E297C - Stanford University



E297C

Ethics of Development in a Global Environment

Rights of Economic Equality Workshop

Professor Bruce Lusignan

NOTE: GRADUATING SENIOR

Economic Growth and Inequality:

Motivations for Redistributive Policies in Brazil

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Guilherme Sousa

SUID 4754347

1. Introduction

Many economists have conducted studies on the potential relationships between economic growth and inequality, in efforts to define solid connections and perhaps develop some kind of cause and effect relationship. This trend in the study of development economics was largely driven by the hypothesis of negative effect of growth on the poor. More recently, the increasing globalization of markets has produced plentiful negative publicity. Many believe in the idea that this global trend has left a large portion of the world population behind. Economic Nobel Laureate Joseph Stiglitz begins his book Globalization and Its Discontents by acknowledging the various positive aspects associated with globalization, such as international trade, access to knowledge and foreign aid. Nonetheless, he goes on to claim:

But to many in the developing world, globalization has not brought the promised economic benefits. A growing divide between the haves and the have-nots has left increasing numbers in the Third World in dire poverty, living on less than a dollar a day. Despite repeated promises of poverty reduction made over the last decade of the twentieth century, the actual number of people living in poverty has actually increased by almost 100 million. This occurred at the same time that total world income actually increased by an average of 2.5 percent annually (Stiglitz, 5).

This type of rhetoric begs a host of questions: Is the economic growth being achieved around the world today not benefiting the poor? Further, could it be making matters worse for the already less fortunate portion of the world population? What economic, political and social policies should be undertaken in order to improve the current scenario of inequality? Is the answer to create wealth, redistribute existing wealth, or a combination of the two?

The first approach is to analyze the theoretical and empirical developments made thus far, and attempt to extrapolate some direction in the analysis of this complex set of questions. Addressing the effects of growth on inequality will eventually lead the analysis into the opposite causal direction. The last step will be the application of the studies on growth and distribution to a specific case, namely the extreme scenario of inequality found in Brazil. The analysis of the various studies conducted on the interconnections between growth and inequality will shed some light on the Brazilian situation. Particularly, they ought to motivate a drive for sustained growth accompanied by sound redistributive government measures.

2. Inequality and Growth

2.1 The Effect of Growth on Inequality

In 1955, Kuznets made the first effort to identify a relationship between growth and inequality. Due to the limited amount of data available at the time, Kuznets studied small samples of developing (India, Sri Lanka and Puerto Rico) and developed (United States and United Kingdom) countries, and utilized a ratio of the income share of the 20% richest to that of the 60% poorest as a measure of inequality. From this early study he extracted the idea that developing countries demonstrate a higher degree of inequality than developed nations. In 1963, Kuznets refined his research, obtaining data for eighteen countries and further strengthening his previous findings. He went on to propose the inverted-U hypothesis, in which he claims inequality rises in the early stages of development (measured by income per capita) but eventually falls as more individuals are able to reap the benefits of growth.

Various studies were conducted to test Kuznets’ inverted-U hypothesis. In particular, many scholars used the cross-sectional method in an attempt to overcome the lack of country-specific inequality data spanning the time necessary to complete Kuznets’ U path. Paukert (1973) compared averages of the Gini coefficient for bins of countries organized by GDP level. The average Gini coefficient traced the inverted-U curve as it progressed from low income bins to high income bins. Nonetheless, Paukert’s data featured significant variation within bins, making the results somewhat unreliable. Further, Ahluwalia (1976) conducted a cross-sectional regression on a group of sixty countries, which also supported the U-hypothesis. Still, data limitations and statistical bias rendered these results doubtful. For instance, cross-sectional studies assume all countries have the same income-inequality relationship. Such notion can be easily objected when considering the different historical paths or the diverging government policies amongst nations.

Some scholars have tried to account for the regional differences by introducing country-specific dummy variables in their analysis. For example, a dummy variable could symbolize the fact that Latin American countries have historically been the most inequitable in the world. Deininger and Squire (1996) used this approach and found results that invalidated Kuznets’ U-curve. In other words, country specific factors were found to be creating the U-curve, as opposed to general trends in the time dynamics of inequality. Moreover, the relationship between income levels and inequality was found to be extremely weak. The most useful result from this study was that overall economic growth led to growth in the income of the poorest quintile in 85 of 91 cases. Thus, Deininger and Squire found that even when inequality had increased, its negative effect on the poor had been outweighed by the positive effect of growth.

