The Blackwell Companion to Sociology (39 page)

and hence to a faster rate of accumulation and growth. It is this chain of

reasoning ± linking distribution with savings, accumulation, and growth ± that

has served more than anything else to underpin the view that there exists an

inevitable conflict between equality and growth.

This theory was never subjected to any rigorous empirical test by the classical

economists; presumably, its truth seemed self-evident to them. In any case, they did not possess at that time the necessary data to test their theory. But the same cannot be said today. An impressive body of evidence has accumulated over

time, and it has not been kind to the classical view. This evidence may be best

summarized by dividing up the classical chain of reasoning into two parts: the

first part says that a more unequal distribution of income results in higher

savings and accumulation because the rich tend to save proportionately more,

and the second part says that the more you save the faster you grow.

A couple of considerations weigh heavily against the first part (Lindert and

Williamson, 1985). To begin with, numerous studies have shown that the rich

and the poor do not differ markedly in their saving propensities. Second, even to the extent that saving propensities do differ, greater inequality will merely enable 154

Siddiqur Rahman Osmani

the economy to save more; it will not ensure that more will actually be saved in the form of productive capital. After all, savings can be utilized in many different ways, some of which ± like building a factory ± lead to the creation of productive capital, while others ± like buying real estate for speculative gains ± do not. The actual pattern of utilization depends on the structure of incentives that exists for encouraging investment into different forms of assets. These two considerations

together suggest that greater inequality does not necessarily lead to a higher rate of capital accumulation, thus casting doubt on the first part of the classical

proposition.

The second part, linking capital accumulation to growth, is also subject to

considerable doubt. The initial ground for scepticism emerged quite a long time

ago, in the 1950s and 1960s, as a consequence of a series of studies that have

come to be known as ``growth accounting.'' The objective of these studies was to quantify the contribution of different sources of growth, in particular to see how much of the observed growth in per capita income was attributable to capital

accumulation and how much to the growth of the labor force. To their utter

surprise, economists then discovered that historically capital accumulation had

made a relatively minor contribution to the growth of developed countries, and

by far the major contribution had come from technological change and an

assortment of other factors whose nature was not well understood. Moses

Abramovitz, the pioneer of growth accounting, called this part thè`measure

of our ignorance,'' so as to underline the message that we knew very little of the forces that actually promote growth. More sophisticated techniques of growth

accounting employed by subsequent writers have reduced thè`measure of

ignorance'' to some extent, but they have not overturned the finding that capital accumulation, at least as conventionally measured, may not be the key to growth

(Abramovitz, 1993).

An even more serious reason for skepticism has emerged in the past few years.

While thè`growth accounting'' literature had cast doubt on the supposedly

overwhelming importance of capital accumulation, it did not dispute the claim

that accumulation did after all contribute to growth. By contrast, some recent

studies seem to strike at the very root of the classical proposition by demonstrating that accumulation appears to have no causal effect on growth at all! By

analyzing the experience of a large number of countries, these studies have

shown that faster growth precedes, rather than follows, higher rates of savings

and accumulation (Blomstrom et al., 1993; Carrol and Weil, 1994). The caus-

ality thus seems to run in the opposite direction; it is growth which raises savings and accumulation, and not the other way round.

It should be noted that these studies are by no means conclusive. The meth-

odology, the database and the interpretation of findings are still being debated.

But the important point is that taken together they cast enough doubt on the old argument that inequality promotes growth by encouraging savings and accumulation.

The opponents of equality do, of course, point to other mechanisms through

which inequality is supposed to promote growth and equality to stifle it. The

most prominent of these is the incentive argument. The essence of this argument

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155

is that economic growth occurs as a result of people working hard and entre-

preneurs taking risks, which everyone is not capable of doing equally. Those who can will naturally be rewarded more than those who cannot. If you do not allow

these unequal rewards, so the argument goes, then those who can will not have

the incentive to work hard or to take risks; as a result, the fountain of growth will run dry.

This argument obviously has some merit. Indeed, some people find its merit so

overwhelming that they are prepared to ditch the cause of equality altogether in the name of incentives. But extremism of this kind is totally unwarranted

because the incentive of differential reward is only one of a variety of ways in which income distribution may affect growth. Against this incentive effect, one

must weigh the effect of a number of other channels through which, according to

some recent research, greater equality may actually promote rather than retard

growth.

To a large extent, this new research has been inspired by the experience of the

East Asian miracle economies. The two main stars of this miracle, South Korea

and Taiwan, started from a base of exceptionally equal distribution of income by developing country standards, brought about half a century ago by some radical

land reforms that took away vast amounts of farming land from rich landlords

and redistributed it equally to poor peasants. Evidently, equality did not harm

the cause of growth in these countries! Indeed, many have argued that equality

may well have helped them achieve the exceptionally high rates of growth that

earned them the reputation of miracle economies in the subsequent decades. (See

the discussion and the references cited in Birdsall and Sabot, 1995.)

