The Dynamics Behind Income Inequality

However, inequality measures by themselves say little about fairness. Inequality could be perfectly fair if the rich were rich because they had studied diligently, worked hard, invested wisely and provided valuable services to their community, while the poor were poor because they were lazy, selfish or dishonest.

Most often, however, income levels have little to do with effort and contributions to society. Income levels and living standards of most people in Latin America today were to a large extent determined even before they were born, by the socio-economic status of their parents. Rich parents could give their children good quality education and intellectual stimulation and introduce them to other rich people for business and marriage. In contrast, children of poor parents were stuck with public education, which often was so bad that they opted out even before finishing primary school, thus severely limiting future income generating capacity.

The importance of family background varies widely between countries, though. Chile, for example, has very high levels of inequality, but family background is not very important in explaining this inequality. This means that social mobility in Chile is high, especially compared to countries like Guatemala, Brazil, Bolivia, Ecuador and Nicaragua (see Figure 1).

Figure 1: Social Mobility Index based on teenagers (13 – 19 years), late 1990s.

Source: (2) 3 1.

High inequality is unfair and bad for economic development if it is combined with low levels of social mobility. In this case there is a large gap between poor and rich, and it is very difficult to cross that gap. The low probabilities of successfully crossing over from poor to rich, means that most poor people don't even bother to try. They don't feel it is worth investing in the education of their children, because the chances of them getting a well-paying job would still be slim, and they don't feel it is worth working hard, saving and investing since it makes little difference in the end. Similarly, the rich kids have little incentive to study and work hard, as they were born rich, and their parents have the connections to secure them a well-paying job even with only a modest effort. The returns to effort are small in this set-up, which obviously discourages effort, and thus economic growth.

But if high levels of inequality are combined with high levels of social mobility, it is a completely different story. In this case there is still a large gap between rich and poor, but it is easier to cross the gap (in both directions). This implies large returns to effort. A poor family which makes the sacrifice to move to the city and help the children obtain a decent education, can expect their off-springs to earn life-time incomes 5-10 times higher than if they had stayed in a rural village. Rich kids would also have to study seriously and work hard, as they would have to compete fairly with a lot of highly motivated people of poorer backgrounds.

A country where everybody has strong incentives to work hard and invest in higher future incomes is likely to grow much faster than a country where nobody has incentives to work hard or invest. In turn, a country which is growing and changing rapidly, is likely to have higher levels of social mobility, as existing strong industries and businesses more quickly become obsolete and have to give way for smaller, cutting edge industries and firms. This means that a country can enter a virtuous circle of high social mobility and high growth, or it can get stuck in a vicious circle of low growth and low social mobility (3) ².

Figure 2 indicates that Guatemala, Nicaragua, Bolivia, Ecuador, and several other poor Latin American countries may indeed be stuck in a vicious circle of low growth and low social mobility, while Argentina, Chile and Uruguay may have entered a virtuous circle.

Figure 2: Social Mobility and economic development, late 1990s.

Source: (2) 3 1. Note: Data from Argentina and Uruguay are from urban areas only.

In situations of high social mobility, low inequality may actually be worse than high inequality, as the former situation limits the returns to effort. Just as in the situation with low social mobility, outcomes have little to do with effort, which discourages effort and thus growth.

In summary, the dynamics behind inequality are much more important than inequality in itself. Governments should strive to secure equality of opportunity (high social mobility) rather than equality of outcomes. They should secure level playing fields, high returns to socially beneficial activities, and punishment for socially damaging activities, such as crime and corruption.

Do you know of any ways or examples to increase social mobility while decreasing inequality? Leave a reply below.

(*) Director, Institute for Advanced Development Studies, La Paz, Bolivia. The author happily receives comments at the following e-mail: landersen@inesad.edu.bo.

(1) See the WIDER World Income Inequality Database ⁴.
(2) Andersen, Lykke E. (2003) "Social Mobility in Latin America: Links with Adolescent Schooling" in Duryea, Suzanne, Alejandra Cox Edwards & Manuelita Ureta (eds.) Critical Decisions at a Critical Age: Adolescents and Young Adults in Latin America. Washington D.C.: Inter-American Development Bank. Chapter 6, pp. 219-247.
(3) See, for example, Raut, L.K. (1996) "Signalling Equilibrium, Intergenerational Mobility and Long-

1. #footnote
2. #footnote
3. #footnote
4. http://www.wider.unu.edu/wiid/wiid.htm