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LECTURE 10:

INSTITUTIONS –
INCOME INEQUALITY
March 21, 2019
Dr Hyejin Ku
University College London
Income inequality
• Thus far considered “averages” in the population, e.g.
GDP per capita
• Distribution of income matters
• Intrinsic reasons
• Poverty
• Aversion to inequality
• Functional reasons
• Effect of inequality on growth
Outline
• Measurement of inequality and some facts about
inequality
• Sources of income inequality
• Differences in characteristics (education, gender, class, ethnicity,
type of employment, occupation, etc.)
• Differences in the way the characteristics are rewarded (e.g.
returns to education)
• Effect of inequality on economic growth
• Accumulation of physical capital
• Accumulation of human capital
• Income redistribution through taxation and efficiency
• Sociopolitical unrest
• Economic mobility
The facts
• How to measure inequality?
• Divide the population into several equal-sized groups (e.g.
quintiles) and to measure how much each group earns
• Divide income into equal-sized intervals and to ask how much of
the population falls into each interval
Household Income in the United States by
Quintiles, 2006
Income Distribution in the United States,
2006
The facts
• Typically, median < mean
• Income distribution typically skewed (“long tails”)
• In statistical analysis, often use “log(income)” vs. “income”
to address this issue
Measurement of inequality
• Lorenz curve
• Cumulative percentage of income on the y-axis and cumulative
percentage of population on the x-axis
• What will be the shape of Lorenz curve in a society where income
distribution if perfectly equal?
The Lorenz Curve for the United States,
2006
Measurement of inequality
• Consider the following income distribution:
• (1, 3, 5, 5, 6, 10, 20)
• Lorenz curve for the above economy?
• Gini coefficient:
• Area between the Lorenz curve and the line of perfect equality
divided by the total area under the line of perfect equality
• Gini ranges from 0 (perfect equality) to 1 (perfect inequality)
The Kuznets hypothesis
• In 1955, Simon Kuznets hypothesized that as a country
developed, inequality would first rise and then later fall
(inverted-U)
• Increase in inequality with growth
• Economic growth (arrival of new technologies) would initially raise
the rate of return to skills
• Decrease in inequality with further growth
• Over time, the higher return to skills would induce unskilled workers
(or their children) to get education, and workers would migrate into
growing regions or sectors.
• Also rates of return to skills would decline
• Empirical relevance still debated
The Kuznets Curve
The Kuznets Curve in England and
Wales, 1823–1915
Income per Capita Versus Inequality
Sources of income inequality
• Differences in characteristics
• Education
• Health
• Gender
• Class
• Ethnicity
• Type of employment (self-employed vs. wage earners)
• Occupation
• Differences in the way the characteristics are rewarded
• Returns to education
• Change over time in the way characteristics are
distributed or rewarded
Determination of income inequality
How the return to education affect the
distribution of income
How the distribution of education affect
income inequality
Income Inequality in the United States:
1947–2005
Explaining the recent rise in inequality
• Technological advances
• Increases the returns to skills and physical capital
disproportionately
• Increases in openness
• Increases the rewards for the factors that were relatively abundant
prior to trade
• Coastal provinces vs provinces in the interior in China
• “Superstar” dynamic
• Extremely highly paid CEOs, athletes, entertainers, etc.
Effect of income inequality on growth
• Four different channels
• Effect on the accumulation of physical capital
• Effect on the accumulation of human capital
• Income redistribution through taxation and efficiency
• Sociopolitical unrest in response to income inequality
Saving Rates by Income Quintile, 2003
Physical capital
• Suppose that we took one dollar of income away from a
household in the richest quintile and gave it to a
household in the poorest quintile.
• What do you think will be the effect of such redistribution
on physical capital?
Human capital
• Unlike physical capital, human capital is useful only if the
person who acquired it uses it (i.e. human capital not
transferable for production)
• For this reason, inequality will be bad for human capital
accumulation for the economy
Marginal Products of Physical and Human
Capital
Human capital
• Compare two societies
• Society A:
• Two persons with wealth of I* each.
• Society B:
• One person with wealth of I* - Δ
• One person with wealth of I* + Δ
• In which society (A or B), will the total human capital level
be higher?
Physical capital vs. human capital
• Over time, role of human capital getting more important
• Openness to international market makes domestic
savings rate irrelevant as a source of physical capital
accumulation
• Negative effect of inequality on human capital not offset
by the positive effect of inequality on physical capital…
Inequality, redistribution, and efficiency
• Redistribution of income through taxation has two effects
• Reduces inequality through transfer of income from rich to poor
• Lowers efficiency
• Who along the income distribution will favor/oppose to
redistribution?
Relationship Between Income Inequality
and the Desired Tax Rate
How an Increase in Income Inequality
Affects the Desired Tax Rate
Median voter
• Theory above predicts
• If two countries have the same average pretax income
• If the actual tax rate is that favored by the median voter
• Then, the tax rate will be higher in the country with more inequality
than in the country with less inequality
• Do you think this will be supported empirically?
Median voter
• Simplistic view of political process: more inequality results
in more demand for redistribution, so more redistribution
takes place
• Realistic view: Despite the rule of “one person, one vote”,
wealthier classes exert political power beyond their
numbers
• More pressure for redistribution doesn’t necessarily result
in more actual redistribution
Relationship Between Income
Inequality and Sociopolitical Instability
Luck vs. Effort
• 1 In the long run, hard work usually brings a better life
•2
•3
•4
•5
•6
•7
•8
•9
• 10 Hard work doesn´t generally bring success - it´s more
a matter of luck and connections
Belief in determinants of income and
redistribution
Source: Alesina et al. 2001
Persistence of inequality
• Engerman and Sokoloff (2002)
• Colonialism and initial inequality in Latin America vs.
North America
• Difference in endowment
• Homogeneous vs. heterogeneous population
• Different institutions (voting, public schools, taxation)
• Long-term consequences of initial inequality
Economic mobility
• Static equality vs. economic mobility
• Economic mobility
• Intergenerational mobility (Equality of opportunity)
• Transition matrix
Intergenerational Income Mobility in
Canada
Economic mobility
• How does economic mobility affect growth?
• Society with a high degree of mobility is more likely to be more
able to utilize the talents of all of its citizens
• Degree of economic mobility can moderate the desire for income
redistribution
• US vs. Western Europe (Benabou and Ok (2001))

• What determines economic mobility?


• Public provision of education and heath care
• Institutions (most powerful people in society often oppose policies
that raise the degree of mobility)
• Positive assortative mating
• Racial or ethnic discrimination
Concluding remarks
• Alexis de Tocqueville wrote
• “among the novel objects that attracted my attention during my stay in the
United States, nothing struck me more forcibly than the general equality of
condition among the people…The more I advanced in the study of
American society, the more I perceived that this equality of condition is the
fundamental fact from which all others seem to be derived and the central
point at which all my observations constantly terminated” (Democracy in
America, 1835)
• Would you say the same thing about America today?
• Do you think it is worthwhile to compromise on efficiency
to reduce inequality, if such tradeoff exists?

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