Inequality is in the news once again and the news is not particularly good. In a speech last month, Reserve Bank of India governor Raghuram Rajan commented that increasing inequality could be curtailing world demand. Since the rich typically spend a smaller portion of their income compared with the poor—who spend almost all of their income—rising inequality is a threat to aggregate demand in the global economy, Rajan argued .

Rajan belongs to a new generation of economists who are beginning to take inequality more seriously than before. In his famous 2010 book, Fault Lines, Rajan argued that refusal to tackle growing inequality in the US led federal policymakers to encourage the housing boom which eventually led to the great crash of 2008, with disastrous consequences for both the US and the global economy. Rajan has been quite blunt about inequality in wealth and power in India as well.

In a 2008 speech to the Bombay Chamber of Commerce, Rajan warned about the fault lines in the Indian economy at a time when most commentators were exuberant about India.

“My former classmate from IIT, Jayant Sinha, recently sent me a spreadsheet he had compiled," said Rajan. “It lists the number of billionaires per trillion dollars of GDP for the major countries of the world. Guess which country tops the list? It is Russia, with 87 billionaires for the $1.3 trillion of GDP it generates. ‘Of course!’ you will say—these are the oligarchs who stole the country’s mineral resources, who participated in the Loan for Votes scheme, etc. But guess which country comes second? It is India with 55 billionaires for the $1.1 trillion it generates."

Rajan then went on to argue that given the size of India’s economy, the number of billionaires it produced was extraordinary compared with emerging market peers such as Brazil, or with developed market peers such as Germany. Moreover, the fact that most billionaires gained wealth because of their access to natural resources such as land or government contracts raised disturbing questions about the nature of India’s growth process. If Russia is an oligarchy, how long can we resist calling India one, questioned Rajan.

If inequality is large or growing in India, why do we not talk about it more often? There seems to be two key reasons. First, until recently, there was dearth of credible data on income inequality in India. Second, within the economics profession, there was a broad consensus that inequality may often be par for course for a fast-growing developing economy such as India, and once it grew richer, the tide would turn.

Both these aspects are changing. We now have newer sources of evidence on inequality in India. Also, economic thinking on inequality has changed considerably across the globe over the past few years.

Historically, estimates of inequality in India have always been based on consumption expenditure data culled from household surveys conducted by the National Sample Survey Office (NSSO). Based on these estimates, inequality in India has always seemed benign and comparable with inequality levels in the rest of the world. Economists were always aware that comparing consumption-based inequality in India with income-based inequality in other countries was like comparing apples to pears, if not to oranges.

Even if the rich earn a lot more than the poor, they are unlikely to spend all of their additional income. Thus, consumption-based inequality measures are expected to understate income inequality. Yet, the absence of an alternative measure ensured that the consumption-based Gini coefficient (which measures inequality) was officially endorsed (by the erstwhile Planning Commission) and widely used.

Even that measure suggests an increase in inequality in recent years. Estimates based on NSSO data by Himanshu, an economist at Jawaharlal Nehru University and a Mint columnist, show that the Gini coefficient based on consumption data rose significantly from 0.298 in 1983 to 0.347 in 2004-05 (the Gini coefficient takes values between 0 and 1, with 0 indicating perfect equality in income or consumption distribution and 1 indicating complete inequality in such distribution). The coefficient rose further to 0.359 in 2011-12.

Despite the increase in the official gauge of inequality in India, the level of inequality is considered moderate given that the Gini coefficient for middle-income developing countries tends to range from 0.400 to 0.500, and exceeds 0.500 in some of the most unequal countries of the world, such as those in Latin America.

However, an alternative dataset based on the India Human Development Survey (IHDS) by researchers from the National Council of Applied Economic Research (NCAER) and Maryland University suggests a starkly different picture.

This dataset was used to estimate household incomes, which were calculated to compute an income-based Gini coefficient for the first time in India. The result was startling: the Gini coefficient turned out to be as high as 0.52 when based on income data, although the consumption-based Gini coefficient was much lower at 0.38, and comparable with the NSSO-based estimate.

In terms of income inequality, India seems scarcely better than some of the most unequal countries of Latin America.

If one were to reliably compute inequality of wealth distribution, India would probably fare worse, as Rajan’s rough analysis suggested. Wealth data is incredibly more difficult to obtain compared with income, and are based on a large number of imputations and assumptions.

Nonetheless, one widely used estimate of wealth across countries is provided by the investment bank Credit Suisse. Their latest report makes for sober reading, as a recent Mint article by Manas Chakravarty pointed out.

The report released recently estimated that the top 1% in India own more than half of the country’s total wealth. The richest 5% own 68.6% of the country’s wealth, while the top 10% have 76.3%. At the other end of the pyramid, the poorer half jostles for 4.1% of the nation’s wealth, wrote Chakravarty.

If the lack of data was one handicap in understanding the impact of inequality, the weight of scholarly opinion in economics was another handicap. Economists neglected inequality for a long time based on two supposedly fundamental laws of economics.

The first one is the simple hypothesis of the equity-efficiency trade-off, which suggests that with rising growth rates, some are left behind and that inequality is an inevitable consequence of the growth process. Conversely, focusing on redistributive policies will impede economic growth. One of the most influential papers in economics, authored by Simon Kuznets in 1955, argued that high inequality, associated with growth, is a transient phase in development. Gradually, growth will trickle down to the poor and inequality will start declining.

