Relationship Between The Income Inequality And Development Economics Essay

Income inequality within the majority of developing countries has been rising – in some cases, sharply over the years. Various studies such as; (Cornia 2004, Birdsall 2005, Van der Hoeven 2008) concluded that the last two decades have witnessed a widespread and symmetric rise in within-country inequality in developing countries. This persistence rise in income inequality in many developing economies has made it difficult to reduce poverty and promote economic development. There is a growing consensus that excessive inequality can stunt growth itself (Birdsall 2005). The effects are not only economic; there are also political and social consequences of income inequality. Alesina and Peroti (1996) found that high income inequality can also have undesirable political and social consequences. “Where the institutions of government are weak, inequality exacerbates the problem of creating and maintaining accountable government, increasing the probability of economic and social policies that inhibit growth, and poverty reduction and where social institutions are fragile, inequality further discourages the civic and social life that undergirds collective decision-making which is necessary to the functioning of healthy societies” (Birdsall 2005). Put differently, high inequality is associated with higher crime rates, lower life expectancy and conflicts. Also According to Alexis de Tocqueville ([1835-40] 1961, 302), “Almost all of the revolutions which have changed the aspect of nations have been made to consolidate or to destroy social inequality.”

Making generalizations about the causes of income inequality in developing countries must be done with care. The situation in each nation depends on country-specific circumstances and policy mixes. Yet, it is clear that there are some common factors behind the widespread surges in income inequality around the world. It has been noted that a worsening situation in the ‘traditional’ causes of inequality such as land concentration, urban bias and inequality in education has not caused the recent increases in inequality in developing countries, although these factors still do explain most of the variation in cross-country inequality (Cornia 1994). Rather, the evidence points to ‘new’ causes associated with neo-liberal policy reforms that have increasingly been adopted in transitional and developing countries (Cornia and Court 2001, Birdsall 2005, Van der Hoeven 2008, UNRISD 2010). The most important of such policy reforms are macro-economic reforms including, inter alia, financial and labour market liberalization, privatization, and reforms in the tax and transfer systems. Despite the numerous studies on income inequality, the extent to which it affects development hasn’t yet been fully explored.

Uganda among other developing countries has been experiencing a gradual and sustained economic growth and poverty reduction over the years. Currently the country is growing at a rate of 6.4% (CIA 2011). The benefits of growth, however, are not being distributed equally. In all regions of the country, income and consumption are growing at a slower rate in rural areas than in their urban counterparts (Ssewanyana N. S. et al, 2009). Moreover, both rural and urban areas are experiencing growing inequality between the top and bottom income quintiles (Appleton & Ssewanyana, 2003). According to Valentine (1993), inequality increases as the incomes of the asset-rich rise at a faster rate than those of the asset-poor. Some policies such as privatisation and financial liberalization may contribute to concentrate the ownership of resources among the few hence affecting the distribution of present and future income which then might affect the development of a country.

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This study therefore will seek to analyse the causes of income inequality and establish its effects on development. Trends in income inequality in Uganda will also be analysed to establish clearly how its increase or decrease has affected the level of the country’s development. This study will also explore the consequences of income inequality to Uganda.

Empirical studies, such as Appleton (2001), and Appleton & Ssewanyana (2003), provide limited policy guidance on how to address the inequality problem in Uganda. The thesis will also look at policy options to curb the rising income inequality levels in Uganda hence fostering development.

Statement of the Problem

In order for Uganda whose economy is experiencing economic growth, to continue on a straight and consistent development path, one of the issues that have to be taken into great consideration is the growing disparity in income distribution. Currently the country is experiencing a high level of income inequality with most of the income being concentrated in the hands of the few. If this state of income inequality continues, the development of the country will be greatly affected. Also this disparity in income could lead to social injustices which would have greater consequences on the economy.

Research Questions

What are the major causes of income inequality in Uganda?

Is there a relationship between income inequality and development?