These results have been further reaffirmed. Dollar and Kray (2000) from the World Bank and Gallup, Radelet and Warner (1998) from Harvard University confirmed the absence of a direct causal relationship between growth and increased inequality. In a yet more recent study, Pfeffermann (2000) discredits Kuznets’ U-hypothesis, and also claims that “the poverty-growth relationship did not change in the 1990s [new economy]” (2000). Addressing some of the worries of Stiglitz regarding globalization, Pfeffermann claims international trade equally benefits the poor and the rest. Similarly, economic downturns, inflation targeting policies, rule of law and fiscal discipline are outlined as factors that either benefit the poor more than the rest or in similar fashion. Pfeffermann’s analysis seems quite generic, perhaps failing in the same manner as cross-sectional studies do. The general findings that have found more substantial support can be summarized as: (1) The U-hypothesis has been refuted by recent studies; and (2) Growth per se does not increase inequality, and evidence shows it decreases poverty.

If it is indeed true that growth does not work against equality, a look in the opposite causal direction becomes sensible. If growth is generally believed to be pro-poor, and is naturally beneficial from a development economics standpoint, how should governments go about spurring it? Can reduced inequality improve the conditions for economic growth? This direction of thought in the growth-inequality relationship has also been extensively explored, yielding applicable results.

2.2 The Effect of Inequality on Growth

Having established the notions of growth as a pro-poor phenomenon that does not have a significant correlation with the level of inequality, the association between growth and development is now reaffirmed. However, the relationship between growth and inequality has not been completely invalidated, as there exists another causal direction. Indeed, many studies have been conducted on the potential effects of initial inequality and subsequent economic growth. Pioneering this discussion were Galor and Zeira (1993), whose study drew the conclusion that “the distributions of wealth and income affect output and investment in the short run and the pattern of adjustment to exogenous shocks” (51). The idea underlying this negative impact on investment and output stems from capital markets imperfections. Galor and Zeira considered the case of credit markets where enforcing repayment is not a costless measure. This leads to higher lending rates to poorer individuals, who in turn are not able to attain the minimum level of investment necessary for productive activities. With a large portion of the potentially productive population excluded from the credit markets and thus unable to invest, output falls below its potential. Furthermore, Banerjee and Newman (1993) analyzed the inability of the poor to provide collateral assets, such as land, to obtain loans. This condition excludes them from the credit market in similar fashion.

Motivated by the findings of Galor and Zeira, Persson and Tabellini (1994) and Alesina and Rodrik (1994) proposed a negative correlation between ex ante inequality and subsequent growth rates. Their regression coefficients, as well as Benabou’s (1996) cross-country empirical data, supported this hypothesis. Further, Deininger and Squire were able to make an important distinction between two types of inequality. Their study conveyed a weak correlation between income inequality and growth. On the other hand, asset inequality as measured by the Gini coefficient of land was found to have a strong negative correlation with growth. In other words, the greater the ex ante inequality of land distribution within a country, the slower growth rates it will experience. This finding is consistent with the aforementioned systematic exclusion of the poorer population from the credit markets, which can be explained by their inability to provide collateral assets to creditors. This inability to access credit reduces investment, which in turn reduces aggregate output.

3. Inequality and Growth in Brazil

The divide between the haves and the have-nots mentioned by Stiglitz has been historically large in Brazil. The plague of inequality is deeply rooted in the country’s history of slavery and exploitative Portuguese colonization. Furthermore, the country experienced a significant increase in inequality in the 1980s (see chart below1). As we begin this new millennium, many questions surround the future of growth and inequality in Brazil. Recently elected leftist President Luiz Inácio Lula da Silva stepped into office starring at the hopeful eyes of millions of poor Brazilians. Indeed, the belief in the possibility of future improvements within the socioeconomic spectrum has received new life with Lula. The momentum the new President has in his favor provides him with a unique opportunity to push forward with reforms that have not been able to break through the status quo in years past.

But what should be the priorities for Lula’s administration? He has taken early measures targeting the country’s return to economic growth. Namely, Lula managed to tame market fears regarding his leftist tendencies and a potential debt default by surrounding himself with a market-savvy economic team that has applied sound monetary policy, and conveying his determination to carry on with social security and tax

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reforms. One result has been the appreciation of the Real against the U.S. dollar (17.5% in the last three months), following a sharp devaluation during the pre-election period. Likewise, the country risk (J.P. Morgan EMBI+ Brazil) has declined from a peak of about 2,400 basis points over U.S. Treasury Bonds (pre-election period, September 2002) to 863 at yesterday’s (May 29, 2003) close. Inflation, which had experienced upward pressure due to the devaluation of the Real, is steadily slowing. Although the Central Bank has been conservative, interest rate cuts are on the horizon. Indeed, that is a clear goal of the administration, as the economy cannot realistically resume sustained growth with the current high level of interest rates. In short, the new government is stirring Brazil on the right track to future growth. Noteworthy, however, is the fact that continuing below trend economic conditions throughout the world will surely undermine the chances of Brazil’s return to growth under Lula.