Much work has recently been done to understand the pathways through

which greater equality may actually promote growth. Four main channels have

been identified so far. These may be described as the theories of: (a) endogenous fiscal policy; (b) capital formation under credit constraint; (c) endogenous

schooling and fertility decisions; and (d) socio-political instability. (For extensive reviews of these theories, see in particular Alesina and Perotti, 1994; Perotti, 1996; Benabou, 1997.)

According to the endogenous fiscal policy theories, distribution of income

determines a government's choice of fiscal policy, which in turn affects the rate of growth. The particular fiscal policy in question may be either taxation or

expenditure, but in either case, the point of these theories is to demonstrate

that a more equal income distribution will lead to a kind of fiscal policy that

would be more conducive to growth. Consider the case where a government

wants to pursue a redistributive fiscal policy by imposing a tax on capital income and by redistributing the proceeds uniformly across the population. Since the

poor have less capital than the rich, they will pay less tax than the rich for any given rate of tax. By contrast, everyone will receive the same amount of money

when the proceeds are distributed uniformly across the population. So a fiscal

scheme of this kind will entail a redistribution of income from the rich to the

poor. The government wants to choose as high a tax rate as possible in order to

maximize the scope for redistribution, but at the same time it wants to be careful about public opinion because it knows that people don't like to pay tax. In

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particular, it wants to ensure that the chosen rate is not considered too high by the majority of the people. So the question is: what does the majority want?

The answer is found by applying a trick known in economic theory as thè`median voter theorem.'' Note that since redistribution will take place at the expense of the rich, they will want to keep the tax rate low. In general, the richer a person is the lower a rate he or she will prefer, and the poorer a person is the higher a rate he or she will prefer. Given this pattern of preferences, the tax rate preferred by the person located in the middle of the income distribution ± the so-called median voter ± will play a crucial role. It is clear that a tax rate that is marginally lower than the one preferred by the median voter is the highest

possible rate that will not be considered too high by the majority. (The majority in this case will consist of the poorer half of the population plus the person

whose income is marginally higher than that of the median voter.) This, then, is the rate that will be chosen by a government that wants to maximize the scope of redistribution while keeping the majority happy.

The chosen tax rate will depend, among other things, on the existing distribu-

tion of income. For any given level of per capita income, a more equal distribu-

tion will imply higher income for the poorer half of the population. The tax rates preferred by the poorer half, including, say, the median voter, will then be lower.

So, if the government wants to keep the majority happy, it will have to choose a lower tax rate under a more equal distribution than under a less equal one. The

chosen tax rate in turn will impinge on the rate of growth of the economy by

affecting the incentives to invest ± a lower tax rate will damage incentives less, encourage investment more, and stimulate faster growth. Thus, greater equality

of income distribution will result in faster growth by raising the income of the poor, which will lead to a lower tax on capital, which in turn will foster more

rapid investment and growth.

The second group of theories also link equality with growth through capital

accumulation, but unlike the endogenous fiscal policy theories they focus on

capital accumulation by the poorer segment of the population. The basic point is that with a more equal distribution of income the poor will be able to accumulate more capital, without impairing the ability of the rich to do the same, so that the society as a whole will be able to accumulate capital faster and grow faster.

The key to understanding the argument lies in the widely observed feature of

the real world that credit and capital markets generally discriminate against the poor. There are a number of reasons why a profit-maximizing lender would

want to discriminate against poor borrowers, even if many of them are poten-

tially creditworthy. Whatever the reason, the fact is that the poor find themselves credit-constrained in a way that the rich do not. It is this feature of the credit market that establishes a link between distribution and growth.

The argument goes something like this. Since the poor have lower levels of

capital than the rich, they would have a higher marginal return to capital, given the standard assumption of diminishing returns. Normally, therefore, the poor

would want to invest more than the rich. But the problem is that the size of

optimal investment typically exceeds what people can afford to spare from their

own earnings. This is not a problem for the rich because they have access to the On Inequality

157

credit market, but it is a problem for the poor who are credit-constrained. The

poor will therefore be forced to invest less than the optimal level. The actual size of their investment will depend on their command over self-finance, which in

turn will depend on their income and wealth. This is where distribution comes

in. The poor's command over self-finance will be higher in a society with greater initial equality of income distribution than in one with less equality, for any

given level of per capita income. It is of course true that, while enhancing the poor's command over self-finance, a more equal distribution will also reduce

that of the rich, but this will not have any adverse effect on capital accumulation, as the rich have ready access to the credit market. On the whole, then, a more

equal society will be able to accumulate more capital and grow faster, other

things remaining the same.

The third group of theories draw the link between distribution and growth via

people's decisions to have children and to educate them. An equal distribution of income is supposed to affect the schooling and fertility decisions in a manner

that would help to promote economic growth. To see how this link works, first

note that schooling and fertility decisions are usually intertwined. The decision to give more education to children usually goes with the decision to have fewer

of them. This is known in the literature as thè`quantity versus quality'' trade-off

± when people want to improve thè`quality'' of children, they tend to reduce

their quantity.

The extent of this trade-off depends on the cost of raising children on the one

hand and the cost of educating them on the other. And these costs are often

related to the level of household income. For a poor family, the cost of educating children can be quite high, especially in terms of opportunity cost, i.e. income forgone. Young children of poor families are known to contribute significantly