What consequences does income inequality pose to Uganda?

Scope

The study will look at how income has been distributed in Uganda over the years and the country’s level of development in the same years. It will also look at levels of poverty and GDP as a measure of development. Human development will also be taken into consideration while comparing income distribution and improvements in human development of the country.

Methodology

The study will be based purely on secondary data. It will review journals and books on theories regarding income inequality and development. Statistics from international organisations’ and Government of Uganda’s’ websites will also be reviewed as part of the study. A comparative analysis of income distribution and Uganda’s economic development will be done to assess the relationship between the two variables.

Causes of Income Inequality

This section looks at the causes of income inequality in Uganda. As highlighted in the introduction section, the rate of income inequality in Uganda has been fluctuating over the years although in an increasing manner. According to the World Bank Gini Index (2011), Uganda’s Gini Coefficient was at 44 as of 2009 and rose slightly to 44.3 as of 2011 indicating a rise in income inequality. There is a huge disparity in income distribution in Uganda with a few individuals holding much of the country’s income. The table below shows that as of 2009, 20% of Uganda’s population received half of the country’s income indicating a huge disparity in income distribution. Therefore what could be the explanation of the rising income inequality? In response to this question, I discuss the possible causes of income inequality and how they relate to Uganda’s case.

Table 1: Uganda’s income distribution for the years 2006 and 2009

Indicator

2009

2006

Income share held by fourth 20%

20

20.7

Income share held by highest 10%

36.1

34.1

Income share held by highest 20%

50.7

49.3

Income share held by lowest 10%

2.35

2.59

Income share held by lowest 20%

5.84

6.08

Income share held by second 20%

9.64

9.78

Income share held by third 20%

13.8

14.1

Source: World Bank Database

Over the years, economists and social scientists have been discussing factors that are responsible for the rising incoming inequality both in developing and developed countries. Some of the identified causes are specific to developing countries and have been discussed from various dimensions. These dimensions range from social, economic to the political causes of income inequality.

One of the factors which is familiar with developing and less developed countries and has been associated with rising income inequality is the issue of foreign aid. Developing and less developed countries have been receiving aid since attaining independence yet the question of aid effectiveness is still highly contestable with some studies suggesting that aid hasn’t done much to improve the living standards in such countries. Several studies have been conducted to ascertain the association between foreign aid and income inequality. Some studies such as (Herzer and Nunnenkamp, 2012; Alesina and Dollar, 2000) showed that foreign aid contributes to income inequality. However the extent of foreign aid’s effect on income inequality hasn’t been conclusive yet. Donor countries and organisation have been donating large sums of money to developing countries as aid, one of such countries is Uganda, whose ODA (Official Development Assistance) had reached 1.8 billion in 2010 according to Global Humanitarian Assistance. Despite this figure having risen over the years, some funds which are aimed at improving the well being of the poor actually end up in the hands of a few individuals hence exacerbating the widening income gap in the country.

Foreign aid may lead to income inequality through various mechanisms all of which point in the direction of aid money flowing to a particular group of people in a society. Layton and Nielson (2009) in their study titled Aiding Inequality: The Effect of Foreign Aid on Income Inequality, which included Uganda showed that foreign aid has contributed to increases in income inequality in the developing world. In their analysis (although inconclusive), they found that the effect of foreign aid on income inequality is somewhere between zero and weakly positive. They also found that an increase in aid of 10% would increase inequality by 2.5 points which according to them, is substantially significant given the slow moving nature of income inequality. Their study also showed that foreign aid has an impact on income distribution with it favouring mostly rich individuals. Layton and Nielson identified politics as one of the channels through which foreign aid benefits the rich. This finding is supported by Boone (1996) who stated that “all political systems favour a “high-income political elite” when it comes to income distribution”. In most cases this distribution of income is in favour of private and selfish interests of their supporters who are more likely to be society’s wealthy and prominent individuals. The assumption here is that these individuals will enable them win subsequent elections in office and also contribute to their campaigns. This creates a widening gap in income inequality with the majority of the population who are poor and supposed to benefit from the aid money usually remaining poor while a few individuals’ income increasing. With the increase in income, the rich are able to invest and amass more wealth which can lead to a decade of income inequality unless the government embarks on re-distributive policies.

