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Income distribution


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Income distribution

  1. 1. INCOME DISTRIBUTIONThis article discusses about the income distribution in a country, the problems involvedand how inequality can be measured for a given income distribution.For calculating income per capita we require total income and total population.However for many countries this data does not exists. So all the calculations are donebased on household income per year rather than average of ten years.Inequality can be measured using a Lorenz curve. It is a graph showing the bottom x%of households, what percentage y% of the total income they have. The percentage ofhouseholds is plotted on the x-axis, the percentage of income on the y-axis. Perfectequal income distribution is depicted by straight line y=x called the line of perfectequality. Inequality is measured using Gini coefficient. The Gini coefficient is the areabetween the line of perfect equality and the observed Lorenz curve, as a percentageof the area between the line of perfect equality and the line of perfect inequality. Thehigher the coefficient, the more unequal the distribution is.INCOME DISTRIBUTION Page 1
  2. 2. The impact of economic development on income distribution is then analyzed. Thedata for income should be after taxes and it should include contributions bygovernment. This type of data will show greater level of inequality in developingcountries. This reduction in the inequality raises real income per capita. Also thedistribution by longer term average income shows less reduction in inequality than dothe distributions by annual incomes.The income inequality in the early phases of economic growth when there is transitionfrom pre industrial to industrial civilization is more rapid; then becomes stable for a while;and then narrowing in the later phases.The hypothesis that income inequality first rises and then falls with development isknown as inverted U hypothesis. It was given by Simon Kuznet in 1955. He observed thisinequality in Germany, United Kingdom and United States. In these countries thedistribution in agriculture was more equal than the distribution of income in urban areas,so as the development and urbanization took place, overall inequality rises. The declinein inequality in later phases was due to better adaptation of children of rural- urbanmigration to city economic life and growing political power of urban rural incomegroups to enact legislation favoring their interests.Montek Ahluwalia took sample of 60 countries and found that income share of allgroups except top 20% first decreases and then increases where as in case of top 20%inverse happens. Kuznets inter-sectoral explanation of changes in income inequality,were later formalized by Robinson 1976. Knight 1976 and Fields 1979, in their framework,the rural–urban income differential is constant but the share of the population in theagricultural sector changes with development, producing the familiar inverted U-shapefor evolution of income inequality over time. This is known as RKF model. Theassumptions of this model are based on the studies of less developed countries.INCOME DISTRIBUTION Page 2
  3. 3. In 1960 rural-urban migration in the LDCs was found to be a symptom of and acontributing factor to underdevelopment. In LDC wages for skilled labour tend to behigher in formal urban jobs than in rural jobs. These studies formed the basis of Todaro(1969) and Harris-Todaro (1970) models which provided a widely accepted theoreticalframework for explaining the urban unemployment in many LDCs3.Rural-Urban migration primarily as an economic phenomenon, the Harris-Todaro model(HT) demonstrates that, in certain parametric ranges, an increase in urban employmentmay actually result in higher levels of urban unemployment and even reduced nationalproduct. The paradox is due to the assumptions that in choosing between labormarkets, risk-neutral agents consider expected wages; that the probability of obtainingurban employment is approximated by the ratio of urban jobs to the urban labor force;and that the urban wage rate is considerably and consistently higher than the ruralwage rate.Under these assumptions, inter-labor market (rural-urban) equilibrium mandates urbanunemployment. This unemployment ensures that the expected urban wage is equal tothe rural wage (which is assumed constant throughout).In LDC upon migration some rural migrants immediately obtain jobs in formal sectorwhile others get employed in small businesses and self employment i.e. informal sector.Thus we have three classes of wage earners: rural (agricultural) workers, urban formalsector workers, urban informal sector workers. Thus the size and income of these threegroups define the inequality during the course of development.Robinson was challenged by James Rauch all individuals would prefer to be in thesector with higher average income , and that once the need for migration equilibrium istaken into account the cause of the inverted-U path of income inequality completelyINCOME DISTRIBUTION Page 3
  4. 4. changes.In Rauch’s model Rauch supposes that individuals are indifferent in equilibriumbetween earning the agricultural income with certainty or taking their chances in urbansector, where they earn a high income if they are lucky and find a formal sector joband a low income if they are unlucky and get stuck in the informal-sector under informalemployment. The main source of inequality in the Rauch’s model is inequality within theurban sector between informally and formally employed workers. As urbanizationincreases the urban sector gains greater weight in the determination of overall esinequality, causing it to rise, but at the same time the share of the underemployed inthe urban population falls, eventually causing inequality within the urban sector andoverall inequality to fall. Therefore the inverted U in the income inequality is closelyrelated to the growth and decline of the proportion of the population that falls into thepoorest class, the underemployed. So Rauch’s result for overall income inequality issimilar to Kuznets’s original Hypothesis.The inverted U curveThe next section is impact of income distribution on economic development. Thedominant view for many years was that income inequality promoted savings andtherefore promoted savings. The studies by Alberto Alesina and Dani Rodrick has shownthat income inequality and inequality of land ownership are negatively associated withINCOME DISTRIBUTION Page 4
  5. 5. per capita income growth during during the periods 1960-85 and 1970-85 for thecountries with available data. From that result they found that the impact of inequalityon development is negative. It was found, the key intervening variable in thismechanism is political instability, so income inequality hypothesized to cause politicalinstability, which in turn is hypothesized to reduce investment, so it will be difficult tosustain development.Two case studies from Taiwan and Brazil has been discussed that show the impact ofgovt. policies on income distribution and the impacts of income distribution on theeconomy. The following graphics show the time line data of the two countries & theireconomic conditions.CASE STUDY: TAIWANINCOME DISTRIBUTION Page 5
  6. 6. CASE STUDY: BRAZILCONCLUSIONThe report aims at highlighting the crucial points about income distribution and theeconomy and the chain of factors linking them. Though in real life there is a plethora offactors that affect the economic development and income distribution but the abovesubject do form the theoretical base for the same.INCOME DISTRIBUTION Page 6