Growth, inequality, and social welfare: Cross-country evidence

David Dollar, Tatjana Kleineberg, Aart Kraay 19 November 2014

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Concerns about inequality are at the forefront of many policy debates today. From speeches by US President Barack Obama to the bestselling book Capital in the Twenty-First Century by Thomas Piketty, it is hard to escape the view that rising inequality poses major challenges in advanced economies. In the developing world too, much has been written about the adverse effects of high and rising inequality on the pace of poverty reduction. Public opinion surveys suggest that strong majorities of respondents in advanced economies feel that the gap between rich and poor has been rising in recent years (Pew Research Center 2013).  

Inequality changes worldwide

These views, no doubt, reflect in part the fact that inequality has indeed been increasing in many countries. In the US over the past four decades, the Gini coefficient of income inequality has risen from around 0.3 to around 0.4. Roughly the same has happened in China, only more rapidly; between 1990 and 2009, the Gini coefficient has increased from 0.32 to 0.42. According to the Atkinson et al.’s data (2011), much of this increase has happened at the upper end of the income distribution.       

However, it is also important not to lose sight of the fact that inequality has not increased in other countries, and has declined appreciably in still others. In Atkinson et al.’s data, income shares of the top decile have been stable, or even slightly declining since the mid-20th century in countries such as Germany, France, Switzerland, the Netherlands, and Japan. In Brazil, the Gini coefficient has declined from around 0.6 in the late 1990s to around 0.55 in the late 2000s. More systematically, in a large dataset of changes in inequality over periods at least five years long, in almost half of episodes the Gini coefficient of inequality increases, while in the other half of episodes it decreases. 

New research on inequality changes

In our recent paper, (Dollar et al. 2014), we aim to shed light on a very simple question, namely how much these changes in inequality, in either direction, matter. To answer this question, we first need to be precise about what we mean by ‘matter’. Our approach here is very modest; we use standard tools of social welfare analysis to calculate how much more or less growth in average incomes a country would need over a given period in order to compensate – in terms of social welfare growth – for the observed change in inequality over the same period. We then document the size of this compensation and its relationship to average income growth in a large dataset of episodes of growth and changes in inequality covering 117 countries between 1970 and 2012.

A simple example helps to illustrate our approach. The World Bank has recently made a major public commitment to the goal of promoting ‘shared prosperity’, defined as growth in average incomes of those in the bottom 40% of the income distribution in each country in the developing world (World Bank 2013). As a matter of simple arithmetic, growth in average incomes in the bottom 40% is the sum of growth in average incomes, and growth in the share of income accruing to the bottom 40%. In China, for example, between 1990 and 2009 average incomes grew at 6.7% per year. At the same time, inequality increased in the sense that the income share of the bottom 40% declined from 20.2% to 14.4%, corresponding to an average annual change of -1.7%per year. Combining these two observations, average incomes in the bottom 40% grew more slowly than overall average income, at 5% per year. From the standpoint of promoting shared prosperity, therefore, the growth ‘cost’ of the increase in inequality in China over this period is about 1.7 percentage points of growth per year. 

To produce more systematic evidence, we work with a large dataset of income distributions covering 117 countries over the past four decades. We focus on within-country changes in average incomes and income inequality observed over episodes at least five years long. In a sample of 285 such non-overlapping episodes, we calculate the contribution of growth in average incomes and the contribution of changes in inequality to growth in social welfare. We do this for a wide variety of social welfare functions, capturing a wide range of preferences for redistribution of income across individuals.

For all of the social welfare functions we consider, social welfare, on average, increases equiproportionately with increases in average incomes. This reflects the fact that changes in the relevant inequality measures are not systematically correlated with changes in average incomes. For all but the most bottom-sensitive social welfare functions, the relationship between growth in social welfare and growth in average incomes is also very tight, in the sense that data points cluster closely to the 45-degree line. This reflects the fact that changes in inequality are small, meaning that variation across episodes in inequality accounts for only a small fraction of the variation across episodes in changes in social welfare. And this, in turn, implies that the additional growth in average incomes required to ‘compensate’ – in terms of social welfare growth – for a typical increase in inequality is, on average, quite small.

Figure 1 illustrates our results for one particular social welfare function based on the Gini index – the Sen (1976) measure of ‘real national income’, which is average income scaled by a factor of one minus the Gini coefficient.  On the horizontal axis we plot growth in average incomes across the 285 spells in our sample, while the vertical axis has corresponding growth in social welfare. Since social welfare growth is the sum of growth in average incomes plus the contribution of inequality changes, the vertical distances between each data point and the 45-degree line indicate the contribution of inequality change to social welfare growth. For points above the 45-degree line, the Gini coefficient fell and social welfare grew faster than average income, while for points below the line, inequality increased and social welfare grew slower than average incomes.

Figure 1. Growth and social welfare for the Sen index of real national income

The main point of our paper is that variation in country growth experience (i.e. variation across episodes on the horizontal axis) is much larger than the variation in the contribution of inequality change to social welfare (i.e. variation around the 45-degree line). When we do more formal variance decomposition, we find that over 90% of the variation in social welfare growth is due to growth in average incomes, and less than 10% is due to inequality changes.

Concluding remarks

The main policy message of our work is to underscore the importance of overall economic growth for improvements in social welfare. Inequality may be a ‘hot’ current topic, but inequality changes in most countries over the past thirty years have been small, while differences in average growth performance have been large. In our paper, we also look systematically at the relationship between a variety of policy and institutional variables and changes in inequality, separating out their effects on growth in average incomes and on changes in inequality. Our findings suggest that it is difficult to isolate robust correlations between policy and institutional variables and changes in inequality, indicating that there is no simple recipe for enhancing equality. Furthermore, the fact that changes in equality are uncorrelated with economic growth means that there are likely to be some equality-enhancing policies that also promote growth, while others reduce growth. With growing pressure to ‘do something’ about inequality, it is important that policymakers are careful to avoid undermining growth in the quest for greater equality, as policies that raise equality at the expense of lower growth may be self-defeating in the sense of not improving social welfare. 

Authors' note: The views expressed here are the authors’ own and do not reflect those of the World Bank, its Executive Directors, and the countries they represent.

References

Atkinson, A, T Piketty, and E Saez (2011), “Top Incomes in the Long Run of History”, Journal of Economic Literature,  49(1):3-71.

Dollar, D, and A Kraay (2002), “Growth is Good for the Poor,” Journal of Economic Growth, 7, 195-225.

Dollar, D, T Kleineberg, and A Kraay (2013), “Growth Still Is Good for the Poor”, World Bank Policy Research Department Working Paper No. 6568.

Dollar, D, T Kleineberg, and A Kraay (2014), “Growth, Inequality and Social Welfare: Cross Country Evidence”,  World Bank Policy Research Department Working Paper No. 6842.

Pew Research Center (2013), “Economies of Emerging Markets Better Rated During Difficult Times”.

Sen, A (1976), “Real National Income”, Review of Economic Studies.

World Bank (2013), “The World Bank Goals:  End Extreme Poverty and Promote Shared Prosperity”. 

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Topics:  Poverty and income inequality

Tags:  Inequality, social welfare, economic growth

Senior Fellow in the John L. Thornton China Center, Brookings Institution

PhD Candidate in Economics, Yale University

Economist in the Development Research Group, World Bank

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