Ethnic diversity has also been seen as having a linkage with income inequality. According to Meisenberg (2007), ethnic diversity at certain levels leads to large discrepancies in income distribution. In countries whose ethnicity is diverse such as Uganda, political leaders from a particular ethnic group might favour individuals from such groups both in terms of resource allocations and distribution of opportunities. Such is common in African countries especially those that are undemocratic where political leaders tend to divert funds meant for public services to such individuals. Diversion of funds causes a discrepancy in income distribution since one group is preferred over others hence exposing that group to opportunities such as better jobs and government contracts which allows them to have a higher level of income. Also an interplay between ethnic diversity, politics and institutions contribute to a rise in income inequality

Similarly, Milanovic (2003) whose focus was on the political-economy side of the story found that ethnic diversity contributes to income inequality. He found that inequality in African countries is high especially in those countries whose ethnic diversity is high. He added that inequality in such countries is even higher if such countries are undemocratic (This is consistent with Mickiewicz and Gerry (2008) who also discovered that countries introducing sustainable democratic institutions early are characterised by lower inequality), and poor. Millanovic also considers the interplay of ethnic fragmentation, low per capita income and lack of democratic pluralism to be an important determinant of income inequality in Africa.

Given the status of developing countries whose ethnicity is diverse and at the same time being recipients of foreign aid, diversion of aid to a particular ethnicity is likely to be much higher. This is likely to contribute to higher income discrepancies especially since the political leaders might divert most of this money to individuals from their ethnicity. Apart from distributing money to people from a particular ethnicity, they will also use the money to directly improve infrastructure in the areas where members of their ethnic group reside. This will ensure that individuals from such areas have better access to certain services, such as; education and health services including better paying jobs; which can guarantee an increase in their income. With only a section of the society being exposed to better services and facilities, the income gap is bound to widen.

Another factor which has been cited as a cause of income inequality is Corruption. This is a channel, through which public funds get diverted for private interests. With public funds being siphoned by certain individuals, a country is bound to have a few wealthy individuals while the majority of the population remain poor hence a wide income gap. According to an IMF working paper (May 1998) titled Does Corruption affect Income Inequality and Poverty?, high and rising corruption increases income inequality and poverty by reducing economic growth, the progressivity of the tax system, the level and effectiveness of social spending, and the formation of human capital, and by perpetuating an unequal distribution of asset ownership and unequal access to education. The World of Work report (2008) also suggested a positive relationship between inequality and corruption.

According to the First Annual Report on Corruption in Uganda (2010) by the Inspectorate General of Government, corruption remains a hindrance to development and a barrier to poverty reduction in Uganda. The World Bank estimates show that Uganda loses $300 million (Ugx 500 billion) annually to corruption. Likewise, the 2011 Transparency International Perception Index gives Uganda a decimal score of 2.4 on scale of 10, placing it as the 143rd out of the world’s 183 countries. Currently with the discovery of oil and the prospects of oil revenue in the relatively near future, Uganda is bound to face major challenges with regards to corruption. With evidence showing that corruption accelerates income inequality, then the income gap in Uganda is also bound to widen.

Education levels in a country also have an effect on how income is distributed; with those individuals whose level of education is low getting less income compared to their highly educated counterparts. In an economy characterised by globalisation and demand for skilled labour, the less educated tend to receive little pay compared to the highly educated; this exerts income in-equalizing effects. A study by Gregorio and Lee (2002) supports this argument. They found that the level of education of the population in a country has an effect on income distribution. Their study also found that equal distribution of education and higher attainment of education; both have equalizing effects on income distribution.

