In an augmented Kuznets hypothesis, two kinds of factors determine the distribution of income in the short run
The famous Kuznets invented U-curve hypothesis (Simon Kuznets 1955) states that at very low levels of income, income inequality must also be low, as practically everybody lives at or close to subsistence level. There is no room for increased inequality because, with the small size of overall output, increased inequality would push many people below the subsistence level. As the process of growth begins, income inequality increases. People migrate from the traditional agricultural sector, where incomes are low, to the modern industrial sector, where the (expected) wage is higher and wage differentiation is greater.
In proposing an "augmented" Kuznets hypothesis, a World Bank researcher argues that the size distribution of income is determined by two kinds of factors in the short run: by those "given"---from the point of view of policymakers or society as a whole---and by those resulting from social (or public policy) choice.[1] The "givens" are the level of income and the regional heterogeneity of a country. Neither of these factors can be influenced strongly in the short run. The level of development (level of income) is obviously a variable that changes slowly, and, for the same reasons, so is the inherited regional inequality.
The public policy factors are (1) the percentage of workers employed in the state and the parastatal sector, and (2) the size of government transfers, measured as a share of a country's GDP. These two factors are the products of political decisions, both current and past (for example, a country might have a large state sector because of a strong past influence of socialist parties). These public policy factors raise a key question: To what extent do social choice factors statistically explain cross-country income inequality?
Once the "given" elements are accounted for, there is still sizable discretion regarding income inequality. Income distribution is viewed also as the product of social choices mediated through elections, lobbying, societal preferences, or historical developments. So, some countries may have a greater proportion of state sector workers because socialist or Communist parties were historically stronger, or the population may prefer to eradicate poverty and redistribute income through transfers, or the middle classes---which decisively determine the size of transfers in developed democracies---may have experienced downward mobility and may regard transfers as an insurance proposition (lest they become poor), as argued by Lindert (1989 and 1991). In any case, variables such as the size of the state sector and the size of transfers will be determined through the interaction of social forces or by the political economy of the country.
Consider the influence of two "social choice" elements in more detail. The large size of the state sector tends to reduce inequality because of its more compressed wage distribution compared with that in the private sector. More bureaucratic structures, in which earnings are determined largely by seniority and academic credentials, have been shown to pay those at the top relatively less and to pay those at the bottom relatively more. Bishop, Formby, and Thistle (1991) find that wage distribution in the U.S. government is consistently more egalitarian than that in manufacturing, services, or agriculture (all of which are entirely private). Meron (1991) obtains the same result for France. Socialist countries further confirm the leveling tendencies of state-owned enterprises, because the majority of workers (outside agriculture) were or are employed in the state sector. Wage distribution, adjusted for the heterogeneity of the country, tends to be more equal in socialism than in capitalism. Thus Phelps-Brown (1988) writes that lower inequality in Soviet-type economies "arises mainly from a slower rise of income above the median, that is, broadly: the more skilled manual occupations and still more the higher clerical, the professional and administrative are paid less than in the West relative to the bulk of manual workers."
Still another reason why a high level of state involvement in the economy may lead to lower inequality: "if decisionmaking is perceived to be largely decentralized, individual advances are attributed to chance, or possibly merit (or demerit). When decisionmaking is known to be centralized, such advances will be attributed to favoritism ... [Centralized systems] will strain to be more egalitarian not just because they want to, but also because they have to: centralization of decisionmaking largely deprives them of tolerance for inequality that is available to more decentralized systems" (Hirschman 1973).
Government transfers tend to reduce inequality, though the reduction in inequality achieved by a given amount of government transfers will vary. If most transfers are captured by those who pay taxes (out of which the transfers are financed), the reduction in inequality may be small (the theory of the middle-class capture of benefits argued by Le Grand 1982 and Sawyer 1982). But generally the larger the transfers, the greater the
reduction in inequality will be, even if additional increases in transfers lower inequality by less and less.
The social choice variables (social transfers and state sector employment), jointly with the "given" variables, were included in the standard formulation of the Kuznets hypothesis. In all formulations of the regressions, the social choice variables show a statistically significant negative impact on inequality.
In a sample of 80 countries in the 1980s, the social choice variables reduce inequality by some 13 Gini points. At a low level of income, the role of social choice variables is almost negligible. As income rises, their importance increases. It could be argued that, at a low level of income, social choice has no effect because everyone is poor and there is nothing to redistribute. But at low levels of income, inequality is relatively high, so social choice variables could, a priori, play a significant role. Why they do not do so can only be conjectured now.
The Bank researcher's hypothesis is that society's preferences change during the process of development and that, as average incomes rise, people place greater emphasis on equality. Their preference for social equality is therefore income-elastic. The implication of this result: the validity of the original Kuznets hypothesis diminishes as society develops. The level of inequality that a society charts throughout its development diverges systematically from the level predicted by the Kuznets curve. This is so because inequality in richer societies
decreases not only due to economic factors but also because societies choose less inequality.