticities which represent a larger
proportion of the budget in high income classes.

In general, the tax policies should be concerned with
a wider implementation of personal and prOperty taxes and
reformulation of indirect tax structure to incorporate the

distributional objectives.

5.8 - Conclusion

 

In the previous sections, the primary concern was
with the choice and implementation of policy strategies to
improve the distribution of income. There are several
points which are deserving of some emphasis. First, no
single type of policy is likely to succeed in achieving
distributional objectives and growth objectives. Many types
(if policy strategies are complementary and require

Simultaneous implementation. For instance, land reform
Iwacauires complementary action on provision of the necessary

~1111>uts and the marketing of production. Educational

137

expansion and training schemes are needed to accompany the
labor absorption measures. Second, there may exist no
tradeoffs between redistributional strategies and growth-
oriented policies. Policies such as population policies,
expanding education, search for appropriate technolOgies,
and land reform promote both growth and distributional
Objectives. Third, any policy which attempts to improve the
distribution Of income in favor of the poor may prove
impossible to implement unless the poor develop sufficient
consciousness and organization to provide support for the

programs over a period of many years.

FOOTNOTES

CHAPTER FIVE
FOOTNOTES

1For instance, C. Frank and R. Webb state that in
Taiwan the Nationalist Chinese had the political power and
the native Taiwanese had economic resources and the former
used their political power, through the system of government
to increase their income and assets. For further discussion
on this matter see Charles R. Frank and Richard C. Webb,
"An Overview of Income Distribution in Less DeveloPed
Countries: Policy Alternatives and Design," in Income
Distribution and Growth in the LesséDevelOped'Counfries,

 

ed. by the same authors (Washington, D.C.: The Brookings
Institution, 1977), p. 17.
2

For the estimated elasticities see Hollis Chenery
and William J. Raduchel, "Substitution and Structural
Change," in Structural Change and DeVelopment Policy, ed.
Hollis Chenery (New York: Oxford University Press, 1979)
p. 160.

3The difference between labor intensity in manufactured
exports and import substitution is fully discussed in Lyn
Squire, Employment POIicy in DeVeIOping Countries: 'A Survey
of Issues and Evidence (New York: Oxford University Press,
1981) Chapter 11.

 

 

 

L‘Lyn Squire, EmplOyment Policies, p. 168.

5One of the most frustrating factors for indigenous
manufacturers to expand their operation is the lack of access
to formal credit institutions. For further discussion on the
matter see S. Sethuraman, "The Urban Informal Sector in
Africa," International Labor'ReView, Vol. 116 (November—
December, 1977) pp. 7920751.

6World Bank, "Land Reform," Sector Policy Paper
(Washington, D.C., May 1975). This paper provides a wide
variety of estimates on different aspects of land reform.

7

 

 

1510., p. 27.

8This form of redistribution is called dynamic
redistribution of assets by M. Ahluwalia, "The Scope for
Policy Intervention," in‘RediStriBUtion'with Growth, ed.
Hollis Chenery, et. a1., (LOndon: Oxford UniverSity Press,
3rd Printing, 1976) p. 80.

138

 

139

9For further details on these estimates, see Chapter
7 in G. Psacharopoulos, Return to Education: An Inter-
national Comparison, (San Francisco and Washington: Josser-
Bass Inc., 1973).

 

0Frederick H. Harbison, "The Education-Income
Connection," in Income Distribution and Growth in the
Less-Developed Countries, C. Frank and R. Webb ed. (Washington:
The Brookings Institution, 1977), p. 130.

11The rate of return on primary education is estimated
to be 27 percent while the rate of return of secondary and
higher education are 16 percent and 13 percent, respectively.
For the method of estimation see George Psacharopoulos,
"Return to Education: An Updated International Comparison,"
World Bank Staff Working Paper, No. 902 (July 1980) p. 99.

l2Michael Todaro, Economic DeVelopment in the Third
World (New York and London: Longman, Second Edition 1981),
p. 195. Boulier also points out that the policies to
raise the legal minimum age for marriage was faced with the
strong opposition and has been defeated. For further
analysis of coercive policies see Bryan Boulier, "Population
Policy and Income Distribution," in InOOme Distribution and
Growth, p. 178.

 

 

APPENDIX

CHAPTER THREE
APPENDIX

The overall inequality of income distribution under
the assumption of a dualistic economy with labor-surplus
can be determined by analyzing the change in labor share
or capital share. The dual-economy model of development
implies that there exists a high rate of growth of the
modern sector intimaprocess of economic growth. The
expansion of the modern sector produces a strong demand for
relatively unskilled labor.

In this appendix it is attempted to investigate the
impact of industrialization on the labor share under a
dual-economy model. The reason for selecting the labor
share is the fact that wage earners usually are in the lower
income brackets, and any factor which increases the labor
share will improve the overall distribution of income.

A dynamic production function is specified for the

modern sector as:
Q : f(.K,L,t) o

The production function is homogeneous of degree one, and

twice differentiable

190

0 99 — 99
fL 8L > 0 fK ‘ OK > 0
and
fLL < O fKK < O
fKL = fLK

In the modern sector, labor and capital are purchased in a

competitive market, so

w = FL and r = fK .

The rate of technological progress is denoted by R and is
defined as:

Qt KfKt + Lth

R = —— = . (A.

