It is a very common phrase in today’s capitalist society to say that "the rich keep getting richer". There is also a common phrase in Mandarin that says "Money grows money". What these two phrases imply is that the income of the more wealthy individuals grows at a much faster rate than the less wealthy individuals. This also means that the income gap between and the rich and the poor is getting larger. Now socially this Income Inequality certainly does not sound like a good thing. But let us first understand whether or not this phenomenon exists before even thinking about social implications.

There are broadly three types of income inequalities that are heavily discussed in Economics Theory. Firstly, there is income inequality between countries which is measured by the difference in average incomes or the famous GDP per capita. Secondly there is income inequality within a country, which is measured by Lorenz curves and Gini coefficients. Lastly, there is global inequality where the poor people of the world are compared to the rich people on a global basis.

Here we are looking at the second form of income inequality which we often compare against economic growth. In particular, we want to understand the movement of income inequality with economic growth. I will take two approaches. The first is to explain the Kuznet’s Inverted U Hypothesis and the second would be to use general Economic Theory. With these two approaches, I hope to convince you that the rich do get richer.

Simon Kuznet, a Russian borned Professor from Havard University and 1971 Nobel Laureate in Economics made one of the most important contribution to the study of income inequality and economic growth in his 1955 paper "Economic Growth and Income Inequality. In the paper he formulated what is known as the Kuznet’s Inverted U Hypothesis. And as seen in the diagram below, Kuznet postulated that as an economy experiences economic growth, it will first experience increasing income inequality which would eventually correct itself as economic growth continues to increase.

Kuznet attributes the initial increase in income inequality to a shift from one sector to another. This is usually viewed in the context of a shift from the rural or agricultural sector to the urban or industrial sector. The urban sector offers on average a much higher income to its workers and this causes the population to move from the rural to urban sector. This shift to a higher income causes income inequality and is what Kuznet calls "compositional effects".

This happens until the threshold level is reached. And the U turn point is achieved and the decrease in income inequality starts to occur. According to Kuznet, there are two effects that cause this U turn.

The first is compositional effect. This causes the rate of average income disparity over time to be reduced as a result of dwindling populations with total income levels constant. This effectively raises the average rural income. So as the rural population dwindles, and incomes increase as a result of a smaller pool of labour, the overall average tends to go up. This higher average rural income reduces the income inequality between that of urban income.

The second is what he calls institutional transformations. This is due to the intervention of institutions within the political and sociological framework which have sought to balance the differences between the rural and urban sector as well as adopt measure and incentive programmes to revitalize and stimulate growth in the rural sector. This can come in the form of land reform, green revolution, adaptation of agricultural technology as well as farm subsidies.

As a result of Kuznet’s Inverted U Hypothesis, the paradigm of income inequality being bad for economic growth was changed. In fact the effect was just the opposite with an increased in income inequality being the herald of economic growth to come according to Kuznet’s Hypothesis.

According to Robinson (1976), the clear formulation, broad theoretical fit, and intuitive appeal of Kuznet’s arguments lead to a growing popularity of the inverted U curve hypothesis across the social sciences and international policymaking communities until it came to "acquire…. the force of economic law".

And this was a hypothesis that Governments intuitively loved as this was a wonderful explanation or excuse for the phenomenon of rising income inequality, which otherwise would have been something that they would have difficulty explaining.

Kuznet’s hypothesis came under much scrutiny in the 1980s and was eventually unravel in the 1990s as more inequality data sought to disprove the hypothesis.

In particular, there are three examples that stand out :

1) In East Asia where economic growth happened without income inequality.

2) In Latin America where there was deepening income inequality as a result of compositional effects but no economic growth.

3) And finally in the Developed World where the U turn according to Kuznet did not happened. In fact income inequality continued to worsen.

With such overwhelming evidence, it is easy to just write off Kuznet’s hypothesis as a nice idealization but a failure when pitted against the rigours of the real world. Among the criticisms,

However, Koreniewicz and Moran (2005) buck the trend by stating that "Kuznets himself, however, might not have been surprised by such discrepancies in the actual patterns of change in growth and inequality. He openly warned that appropriate longitudinal data to test his hypothesis were not available at the time." They also pointed out that "Kuznets openly acknowledged that his hypothesis was constructed on the basis of sparse empirical data, simplistic mathematical extrapolation, and pure theoretical speculation. Such caveats were rapidly disguised as the hypothesis became coated in the optimistic certitude that generally accompanies the construction of developmental panaceas".

Koreniewicz and Moran (2005) then go on to suggest that "a more productive theoretical framework can be formulated by recasting Kuznets’s original contribution, altering its reliance on a modernization framework, to construct instead (in fact following Kuznets’s own spirit) a historically grounded interpretation of the relationship between income inequality and capitalistic growth."

