Potential of the Destitute

Politicians around the world pay unreasonably high attention to economic growth, which in itself is another debate whether we should obsess over such a flawed measure of a government’s success. Evidence reveals that high economic growth helps improve the welfare outcomes of the individuals in a country, but this positive impact of growth might be dampened if there is high income inequality. Income inequality and economic growth are thought to have a bidirectional relationship; we can find literature on both the directions of relationship. The first is growth to inequality, and the second is inequality to growth. The literature on growth to inequality is ambiguous; one school of thought argues that inequality is a necessary evil that drives growth as the capitalists save a major proportion of their income, and invest it where the incremental profit is high which further fuels growth. The other school of thought argues that income inequality is not an outcome of economic growth as there have been various examples of countries that have been able to grow at a fast pace without having a considerable rise in income inequality. On the other hand, the empirical literature on inequality to growth is clear, and most evidence emphasizes that rising inequality is negatively related to economic growth. An International Monetary Fund research found that increasing the share of income of the poor and middle class increases growth, while a rise in the income of the top 20% lowers growth. 

Even though global income has risen, there are still more than 1.2 billion people living in extreme poverty. The richest 1% of the people own almost 40% of the global assets, while the poor at the bottom own almost 1%. Despite a decline in maternal mortality, women living in rural areas are thrice more likely to die while giving birth than women living in urban areas. Similarly, children living in rural areas are 30% less likely to complete primary education than those in urban areas. According to UNDP (2012), 87% of the differences in infant mortality rates between the richest and the lowest quintiles could be explained by just income inequality. According to Oxfam, India could have eliminated extreme poverty by 2019, if it had reduced its income inequality by 36% only which would have accelerated its economic growth and improved the welfare measures also. 

These stats show that poverty reduction and income redistribution from the rich to the poor could help improve the economic growth and increase the levels of human development in a country, but the question that arises here is: how does this redistribution process help achieve these goals? Various mechanisms could help us answer this question; major mechanisms include the fertility differential mechanism, sociopolitical unrest, imperfect credit markets and political economy mechanism. 

Fertility differential is a function of the income distribution; poor people are more likely to have a greater number of children because their opportunity cost of having children is low while rich people are more likely to have fewer children because their opportunity cost associated with childbearing is high; hence, high-income inequality is associated with a large fertility differential. The poor also tend to invest less in the education of their children as they cannot afford it while the rich can afford to invest in education and if we proxy human capital using education, then the future stock of human capital of a nation would be the weighted average of the education of the present-day children. If the fertility differential between the rich and the poor is high then in future there would be more weight associated with the children having less education because of their higher proportion in the population which would lower the average human capital in an economy, causing low productivity and economic growth.

On the other hand, increasing income inequality fuels socio-political unrest; there is a rise in aggression and frustration among the poor. When the poor feel that they are not being given their due rights, they engage in crimes and resort to illegal ways to get money which is a direct waste of the resources and capabilities of those individuals who could have been a productive asset for the economy. The poor might also engage in riots, and destroy private and public property which deters investment and disrupts the market activities. The stability of the political institutions might also be undermined; there will be an increased frequency of coups, revolution and violence; hence, the political instability due to these riots, etc. would create uncertainty in the country regarding the laws and rules as they would have a shorter expected duration which would also deter investment. In addition to that violence, rising inequality erodes the trust of the citizens in the institutions of the country and weakens the social cohesion, all of which hampers the progress of an economy.

Another channel which explains the negative impact of rising income inequality on growth is the imperfect credit- market mechanism. Imperfect credit markets are those in which there is information asymmetry; one party has more information than the other, and the legal institutions are also limited in their power. For example, law-enforcement might be imperfect as bankruptcy law could protect the assets of a debtor. If investment in human capital is to be financed through credit, then in imperfect markets where information is costly, only those people would be able to get access to credits that have assets to be used as collateral. At a certain level of income per capita, there would be limited access to credit especially for the poor households which would limit their chances of investing in human capital, and human capital earns high rates of return for the economy through an increase in the skill-set of the labour, but when large wealth and income inequality would persist people from the lower-income group would not be able to invest in human capital which would lower the skill-set of a nation and its economic growth.

It is suggested in various research papers that if the median voter income in an economy is less than the mean income, then the voting process favours redistribution of income from the rich to the poor. The greater the inequality the greater the amount of redistribution requirement, the redistribution could be through welfare payments, public education and healthcare programs. But the rich are more powerful in a system that has high inequality, these rich people may use the system for their benefit. They may buy the votes of the legislators and prevent these redistributive policies. The energies of these people would be spent in an unproductive manner, and the economic resources would be consumed to stop redistributive policies which would also give rise to more corruption. Hence, income inequality can adversely impact economic growth even if no redistribution of income occurs. Empirical research also finds that as the distance of the median voter from the average wealth in the country increases due to income inequality, the individual favours a higher tax rate. Higher tax rates give rise to economic inefficiencies, and also tend to reduce investments in an economy. Hence, the political economy channel could hamper the economic growth process through lobbying activities and higher tax rates.

While exploring these channels one could realize that high income inequality might be the link that explains the difference in the welfare outcomes across countries with the same income levels, and the sustainability of economic growth in countries with more equal distribution of income. Analyzing the fertility differential mechanism for Pakistan we find that the fertility differential between the rich and the poor is very high in Pakistan while history itself stands witness to the socio-political unrest in the country. The financial literacy rates in the country are also low and the access to credit for the poor is very limited which, in turn, limits their access to education, hence limiting the economy’s potential of human capital growth. As far as the political economy mechanism is concerned, the politicians’ apathy to the daily struggles of a common man is evident in high taxes being imposed to fulfil the debt obligations of the country. 

We bear witness to growth without development in Pakistan; GDP per capita has risen for Pakistan from US$83.38 US$1,284 since 1960 to 2019, but the social development indicators are the worst in the region, Pakistan was positioned 154th out of 189 countries on UN’s HDI in 2020 — the HDI reflects performance on the majority of the measures of human welfare. Growth for Pakistan has been unsustainable, and follows a stop-go cycle; its unsustainability might be blamed upon income inequality, as income inequality deters investment through various channels mentioned previously and Pakistan has always had a lower investment rate than the rate required to achieve the optimal amount of capital accumulation. Hence, it is the destitute who have the potential to help us navigate the difficult path towards economic prosperity.  One might, instead of perplexing the politicians with jargon, resort to using stats to highlight the potential of the destitute and how improving their economic conditions would help us grow collectively.   

The writer is in the final year of her BSc (Hons) at the Lahore School of Economics, majoring in Economics and Finance.