Notwithstanding the relatively positive outlook of Brazilian growth, the question remains as to how inequality will be addressed in the short and medium term. The aforementioned theoretical and empirical studies on the existing relationships between growth and inequality provide us with some valuable insight into this question. If Lula were to base his strategy on the Kuznets hypothesis, pursuing growth through sound monetary and fiscal policies would suffice as a medium for reducing inequality in the long-run. According to Kuznets, Brazil would most likely be around the maximum of the inverted U-curve. One would expect that when considering the already extremely high level of inequality found in Brazil (approximately 0.6 Gini coefficient) by world standards. This hypothesis would predict that after reaching this maximum level, inequality would diminish as GDP per capita rose. Kuznets inverted U-curve, however, has been widely refuted in recent studies. Deininger and Squire (1996), amongst others, have actually found no significant signs of a causal link between growth and inequality. In my analysis of GDP per capita growth and Gini coefficient growth in Brazil over the last two decades, the relationship has also proven to be extremely weak (see Growth Rates chart below[i]). The correlation between the growth rates is of magnitude less than 0.1, i.e., statistically insignificant. Confirming the findings in more depth, my regression analysis on the Brazilian GDP per capita and Gini coefficient growth rates since 1980 (see Regression chart below1) again displayed the weak causal effect of

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growth on inequality. The scatter plot shows a trend line, i.e., a line of best fit, but it is clearly visible that there is no linear relationship in the data. The R2 coefficient of 0.0092 is indicative of that fact, and is consistent with earlier findings. This leads us to conclude that achieving sustained economic growth in Brazil will not effectively address the problem of inequality.

Furthermore, the studies on the effect of inequality on growth have suggested that the level of initial inequality is negatively correlated with the level of subsequent growth. In particular, the findings of Deininger and Squire (1996) suggest the distribution of land

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– a historically problematic issue in Brazil – is crucial in promoting subsequent economic growth. This strong negative correlation between initial land inequality and subsequent growth should underscore the importance of land reform for the Lula administration.

This is an encouraging finding because, having established that growth is pro-poor, it provides developing countries like Brazil with the basic roadmap to where their government’s efforts should be targeted. In order to effectively reduce inequality and promote long-term sustainable growth, Lula should couple growth-oriented measures with policies that will optimize the distribution of existing wealth.

3. Conclusion

Lula has taken the right steps thus far in directing the country back to its path of economic growth. He has shown great commitment to the tax and social security reforms, which would represent giant steps for Brazil on various levels. First, they would assure a more efficient and equal distribution of social security benefits and the tax burden. Second, the passing of these reforms would boost the general external confidence in the country, which would in turn result in more foreign credit and investment, higher demand for Brazilian assets and a lower risk premium. Third, more efficient tax and social security systems would improve the country’s fiscal position and allow for a reallocation of funds to important under-funded projects.

The issue of land reform in Brazil is even more complex, and its history has been one of broken promises and unmet expectations. The inequality of land is even more extreme than that of income (approximately 0.8 land Gini coefficient), which is an alarming fact in light of the findings of Deininger and Squire (1996). Lula recognizes the importance of agrarian reform, but it remains to be seen how much he will be able to achieve during his term. He has indicated his intention to focus on microfinancing and improving the conditions of family-based agriculture. Furthermore, he has promised to compete with past governments in the quality – not quantity – of land settlements. In this regard, it will be crucial to recognize that, in a competitive global environment, the mere expropriation and redistribution of land is not sufficient in assuring improved welfare. There needs to be investment that assures an efficient market of inputs, technical training and an improved rural infrastructure. This should in turn lead to efficient production and financial return for the stake-holders.

Notwithstanding the challenges that lie ahead, Lula has demonstrated an understanding of the necessity of a two-way strategy that encompasses pro-growth and pro-equity measures. He conveys this understanding in his Plan of Government:

Development with social justice implies a departure from two historical tendencies of Brazilian society: an excessive external dependency and an acute concentration of wealth that generates extreme social exclusion. For this reason, the social dimension must be the axis of development and not a mere appendix or a supposed natural result of the economic growth.

Miriam Leitão (Economy columnist, O Globo newspaper) further adds to the notion of a two-way development strategy, rightly noting that their dimensions should be simultaneous and complementary:

It does not mean that only after all done – approved reforms, increased savings, the poor included, the people educated – will we manage to grow. The country will grow while it performs these tasks. But without them nothing will be sustainable.