 

00 KfK + LfL

The nature of the bias in technological progress in terms

of the Hick's concept of factor saving is represented as:

B = ——— - ——— . (A.

Since we are only interested in labor share (0L), we have
define all of our variables in terms of 0L. To do this
manipulation we have to first divide R by fL and multiply

B by L/Q ratio. We then have:

jg = KfKt + Lth (A
fL QfL QfL
£2 : LfKt _ Lth (A.
Q _—QfK ~"‘00,,
Kf Lf Lf _ Lf
+ 1.12 _ Kt + L't + Kt _ Lt (A.

 

997’
O
O
H)

r:
.o
H,

r:
C
F"

x
.o
H,

r'

l)

2)

to

3)

9)

5)

192
Kf f Lf f

 

 

 

 

 

f -
QR + LfL B = K Kt + K Lt + LfL Kt LfK th (A 6)
fL Q QfoK
QR + LfL B _ fKt(KfK + LfL)
L L K
LfL
From Euler's Theorem KfK + Lft = Q, and —6— = ¢L° SO the
results of (A.7) is to:
f
—-Kt = R + 9 B (A.8)
fK L
fKt
Equation (A.8) establishes a relationship between 11 ,R,and
k
B. Dividing (A.1) by fl< and multiplying (A.2) by-g and
using the same manipulation, we can get
f
_£3 0 R - (1 _ 0 ) B . (A.9)
fL L .

For any production function which is homogeneous of degree

one, it is always true that:

fKK = LfKK and ka = LfLK . (A.lO)
K .
where k = f ratio.
And also:
—LfLL 5 KfLK (A.ll)
-KfKK 3 LfKL . (A.l2)
foLQK

Next, by multiplying ka by ?Ef;UK— and u51ng (A.lO)

equalitys, fKL is derived as:

558 = LfL . 315555 (A 13)
fK QTfk KfoK

193

Using the identity (A.12) in equation (A.l3) and arranging

terms, one can derive

£59 = -¢ - E - QfLK (A 19)
fK L K iii;

An expression for the elasticity of substitution for

production functions homogeneous of degree one is:

 

a _ 0101(K/L) = foK
f Qf
0101(0E) LK
K

Using the above definition in equation (A.l9), it results to:

Kk : _ 3L . (A.lS)

Dividing (A.lO) by f
Q°f

617?— and a similar manipulation process, it is possible to
K

L and then multiplying the result by

write:

F (1 - ¢ )
Lk _ L

 

The rate of growth of the marginal product of capital can

be Obtained as:

fK = fKt + fKK K + fKL L (A.17)
and .
f f f - f -
f5 = 7;: + 3§5 K + 7§E L (A.l8)
K K K K

Using (A.ll), equation (A.lO) yields:

 

 

fK _ fKt LfKL ' fKL ' _ fKt LfKL ° '
F'T’Rf K+TL‘f— ’f—(K'L)
K K K K K K
fK _ fKt LfKL k (A 19)
f" ' TF"’ 'f' E '
K K K '
. . fL . . fKt
Multiplying (A.l9) by f_ and substituting (A.8) for 70—,
L K
(A.19) results to:
f 0 °
K" LOIS
i; - R + ¢LB — 0' k . (A.20)
By using a.similar method and manipulation, it is possible
f f
to derive —L in terms of 0 a R, B and o. —E-will be:
fL L fL
f (1 - ¢ ) '
L _ L E
?; _ R - (1 - ¢L)B + a k (A.21)

And finally the rate of growth of real output is:

Q = Qt + fK K + fL L (A.22)

° Q f . f .

Q = _£ + _E K + _E L A.23)

Q Q Q Q ‘

. f f O

_Q_ - logs. —IJ.'O£O

Q - R+ Q KK+ Q L L (A.29)

.9: _ 8 i

Q R + (1 0L) K + 0L L (A.25)
From Euler's Theorem 0L + 0K = 1. Then (A.25) can be
written as:

9: _ _K__ - 13. i

Q R+(1 ¢L)K (1 ¢L)L+L

9. _ E i

Q R + (1 0L) k + L . (A.26)

195

And finally the rate of growth of labor share is:

(p. o o o
L .. 2! 0 - 9.
(3E) — (w) + (L) (Q) (A.27)

Before the turning point, the wage rate is constant. The

constancy of wage rate implies that (3) is equal to zero.

So before the turning point the rate of growth Of labor

share will change to:

¢o
__L. = l: .. Q
(¢L) (L) (Q (A.28)
45::
Substituting (A.26) in (A.28), one can write (E-) as:
L
¢o ° 0 0
L _ L _ _ _ k _ E
(3;) - (E) R (1 0L) k L . (A.29)
or .
¢L 12
(3‘1: - - R - (1 - ¢L) E .

So, before the turning point, capital accumulation (i) and
technological improvement, leads to a decrease in the rate
Of growth of labor share. After the turning point, the
supply of labor is no longer perfectly elastic. The rate

of growth of labor share will change to:

«)L (1-0L)k
(E) - R-(1-0L)B+ E
12 12 i.
+ E - R + (1 - ¢L) E " E ,
or
¢. 0
L - _ - _ _ E
(3;) - (1 0L) [B (1 1/0) k]
(i.
So (3—) increases if the nature Of technology is labor-using
L

(B < O) and the elasticity Of substitution between labor and

capital is less than unity.

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