Lecture 5 Inequality and Poverty Reduction:

Social Objectives and Policy Options

Course on Poverty and Inequality Analysis

Module 5: Inequality and Pro-Poor Growth

Francisco H. G. Ferreira

DECRG

Roadmap

1. Introduction

2. Evidence that Inequality Matters

3. Policy Options

4. Conclusions

1. IntroductionPoverty vs. Inequality

• Poverty and inequality are different things.

• Poverty measures can be seen as negative social welfare functions, truncated at z. Everyone tends to agree that poverty should be reduced.

• It is less obvious that we ought to pursue inequality reduction for its own sake. Nevertheless, there may be both intrinsic and instrumental reasons why high inequality is undesirable.

1. IntroductionInequality may be a bad thing for…

• Intrinsic reasons: – Social Welfare Functions may be concave.– Individual welfare may have a relative component.– Inequality of Opportunities may be judged unfair.

• Instrumental reasons:– Inequality Reduces Growth

• Imperfect credit or insurance markets• Political economy malfunctions

– Inequality slows down poverty reduction, even at a given rate of growth

– Inequality leads to more conflict / violence

1. IntroductionBut inequality may be a good thing because:

- to the extent that outcomes differ based on effort, it may help provide incentives for greater effort and output, i.e. more efficiency.

- If policies aimed at reducing it have high costs in terms of disincentives to:

- Work- Accumulate capital, physical or human

- Either because returns are lower (taxation)- Or because property rights have become uncertain

(expropriation)

1. IntroductionUtilitarianism with Concave Social Welfare Functions

n

iiyUMax

1

subject to nyn

ii

1

ii

ii ynyUL

The FOCs imply that:

i

i

i

yn

yU

1

)(' iy

If U’’(y) < 0, the SOC implies that is a maximum.

But note: this result does not include any incentive effects, in the shape of incentive compatibility constraints; and assumes identical utility functions.

1. Introduction A Relative Component in Welfare?

• What if with ?

• Easterlin (1974) – evidence that long-run growth does not measurably improve happiness in rich countries.

• Dupor & Liu (AER 2003), “Jealousy and Equilibrium Overconsumption”.

• Luttmer (QJE, 2005), “Neighbors as Negatives: relative earnings and wellbeing” -- evidence of effect of mean neighborhood income on subjective welfare.

• Kingdon’s evidence on negative effect of racial mean income on subjective welfare in South Africa.

ii

yyU , 0, 21 UU

1. IntroductionBeyond Utilitarianism: Other Legitimate Social

Objectives

Figure 1: Different Choices Along an “Advantage Possibility Frontier”

O 2

B

R

E

O 1

X

O 2

A

C

P

Note: Figure 1 is a reproduction of Box Figure 4.1 in WDR 2006 and, as acknowledged there, is drawn

from Buchanan (1976), through Atkinson and Stiglitz (1980).

vdFv

0

max

T

Tminmax

1. IntroductionInequality of Opportunities

• What if inequality in outcomes were not what people objected to, but inequality in opportunities?

• Dworkin (1981), Roemer (1998), WDR 2006.• Outcomes are a function of circumstances and efforts: y = y (c, e).

Society ought to ensure a level playing field, so that across types (defined by exogenous circumstances):

• In fact, since levels matter too, and taking into account an aversion of extreme deprivation in outcomes, the WDR 2006 proposes something like:

jiuFuF jiTT ,,

subject to

dse tj

s

t

st

jt

minmax

tsjiuu sijs ,,

2. Evidence that Inequality MattersCursory Evidence on Perceptions of Fairness

Figure 1 .2: P erceptions of fa irness of the incom e d istribution in Latin Am erica

0% 20% 40% 60% 80% 100%

Venezue la

U ruguay

Peru

Paraguay

Panam a

N icaragua

M exico

H onduras

G uatem ala

E l Sa lvador

Ecuador

C osta R ica

C olom bia

C hile

B razil

Bo liv ia

A rgentina

Average

Very fa ir Fair U nfa ir Very unfa ir

* Source: Latinbarom eter (2001). R esponses to the question: "D o you th ink that the incom e distribution is … ?"

See also experimental evidence that people value fairness per se. E.g. Fehr and Schmidt (QJE, 1999), Fehr and Gachter (AER, 2000)

2. Evidence that Inequality MattersBasic opportunities are very unequally distributed

Source: WDR 2006

2. Evidence that Inequality MattersUnequal opportunities often lead to wasted

productive potential

1. The risk-adjusted opportunity cost of capital is often higher for poorer entrepreneurs (WDR 2006, Ch. 5).

2. Adopting lucrative innovations often has an initial cost that, in the absence of functioning capital markets, may discourage the poor from taking advantage of them. (e.g. pineapple cultivation in Ghana, Goldstein and Udry, 1999).

3. Stigma may lead to underperformance by subordinate groups (e.g. Hoff and Pandey, 2004).

2. Evidence that Inequality Matters This may be reflected in reduced-form relationships

between asset inequality and growth.

2. Evidence that Inequality Matters Even for a given growth rate, income inequality

hampers poverty reduction.

Source: WDR 2006

3. Policy OptionsClarity on objectives and constraints

• Alternative policy objectives:– To reduce poverty.– To maximize the opportunities of the least

advantaged group (“leveling the playing field”)

• Policy Constraints:– Budget constraints.– Administrative capacity constraints.– Participation and incentive compatibility (i.e.