If Lula succeeds in achieving economic growth around his social axis, Brazil may finally bridge the giant gap between its haves and its have-nots. Only then, will Brazil be able to grow into the developed world, finally seizing to be the “country of tomorrow”.

4. Appendix: Workshop Presentation Summary Sheet

Growth and Inequality:

Motivations for Distributive Policies in Brazil

NEWS BRIEF by Guilherme Sousa

But to many in the developing world, globalization has not brought the promised economic benefits. A growing divide between the haves and the have-nots has left increasing numbers in the Third World in dire poverty, living on less than a dollar a day. Despite repeated promises of poverty reduction made over the last decade of the twentieth century, the actual number of people living in poverty has actually increased by almost 100 million. This occurred at the same time that total world income actually increased by an average of 2.5 percent annually (Stiglitz, 5).

Questions

Are the poor not reaping any benefits from economic growth?

Could growth be considered anti-poor?

What government policies should be undertaken in order to improve the current scenario of inequality?

Is the answer to create wealth, redistribute existing wealth, or a combination?

Findings

• Kuznets first predicted the U-curve hypothesis, but it has found no support in recent studies

• The consensus is that growth reduces poverty, and it has no significant causal relationship with inequality

• The other causal direction is more relevant: high level of initial inequality undermines subsequent growth

• This is particularly true when considering land inequality

Brazil under Lula

• Immense inequality: 0.60 Gini coefficient, 0.80 land Gini coefficient

• Under Kuznets’ hypothesis, we could expect inequality to diminish in the later stages of growth, but studies have refuted this possibility.

• No apparent direct causal link between growth and inequality, supporting recent studies (correlation < 0.1, R2 = 0.0092)

• Growth per se won’t bring equity, but more equity can help sustain growth: there needs to be a two-way strategy for development

• Recently elected leftist President understands this: “the social dimension must be the axis of development and not a mere appendix or a supposed natural result of the economic growth.”

• Main priorities: (1) Land Reform, (2) Tax and Social Security Reforms, (3) Sound monetary and fiscal policies, lower interest rates

• To assure a successful Land Reform: technical training, efficient market of inputs, improved rural infrastructure, access to credit markets

• Lula has promised to focus on microfinancing and improving conditions for family-based agriculture

• It remains to be seen if he will live up to his promises and bring Brazil back to growth around his social axis

5. Bibliography

Alesina, A., and D. Rodrik (1994). “Distributive Politics and Economic Growth,” Quarterly Journal of Economics 108, 465-490.

Ahluwalia, M. (1976). “Inequality, Poverty and Development,” Journal of Development Economics 6, 307-342.

Benabou, R. (1996). “Inequality and Growth,” NBER Macroeconomics Annual, 11-76.

Banerjee, A. V., and A. Newman (1993). “Occupational Choice and the Process of Development,” Journal of Political Economy 101, 274-298.

Deininger, K., and L. Squire. (1996). Economic Growth and Income Inequality: Reexamining the Links. Retrieved April 18, 2003, from

Dollar, D., and A. Kray. (2001). “Growth is Good for the Poor.”

World Bank, Washington D.C.

Gallup, J. et al. (1998). “Economic Growth and the Income of the Poor.” Discussion Paper No. 36, Institute for International Development, CAER II (November), Cambridge, Mass., Harvard University.

Galor, O., and J. Zeira. (1993). “Income Distribution and Macroeconomics,” American Economic Review 86, 35-52.

Kuznets, S. (1955). “Economic Growth and Income Inequality,” American Economic Review 45, 1-28.

Kuznets, S. (1963). “Quantitative Aspects of the Economic Growth of Nations: VIII. Distribution of Income by Size,” Economic Development and Cultural Change 12, 1-80.

Leitão, M. (2003). Espetáculo.

Retrieved May 20, 2003, from

Palocci, A. (2002). Programa de Governo 2002.

Retrieved May 2, 2003, from

Paukert, F. (1973). “Income Distribution at Different Levels of Development: A Survey of Evidence,” International Labour Review 108, 97-125.

Persson, T., and G. Tabellini (1994). “Is Inequality Harmful for Growth?,” American Economic Review 84, 600-621.

Pfeffermann, G. (1995). Capital Markets and Poverty Alleviation.

Retrieved from

Pfeffermann, G. (2000). Paths out of Poverty: The Role of Private Enterprise in Developing Countries. Retrieved on April 25, 2003, from

Ray, D. Development Economics.

Princeton: Princeton University Press, 1998.

Stiglitz, J. Globalization and Its Discontents.

New York: Norton, 2002.

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[i] Data Sources: GDP: Instituto Brasileiro de Geografia e Estatística (IBGE). Gini coefficient: IBGE and Deininger Database. No available Gini data for 1994.

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