Education levels in Uganda are also unevenly distributed. According to Mugendawala (2012), the Ugandan education system still manifests inequities based on sex, location and income quintile. He further mentioned that the inequities also explain the income gaps in Uganda. The difference in education attainment is also an explanation for the variation in income distribution and inequality levels between urban and rural areas in the country. Mugendawala found that education disparities between rural and urban areas also caused income disparities between the two. Also in terms of socio-economic classes, he found that there is more inequality amongst the poor while more equality prevails among the rich. This could be due to the ability of the rich to afford better education services for their children unlike the poor who are in rural areas with access to free government education whose quality is questionable. With this disparity in access to education, a vicious cycle might be created where the poor remain less educated hence receiving little income while the rich attaining higher education and eventually accessing well paying jobs. This disparity will most likely maintain or accelerate the disparity in incomes over time.

Other studies which share the above argument include; Odedokun and Round (2001) who found that a high level of illiteracy (and, hence, low level of skilled workers) exerts in-equalizing effects. Also Ssewanyana et al. (2004) showed that education is as a key factor in explaining most of the observed variations in income in Uganda. In this case, education was seen as a means through which policies that seek to make education accessible could lead to a reduction in income inequality over time. Mickiewicz and Gerry (2008) found that education fosters equality. Other scholars who found that education has income equalizing effects over time included (Morely, 1995; Alderson and Nielsen, 1995; Lee, 2005). According to these studies, the equalizing effect occurs because education allows the poor to escape poverty and enter into jobs that pay better wages.

A number of economic factors have also been found to contribute to income disparities; one of such factors is globalisation. Globalisation through a number of variables has also been identified as a determinant of income inequality. Some studies which particularly looked at the effects of trade liberalisation on inequality showed that it might have an income gap widening effect. Meschi and Vivarelli (2009) found total aggregate trade flows to be weakly related to income inequality. However, once total trade flows were disaggregated according to their areas of origin/destination, they found that trade with high income countries worsens income distribution in developing countries, both through imports and exports. Still with regards to trade, Angeles-Castro (2008), found that manufactured exports reduce inequality, whereas the expansion of primary exports does not have any positive effects on income distribution in any way. As of 2011, Uganda manufactured export was 22.9% as a percentage of total merchandise exports while export of primary products such as raw material and food accounted for 74%. With developing countries such as Uganda, whose major exports are primary products, the above argument, is bound to hold.

Similarly, Breen and García-Peñalosa (2005), showed that greater volatility (which they measured by the standard deviation of the rate of growth of output), is associated with a higher degree of income inequality. Breen and García-Peñalosa (2005) also examined the effect of volatility on income shares of various quintiles and found that greater volatility results in redistribution from middle income groups (second and third quintiles) to the top-income group (fifth quintile). They also mentioned that an interplay of factors that previous research has shown as determinants of income inequality such as the degree of dualism and the extent of civil liberties together with volatility prove to have a robust impact on the distribution of income.

Anyanwu (2011) in his study of International Remittances and Income Inequality in Africa found that, international migrant remittances have a significant positive impact on income inequality. After instrumenting for the possible endogeneity of remittances, he found that “a 10 percent increase in remittances as a percentage of GDP will lead, on average, to a 0.013 percent increase in income inequality”. Remittances are also contributing greatly to Uganda’s economy. According to a Bank of Uganda Report titled International Remittances 2008, remittances increased from US$406 million in the year 2006 to US$732 million in 2008. Income inequality in Uganda could then be explained as being fuelled by international remittances from.

In the same study, Anyanwu (2011) found inflation rate as one of the strongest factors influencing income inequality in Africa. This can be substantiated by findings from several works (Bulir, 2001; Easterly and Fischer, 2001) among others which presented evidence correlating high rates of inflation with income inequality and/or poverty.