In a famous graduation speech, Thomas Sargent, a Nobel laureate, listed the trade-off between equity and efficiency among the “valuable lessons of our beautiful subject".

Another Nobel-winning economist, Robert Lucas, was harsher on attempts to curb inequality. Lucas suggested that focusing on inequality is “harmful and most poisonous". In a tongue-in-cheek response, two International Monetary Fund (IMF) economists used one of his own papers and showed that the welfare costs involved with tolerating inequality outweigh gains made by growth-enhancing strategies.

The initial postwar experience indeed seemed to vindicate Kuznets’s U-curve hypothesis on inequality. But as an earlier Economics Express column pointed out, the seminal work of Thomas Piketty as well as contributions from scholars such as Anthony Atkinson have challenged Kuznets’s hypothesis. Their work suggests a sharp rise in top income shares across countries in the developed world since the 1970s after a period of moderation in the years following the Second World War.

Recent research from the IMF suggests that inequality may in fact harm the growth prospects of an economy. An IMF discussion note published last year put together cross-country evidence that suggests that lower initial inequality may facilitate high growth rates for a long duration, while high levels of inequality may cause redistributive pressures and lead to an unstable growth path. There is little macroeconomic evidence for an equity-efficiency trade-off, the note by IMF economist Jonathan D. Ostry and his colleagues said.

The other economic principle that has been employed to claim that inequality isn’t as important as it is made out to be is the Pareto principle. The Pareto principle suggests that if the income of a particular individual or a set of individuals increases without affecting the well-being of others, such an outcome could be desirable for society.

But most policies to tackle inequality involve making at least some people worse off. Hence, the Pareto principle seemingly comes in the way of such policies. Nobel laureate Angus Deaton, in his latest book The Great Escape, challenges the Pareto principle by arguing how the concentration of wealth impedes non-pecuniary well-being.

“The very wealthy have little need for state-provided education or health care; they have every reason to support cuts in Medicare and to fight any increase in taxes," writes Deaton. “They have even less reason to support health insurance for everyone, or to worry about the low quality of public schools that plagues much of the country. They will oppose any regulation of banks that restricts profits, even if it helps those who cannot cover their mortgages or protects the public against predatory lending, deceptive advertising, or even a repetition of the financial crash."

“To worry about these consequences of extreme inequality has nothing to do with being envious of the rich and everything to do with the fear that rapidly growing top incomes are a threat to the wellbeing of everyone else," writes Deaton. “There is nothing wrong with the Pareto principle, and we should not be concerned over others’ good fortune if it brings no harm to us. The mistake is to apply the principle to only one dimension of wellbeing—money—and to ignore other dimensions, such as the ability to participate in a democratic society, to be well educated, to be healthy, and not to be the victim of others’ search for enrichment. If an increase in top incomes does nothing to reduce other incomes but hurts other aspects of well-being, the Pareto principle cannot be called on to justify it."

In a Science article published last year, renowned development economist Martin Ravallion of Georgetown University points to three important consequences of inequality.

First, poverty typically declines at a lower rate in countries with high inequality. Second, when there’s extreme initial inequality, growth alone can’t lift all the boats as poverty becomes less responsive to economic growth. Third, when there’s a large rent accruing to a small set of rich elite, they will try to impose barriers on policies that promote innovation and foster market competition.

Of course, inequality is also a cause for worry because it may lead to social unrest. At least on this, economists and other social scientists have been worrying for quite some time.

In a widely cited 1973 research paper, economists Albert Hirschman and Michael Rothschild coined the term “tunnel effect" to describe how inequality can lead to conflict. The tunnel effect referred to a parable about multi-lane traffic that the authors used to describe inequality’s impact. New York University development economist Debraj Ray presented a modified parable to explain this effect in a 2010 research paper:

“You’re in a multi-lane tunnel, all lanes in the same direction, and you’re caught in a serious traffic jam," wrote Ray. “After a while, the cars in the other lane begin to move. Do you feel better or worse? At first, movement in the other lane may seem like a good sign: you hope that your turn to move will come soon, and indeed that might happen. You might contemplate an orderly move into the moving lane, looking for suitable gaps in the traffic. However, if the other lane keeps whizzing by, with no gaps to enter and with no change on your lane, your reactions may well become quite negative. Unevenness without corresponding redistribution can be tolerated or even welcomed if it raises expectations everywhere, but it will be tolerated for only so long. Thus, uneven growth will set forces in motion to restore a greater degree of balance, even (in some cases) actions that may thwart the growth process itself."

Rising caste conflict in India arising out of demand for reservations in jobs is an illustration of the tunnel effect. Huge inequality in wealth distribution within the Patidar group in Gujarat has led some of them to demand reservations in government jobs. Tunnel effect was also at play during the Gujjar-Meena clashes in Rajasthan.

In 1968, Shrilal Shukla wrote his great dystopian novel Raag Darbari, in which he describes how the local elite in a fictional village called Shivpalganj stifled every possibility of removing inequities. Raag Darbari offers a useful prism to explain the contemporary rise in inequality and its perverse effects.

Economics Express runs weekly, and features interesting reads from the world of economics and finance.

Comments are welcome at feedback@livemint.com

Subscribe to Mint Newsletters * Enter a valid email * Thank you for subscribing to our newsletter.

Share Via