They identified two areas which are the fundamentals in which Kuznet’s hypothesis rests on. The first area was how the compositional effects between two sectors need not be just limited to rural and urban sectors. It can also include new industries like IT and Biotech. The second area is that of the impact of institutions which appear to be playing a larger and larger role in shaping economies and societies today.

The first area ties in with the idea of capitalism of Schumpter (1942), in the idea of being a continuous element of change or creative destruction. (Koreniewicz and Moran (2005)).

Schumpeter (1942)

This form of Creative Destruction is very similar to Kuznet’s compositional effects in that the new sector tends to attract labour from the old sector and that income levels are much higher in the new sector as compared to the old sector. As the old sector is unable to catchup, this results in income inequality. In the US, especially in Silicon Valley, we do see a trend whereby successful startups attract lots of skilled labour.

When looking at the role of institutions, we do see that institutions definitely play a role in maintaining income inequality. The East Asian model seems to be founded on institutions ensuring growth in the rural areas as well to minimize disparities in income inequality or Kuznet’s compositional effects. Also the increasing income inequality in US and UK compared to France, Canada, Japan and Australia has been attributed to the weakening of the labour unions. This further confirms the discussion on role of the institution in maintaining income inequality.

So really, there is still value in Kuznet’s hypothesis and when appropriately recast is still a rather appropriate framework to help one shape one’s understanding of economic growth and income inequality.

I cast my net a little broader to Economic Theories which may aid in the understanding of the relationship between income inequality and economic growth. In particular, the effect that stands out is really that of the rich getting richer. There are three broad arguments that can help discuss this relationship. They are the savings rate argument, political economy argument and credit market imperfection argument.

The savings rate argument very much ties with the Keynesian belief that savings rates increase with the level of income. So with this a richer person would save on average a larger fraction of his or her income than a poorer person. Thus the way to maximize the level of aggregate savings in any economy is to concentrate most of the wealth in the hands of a small group of rich people rather than divide it equally among a larger group of poor people. According to this line of thinking a richer person on the average saves a larger fraction of his or her income than a poorer person.

The higher savings rate leads to a higher investment rate which in turn increases the rate of economic growth. Thus in an economy where income and assets are concentrated in the hands of a rich minority, this economy is likely to experience a higher rate of economic growth. Of course a key assumption is the close relationship between the rate of savings and the level of investment. But looking at the world today, the rich person definitely has a higher level of access to information flows with regards to investment and investment opportunities. Thus this assumption seems reasonable.

The political economy argument lies in the relationship between income redistribution policies and political power. If most of the voters earn less than the mean income, then they will vote for a government that advocates and implements income redistributive policies. These redistributive policies reduce investment incentives and could consequently reduce growth. One example is the recent Indian election where the Labour Party ousted the BJP as a result of gaining the favour of the rural voters.

However it could be these more developed economies that implement more far reaching redistributive policies as seen from the developed countries of Canada, France and Continental Europe. Social welfare and high tax rates are at the heart of this effect, as is the fickle political support of the general population. In Singapore, there is often talk that the government should distribute or tap into its foreign reserves. A weaker government might have caved in to such requests.

The credit market imperfection argument lies in the impact of inequality on the ability of individuals to accumulate human and physical capital, as per Deininger and Squire (1996). The ability of an individual to get access to credit depends on their own levels of assets and incomes. Thus many people who are not as wealthy in unequal societies face borrowing constraints that force them to forego productive investments in human and physical capital.

Therefore, more unequal economies have lower stocks of physical and human capital, and consequently lower per capita income growth rates. However, according to Barro (1999), if larger investments yield disproportionally greater returns than smaller investments, then a concentration of income and assets in the hands of a few individuals would be beneficial for growth.

As mentioned above, the rich are likely to a higher level of access to information flows with regards to investment and investment opportunities. They are thus able to make better investments than the poor. This accentuates the fact that the poor cannot get access to capital and thus cannot make investments beyond their current savings rate. Added to the fact that they have poorer access to information flow with regards to investment and investment opportunities, this makes it even more likely that the rich will get richer.

As for economic growth, it really depends on the relative returns of bigger investment compared to smaller investments. However this is likely to be the case in any economy. As a simple point of illustration, investors in the stock market can invest on their own or invest in funds where fund managers pool monies and experience better returns as a result of having more substantial capital to invest in a more diversified way.

Looking at Approach 1, Kuznet does offer a framework which when meshed with the capitalist society of today that suggest that the rich get richer as a society experiences economic growth. Such income inequality is a unavoidable by-product of capitalism in a sense.

Looking at Approach 2, while these three arguments are dependent on other variables to determine whether or not income inequality and economic growth are directly proportional, it does appear that the reasonable assumptions made on these variables will yield the fact that income inequality is directly proportional to economic growth. Furthermore, the savings rate argument and capital markets imperfection argument suggest that the rich will get richer.

And that leads to the final implication and conclusion of this article. Income inequality and economic growth moving in the same direction. And to answer the question, yes, the rich are getting richer.

Any opinions or comments ?