“incentive” constraints).– Ethical or political policy choice constraints.

Individual traits and preferences: tastes, talents, efforts, …

Endowments: Wealth, land, social group, family background,…

Outcomes: income, consumption, health, environment,…

Process: investment, schooling, market transactions, political process.

Opportunities

3. Policy OptionsOpportunities and socio-economic processes.

3. Policy OptionsPolicy “entry points”

Box 1: Schematic Representation of Household Income Determination I (Z, w)

Investment in Human Capital P (X, Z, w) V(J) The Matching Function

D( p(X, Z, J), X, Z, J, w) Remuneration in the Labor Market G(, w) Household Formation

F(y) Redistribution H(y+t)

3. Policy OptionsPolicies for Human Development (i)

Mental development of undersized children (low height for age):

The Jamaican Study

Source: Grantham-McGregor et al., 1991.

3. Policy OptionsPolicies for Human Development (ii)

3. Policy OptionsAccess to titled land (and functioning land

markets)

Source: WDR 2006

3. Policy OptionsProgressive provision of access to

infrastructure and other government services.

Water sources and water price in Niger

Source: WDR 2006

3. Policy OptionsThe incidence of public expenditures varies

dramatically across programs.

PROGRESA school

PROGRESA food

Health (SSA)

Primary education

Lower sec. education

School breakf. (DIF)

PROCAMPO

Tortilla (FIDELIST)

ALL (excl. Pensions)

Upper secondary education

Milk subsidy (LICONSA)

Active workers (IMSS)

Health (IMSS)

Electricity Subsidy

Tertiary education

Health (ISSSTE)

Active workers (ISSSTE)

Pensioners (IMSS)

GINI

Pensioners (ISSSTE)

-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6

Concentration coefficients for programs in Mexico.

Source: de Ferranti et. al., 2004

3. Policy OptionsFairness in Markets (i)

• Between the “extremes” of redistributing assets (ex ante) and incomes (ex post), there lies the realm of markets and institutions.

– Eliminate discrimination.– Combat segmentation.– Reduce barriers to entry.– With the exception of labor markets, where monopsony

arguments apply with special force, competition on the supply side is likely to be both equitable and efficient.

– Always mind the impact of policies on individual incentives to participate and produce.

– The distribution of power matters for how institutions work.

3. Policy OptionsFairness in Markets (ii)

Subject to some basic principles, very different institutional designs are consistent with similar performance.

Source: WDR 2006

3. Policy OptionsRedistribution of Incomes

• Social security systems generally much larger than social assistance in LDCs. – SSS typically ‘truncated’, reaching only formal sector

workers and excluding most of the poor.– In a context where labor productivity may be very low,

worry about disincentive effects.

• Conditional cash transfers (CCTs) have proved successful in negotiating both issues:– Targeted to poor families (means-tested)– Conditional on specific behavior by household members

(usually some investment in human capital, such as school attendance or child care)

3. Policy OptionsRedistribution of Incomes: CCTs

– Examples:• Bolsa Família (Brazil)• Oportunidades (Mexico)• Cash for Education (Bangladesh)• PRAF (Honduras)• RPS (Nicaragua)• Familias en Acción (Colombia)

Figure 5-3: Distribution of eligible households by deciles and quintiles of income

decile PRAF

(Honduras) RPS

(Nicaragua) PROGRESA

(Mexico) SUF

(Chile) FFE

(Bangladesh)

1 22.1 32.6 22 2 42.5 55 39.5 67

3 66.9 70.2 51.9 4 79.5 80.9 62.4 88.8 48

5 88.6 89.6 70.9 6 93.5 94.3 80.5 97.2 7 97 97.1 87.8 8 97.3 99.1 93 99.8 9 97.7 99.8 98

10 100 100 100 100 100

Source: Coady & Morley (2002)

Incidence

3. Policy OptionsRedistribution of Incomes: CCTs

• Impacts on Education

Program Program effect Age rangeMexico (PROGRESA-Oportunidades: rural areas)

2.7

(11.1)

1st-5th grade at baseline

(6th grade)

Nicaragua: RPS 17.7 Age 7-13

Honduras: PRAF 3.3 Age 6-12

Ecuador: BDH 10.0 Age 6-17

Colombia: Familias en Accion

2.1

(5.6)

Age 8-13

(age 14-17)

Brazil: Bolsa Escola 3.0 Age 10-15

Cambodia: Scholarships for girls

22-33 Secondary school

Bangladesh: stipends for girls

12.0 7th grade at baseline

3. Policy OptionsThe international arena also matters.

• Trade: less distortion by rich countries

• Migration: greater scope for labor mobility

• Intellectual Property Rights: innovative solutions

• Aid: greater volume and effectiveness, fewer ties.

• Global Commons

Source: Lanjouw, 2004.

4. Conclusions

• Public action should aim to level the playing field, by expanding access to opportunity to the least advantaged.

– Maximin in the space of opportunities implies growth with equity.

– Human freedoms are the paramount objectives of development.

– Individual incentives matter greatly. To attain prosperity, equity must be pursued within a framework of functioning markets.

– Efficiency – equity trade offs exist, but may be less pronounced when all the long-term benefits of fairness are recognized.