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FEATURE STORY

Growth, Inequality, and Social Welfare: Cross-Country Evidence

July 3, 2014

STORY HIGHLIGHTS
  • While income inequality has been rising in a number of rich and developing countries, the trend is not universal, with inequality staying the same in some countries, and falling in others.
  • Over the past 40 years, most of the variation in changes in social welfare—a measure that takes into account both the average level of income and how it is distributed across individuals—has been driven by differences in growth in average income.
  • In contrast, changes in inequality in either direction have on average had a much smaller impact on trends in social welfare.

Trends in inequality around the world have become a focus of media attention and policy debate over the last few years. From the conversation about increasing inequality that Thomas Piketty’s research has prompted to protests against wealth concentration in rich countries, the issue is at the forefront of public concern and the development policy agenda.

This June’s Policy Research Talk, a monthly series hosted by the World Bank’s research department, was presented by Senior Research Adviser Aart Kraay. His talk drew on his recent working paper, “Growth, Inequality and Social Welfare: Cross-Country Evidence” (authored jointly with David Dollar of the Brookings Institution and Tatjana Kleineberg of Yale University).

“There are concerns about rising inequality everywhere around the world, even in the most conservative corners,” said World Bank Research Director Asli Demirguc-Kunt. Referring to the World Bank’s twin goals of poverty reduction and shared prosperity, she added, “The World Bank has signaled that it is sensitive to inequality issues by committing to monitor the growth in the average incomes of those in the bottom 40 percent of the income distribution in every developing country. So what does shared prosperity mean? What sort of a social welfare function does this goal correspond to?”

While there is evidence of rising inequality, not all countries are experiencing this trend in the same way. According to a 2013 Pew Research Center survey, a median of 80 percent of respondents in developed countries perceive income inequality to have worsened, compared to medians of 70 percent in developing economies and 59 percent in emerging markets. Inequality has indeed increased in some countries, for example in the United States over the past 40 years and China over the past 20. However, inequality has remained stable in countries such as Japan, Switzerland, and Germany, and even fallen significantly in countries such as Brazil.

While debates about inequality touch on many areas, Kraay focused his discussion on one particular question: how much do trends in inequality matter for changes in social welfare?

Kraay relied on a variety of standard social welfare functions to assess the importance of changes in inequality, relative to changes in average incomes, for growth in social welfare. This approach serves two purposes: it provides useful perspective on whether changes in inequality are big or small, and it makes explicit what various measures of inequality imply for the weight placed on individuals at various points of the income distribution. Using China as an illustrative example, Kraay examined what the trade-offs in terms of growth and inequality look like when relying on the World Bank’s own goal of shared prosperity, defined as growth in average incomes in the bottom 40%. Between 1990 and 2007, growth in average incomes in China was 6.7%, while growth in the income share of the bottom 40% was -1.7%, so growth in social welfare still amounted to a notable 5.0%.

Open Quotes

Inequality changes don’t seem to matter nearly as much for changes in social welfare as do differences in average growth performance across countries. Close Quotes

Aart Kraay
Senior Research Adviser, World Bank Research Department

Relying on this approach, Kraay proceeded to explore the relative contributions of changes in inequality and growth to several leading social welfare functions, based on a number of datasets covering various timeframes and sets of countries. Kraay drew on the World Bank’s own global cross-country data, Piketty’s data on top incomes, and the work of Francois Bourguignon and Christian Morrison examining global inequality from 1820 through 1992. All of the analyses pointed to the same broad conclusion: variation in social welfare growth across countries and over time has been due mostly to variation in average growth rates rather than variation in inequality.

Kraay went on to discuss how changes in growth, equality, and social welfare are related to initial conditions of inequality. On the one hand, he found there is little evidence that initial inequality is correlated with subsequent income growth. On the other hand, high initial inequality is correlated with subsequent declines in inequality, while low initial income is correlated with faster subsequent income growth. According to Kraay, “these empirical results suggest that you're going to see faster growth in social welfare in countries that are initially poor, and initially more unequal.”

Kraay then turned to the policy implications of his findings. He concluded that “inequality changes don’t seem to matter nearly as much for changes in social welfare as do differences in average growth performance across countries. We should be careful, with all of the renewed emphasis on inequality, to ensure that the emphasis on inequality doesn’t come at the expense of an emphasis on policies and institutions that matter for growth.”

The question and answer session that followed the talk considered other ways of analyzing inequality, including in terms of access to opportunity, health, and education, and the policy implications of related research. With the recently published "Inequality of Opportunity and Economic Growth: a Cross-Country Analysis," World Bank researchers Francisco Ferreira, Christoph Lakner, Maria Ana Lugo, and Berk Ozler recently contributed additional research to this ongoing development conversation.

Discussant Marcelo Giugale, Senior Director of the World Bank’s Macroeconomics and Fiscal Management Global Practice, noted that “both Piketty and the inequality crowd are, in a way, papering over the fact that more data is becoming available now to estimate not inequality of outcomes, but inequality of opportunities—focusing not only on equality, but on equity.”