Table 2: Summary of reviewed literature on causes of income inequality

Cause

Papers

Measured variable

Effect on Income Inequality

Possible problems

Foreign Aid

The effect of foreign aid on income inequality: Evidence from panel cointegration Herzer and Nunnenkamp, (2012)

Foreign Aid and Income Inequality

Direct Effect: Foreign Aid exerts an income inequality increasing effect

Measures aid using Net Aid Transfers (NAT) which is problematic for aid research and donor evaluation

Aiding Inequality: The Effect of Foreign Aid on Income Inequality, Layton and Nielson, (2009)

Foreign Aid and Income Inequality

Direct Effect: Foreign aid has a positive effect on income inequality

Findings inconclusive

Politics and the Effectiveness of Foreign Aid, Boone (1996)

Foreign aid and politics

Indirect Effect on income inequality: Politics influences allocation of foreign aid.

Effects on income inequality not measured

Ethnic Diversity

Is Inequality in Africa Really Different, Millanovic (2003)

Income Inequality and Politics

Direct Effect: High ethnic fractionalisation results to high income inequality

Findings not satisfactory due to inability to test for ethnicity conclusively

Corruption

IMF working paper (May 1998): Does Corruption affect Income Inequality and Poverty?

Corruption, Income Inequality and poverty

Direct Effect: Increase in corruption increases income inequality

Education

Education and Income Inequality: New Evidence from cross country data. Gregorio and Lee (20020

Education and Income Inequality

Education has equalizing effects on income inequality

Didn’t discuss the issues of reverse causation between variables

International Remittances

International Remittances and Income Inequality in Africa, Anyanwu (2011)

International Remittances and income inequality

Direct Effect: International Remittance increases income inequality

Inflation

International Remittances and Income Inequality in Africa, Anyanwu (2011)

International Remittances and income inequality

Indirect Effect; International Remittances increase inflation which fuels income inequality

Relationship between Income Inequality and Development

This section looks at the relationship between income inequality and development. In a bid to ascertain the nature of the relationship, it discusses mechanisms through which income inequality affects or might affect development.

Measuring the development of a country can be done using a number of economic and social variables. Such variables include GDP, GDP per capita, life expectancy, and literacy rate among other. The UNDP also developed the Human Development Index which is a compound indicator that uses the above variables to determine the level of human development of a country. In determining the relationship between income inequality and development, the above variables for measuring development are taken into consideration.

Studies on the relationship between income inequality and development originated from the groundbreaking research by Simon Kuznets where he studied economic growth and income inequality and came up with a hypothesis that is currently regarded as the Kuznets hypothesis or the inverted U shaped hypothesis. The Kuznets hypothesis formed the basis from which most preceding studies analysed the relationship between income inequality and growth. Kuznets (1955) postulated that in the early stages of development, both a country’s economic growth and its inequality increase. As countries grow and develop, the income gap between the rich and the poor should decrease. Indeed, according to Kuznets, there is a gradual shift from a low-inequality, low-income, agricultural economy, towards a high-income and medium-inequality economy characterized by industrial production. This shift would lead to the inverted U-shaped relationship between real GDP per capita and inequality. Kuznets argues that in the initial period, agriculture represents the majority of a country’s economy, which is also characterized by low levels of inequality. According to Kuznets, a shift towards the secondary and the tertiary sectors has in essence two effects in the short run. The first effect is that it accelerates economic growth leading to higher levels of GDP per capita. The second and most dramatic effect is that this increases the level of inequality. Consequently, in the initial stages of economic development, the level of GDP per capita and inequality are positively correlated. As countries develop they shift more and more resources from agriculture to industry (and later to services), and this will in time decrease the income gap between the industry and agriculture simply because there will be more and more workers working in the industrial sector. Consequently, the long run relationship between inequality and GDP per capita is negative. The Kuznets hypothesis therefore showed causality from development to income inequality.

