Economic Inequality and Its Implications

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Economic Inequality and Its Implications

Inequality can come in many different forms like gender, racial or social inequality. In this essay, I will focus on economic inequality as it often exaggerates and contributes to the other types of inequalities mentioned. Economic inequality comes in two forms mainly: income and wealth inequality. There are many different measures of inequality: using the Gini Coefficient, ratio measures or looking at the wage gap. Generally, high levels of economic inequality are a bad thing for a country with negative implications for the economy, and as a result on the individual and society as well. It is associated with poor economic growth, crime and social polarisation. To support this, there is a lot of literature from many different countries analyzing the impact of economic inequality on the socioeconomic situation of a country and the extent to which inequality is a significant factor contributing to issues regarding society, the individuals and the economy. It is important to look at the impact of inequality as it helps direct policy makers who aim to reduce the negative impact of inequality.

Economy

Generally, we observe a negative relationship between economic growth and an unequal distribution of income. Furthermore, Panizza (2003) uses empirical analysis to find a negative relationship between growth and inequality in the United States using cross-state panel data from 1940 to 1980. Specifically, it finds that “a one standard deviation decrease in the Gini Coefficient is associated with a 0.2% increase in average annual growth over the next 10 years”. Given that the data is measured correctly in the annual reports of Statistics of Income (SOI), this relationship derived is causal as it is looking at panel data that controls for unobservable variables. Clarke (1995) also uses empirical analysis to find this negative relationship between inequality and economic growth using several different measures of inequality (Gini coefficient quintile measures, Theil’s index, etc.) suggesting that there is not an issue with how the data is measured.

There is a range of economic literature that discusses possible reasons for this negative association. Galor and Zeira (1993) discuss the possibility that this relationship is attributed to differences in investment in human capital. In the context of imperfect capital markets where the cost of borrowing money is more expensive than the price at which people lend, those that inherit wealth are more likely to invest in human capital as they don’t have to borrow as much for this investment. As a result, those initially favored in the distribution of wealth, can invest in education and training and earn a higher income as skilled labor in subsequent periods. If inequality is high and the percentage of people who can make these investments in human capital is small, this depresses aggregate economic activity in the short run. Because these affects are carried into the long run due to its effect on distribution of income and its intergenerational effects, an unequal distribution of wealth leads to low economic growth.

Alesina and Rodrik (1994) also supports this negative relationship between inequality and economic growth. It takes a political approach and states that high inequality of wealth and income result in policies that lower growth such as a higher rate of taxation. This is because disposable income, income after tax is deducted can be consumed and consumption stimulates the economy. The paper states that due to inequality, there are different optimal tax rates amongst groups in the economy as “the lower an individual’s share of capital income (relative to his labor income), the higher is his ideal tax, and the lower his ideal growth rate” since capital earning is derived directly from a higher economic growth rate. In economic theory, policies are determined by the median voter, ‘the median voter theory’, and the more equal a society is, the higher the capital endowment of the average voter and the more likely they are to choose policies that lower taxation and increase economic growth. The validity of this argument may be debatable and vary from country to country depending on their political system, e.g. especially in countries that are less democratic where the government does not respond effectively to voter demands. Furthermore, in democratic countries where there is a lot of inequality, there is a very large demand for redistributive taxation which can be harmful for economic growth as it may stun productivity among higher paid workers.

However, there is also research suggesting that the relationship between inequality and growth is a positive one. Particularly, studies from the 1960s on the equity-growth trade off. Kaldor (1957) explains that inequality in a society encourages innovation and productivity. If policy attempts are made to reduce inequality, for example through redistribution taxation, the returns from higher education for those aspiring for higher paid jobs would decrease and fewer people will choose to invest in education as a result. In such a case, although redistributive taxation can improve equity, it will have negative implications for economic growth. Furthermore, this paper finds that since the wealthy have a higher propensity to save and invest in capital accumulation, more inequality can lead to a higher growth rate.

Therefore, although more recent evidence shows a cross country data verifying a negative relationship between inequality and growth, the relationship is not clear and empirical evidence may be biased due to unobserved characteristics like innovation which can affect economic growth.

Individual

In this section, I will focus on the effect of inequality on crime rates as it is linked to issues of trust and social disorganization as well as economic issues. Inequality has a positive impact on crime. Lower economic growth, which we found to be correlated with higher inequality, increase unemployment and increases crime rates due to the financial rewards of crime.

Becker (1968) finds that the payoffs from crime are higher in an unequal society as income of victims is higher and criminals find that they have a higher payoff from illegal work than legal work. Furthermore, individuals with lower earnings have lower opportunity cost in terms of loss of income if they get caught (Fleisher, 1996). Inequality also has a behavioral effect on individuals and is found to increase violence and homicide levels. This is because inequality encourages social competition and limited opportunities (Galor, Zeira,1993) bring forth feelings of fear and violence. Elgar and Aitken (2011) found a negative association between income inequality and trust to demonstrate this. In economic literature, the effect of income inequality on crime rate has been measured using various indicators of inequality and crime rate, which imply robustness of these results. Fleisher (1996) for example shows the positive effect of an increase in size difference of incomes in second and highest quartile on arrest a court appearance rates. Fajnzylber, Lederman, and Loayza (1998) uses panel data to find the causal effect of income inequality on violent crime such as homicide and robbery.

Other research finds that income inequality has a significant impact on violent crimes exclusively and none on property crimes (Kelly, 2000). However, inequality results in high poverty areas and high poverty has a significant positive effect on property crimes.

Society

Economic inequality leads to social conflict and polarization. Wilkinson and Pickett (2009) find that inequality in a society contributes to feelings of anxiety and social competition which are driven by a sense of social deprivation and exploitation. In general, this paper finds that more unequal societies have more health and social problems.

The greater inequality is associated with a higher rate of homicide, violent crime, obesity, racism, teenage births, mental illness, social mobility and a lower rate of trust, and worse math and reading scores. Issues like racism and violent crime cause distrust and disassociation with certain groups in society.

I believe this evidence of distrust and social disorganization in unequal societies can also explain the high occurrence of crime in these societies as well as the low levels of political participation (Ulsaner and Brown, 2005). In unequal societies, the groups at the bottom of the income and wealth distributions feel exploited by those on top and feel as though they do not share common values. This can lead to lack of solidarity in society as people contribute less to common welfare (Pascov, Dewilde 2012)

Conclusion

In conclusion, the main impact of inequality is its effect on economic growth. The direction of this effect is unclear and can vary from country to country depending on the extent of inequality, and generally high inequality is considered to counteract the benefits of inequality to the economy, the social climate and the political system specifically. This is because inequality does not affect economic growth directly but due to the nature of the political framework in which policy attempts are made to reduce inequality that affect incentives and therefore growth.

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