Although several investigations have found some support for the Kuznets hypothesis (e.g. Oswang, (1994); Milanovic, (1994); Fishlow, (1995) as well as Ali, (1998), some studies such as Ahluwalia, (1976); Bruno, Ravallion and Squire, (1995) and UNCTAD, (1997) however, found no such relationship between growth rates and income inequality. Deininger and Squire (1996) also did not find any evidence for the existence of such (Kuznets Relationship) a relationship between development and inequality. This shows that not all economies follow the inverted U shaped hypothesis during their development path.

Apart from Kuznets, several scholars have shown the relationship between income inequality and development mostly through a number of social variables such as; health and education and also through economic variables such as; taxation, credit markets and investment. The political mechanism has also been emphasised as one through which income inequality is associated with development. Most literature on the subject shows evidence of income inequality being detrimental to development.

The World Bank’s World Development Report (2006) says in its introduction that there is considerable evidence that equity is also instrumental to the pursuit of long-term prosperity in aggregate terms for society as a whole.” This goes a long way in saying that income inequality is detrimental to the welfare of a society.

Galor and Zeira (1993) found that inequality affects growth through credit market imperfections for financing investment in education. In this case, their finding was in regards to the poor who face borrowing constraints in financing education and hence in accumulating human capital. This has further effects on investment by the poor since they are forced to forego human capital even if the investments have a high rate of return. Therefore, the greater the degree of wealth and income inequality, the greater the number of people for which the constraints would be binding and, therefore, the lower is the stock of human capital in the economy. Economic growth is presumed to be enhanced through human capital accumulation. Therefore with less or no human capital accumulation, growth tends to be affected. Low levels of human capital formation are associated with low levels of human development which leads to low levels of development especially among the poor. However, the effect of this channel is weaker if education is being financed by the state of if it’s made compulsory; for example, in a country like Uganda where primary and secondary school education is being financed by the government. The poor though would still find challenges in financing higher education. With education being seen as a mechanism through which the poor can escape poverty, it’s limited accessibility by the poor has huge impact on the development of the country.

Perotti (1996) after carefully examining the various channels through which income inequality may affect economic growth provided support for the Galor-Zeira hypothesis showing that inequality is indeed associated with lower level of human capital formation, and lower human capital formation is associated with lower levels of economic growth.

Further support for the education channel is advanced by Deninger and Squire (1998) who utilized the distribution of land as a proxy for the distribution of assets and found that initial inequality has a significant adverse effect on education and economic growth. Moreover, consistent with the theories advanced by the credit market imperfections approach – that these imperfections ought to have a larger effect on the investment decisions of individuals with lower income – they find that initial inequality primarily hurts the poor.

From a social perspective, various studies have shown that social political unrest hurts development. Countries that have experienced such unrests provide evidence of the extent to which their development is affected. Alesina and Rodrik (1993) after studying a set of 70 countries found quite solidly that income inequality increases socio-political instability which in turn decreases investment. Subsequently, Alesina and Perotti (1996) linked inequality to social political unrest where they showed the likely negative effects of high inequality on economic growth through increased crime, social unrest and political instability. Despite its effect on growth, social political unrest also has an effect on development, first since all development activities will be halted in areas experiencing the unrest. This will affect various social variables such as education, health and access to basic services. These unrests tend to cause death and destruction of property in countries where they happen. Also institutions in such countries especially when the unrests are severe tend not to function optimally. A country’s development therefore either gets retarded or remains stagnant as a result of the unrests, even the economy ceases to grow. Foreign Direct Investment to such countries gets halted since investors are scared of investing in countries that are unruly. All these factors combined have far reaching dangers on development.

Alesina and Rodrik (1994) argued that inequality affects the economy through endogenous fiscal policy or political economy. They argue that a high level of inequality leads to redistributive fiscal policy in the form of higher government expenditure and distortionary taxation which, in turn, are believed to retard growth. They formed the median voter paradigm which is based on the assumption that political power (e.g. one-person-one-vote in a democratic settin