Why inequality matters and the limits of Gini-coefficient

By: Bikal Dhungel

There are already few articles about inequality in this blog. In one I dealt about the educational causes of inequality and in others the status of inequality around the world, historical causes and so on. This article will focus on why inequality matters for us and what are some of the drawbacks of inequality measurement tool called Gini-coefficient. Why I combine these two issues is because Gini-coefficient can be misleading, it might not represent the real world issues of inequality and biased data might arise which is likely to induce wrong policy.

To answer the question of why inequality matters, it is worth rewinding the origin of inequality quickly. There are basically five reasons of inequality.

1) Luck and the starting point – Luck is one of the most important determining factors of our success in life. If we are lucky and were born to rich parents, our likelihood of having a better life is higher. In the contrary, being born to poor parents or in a poor country, we are less likely to succeed or face difficulties in various aspects of life. For example, studies on inequality have shown that being a woman means earning 21% less in average. Being a Bangladeshi or black African in the US would mean that you will earn 20% less in average. Being a white and male would mean that you will earn more. You don’t determine yourself either you will born to whites or blacks or Asians or South Americans. You luck, which means, you didn’t choose to belong to a particular group will have a huge impact in your life. Hence, it is one of the most important factors that will determine inequality.

2) Childhood and early life opportunities – It is little bit related to the first point but not fully. It is not necessary to belong to a rich family. Also when we are in a country that at least guarantees us education, health and equality of opportunities, this will predict our better future. A child born in a family that is not really rich but can afford these things, children will earn more in the future than those who did not enjoy such privileges. Hence, the inequality between them will rise. This is why, in countries that guarantees all its citizens with free education health and opportunities are more equal than those that could not guarantee.

3) Global Factors – We live in a globalised world. We are more globalised than any time in history. But globalization is not without faults. A detailed account of this has been written on Joseph Stiglitz's book 'Globalisation and its discontents', but also in many others. One major criticism of globalization is, it has accelerated the increase of inequality. Firms internationalize and though it might have increased the total employment rate, inequality has increased. Moreover, the rise of so called 'Emerging Economics' like China, Brazil and South Africa has increased inequality. Here exactly I would like to mention why I incorporated the issue of Gini-coefficient. Though the rise of emerging economies has increased inequality, this might not be necessarily bad for us. But we will discuss this later. Then there is the issue of trade liberalisation and economic liberalization of national economies. This include deregulation, free trade etc which will help some industries to grow but there are also losers of free trade and globalization in practice. Once there are additional firms operating within a country, there will be a shift of labours from agriculture to manufacturing. This will contribute to growing inequality as well because the productivity of manufacturing is higher than in agriculture. Hence, those working in agriculture will be more unequal in comparison to industrial labourers.

4) National Economic Form – The form of an economy determines the degree of inequality. For example, if 20% of the economy consist of financial sector and the remaining agriculture, the income of this 20% will be very unequal than those working on fields. In an agricultural economy where largest portion of the population is subsistence farmers, there will be high equality. Accordingly, we can differentiate how many percentage of the labour force are engaged in manufacturing or agriculture of service sector to predict inequality. Levels of unionization also play a role in it. Trade Unions bargain wages for the workers and avoid their misuse and ensure that the workers get decent wages for living. This will reduce inequality. Countries with strong trade unions are typically more equal than those without.

5) Tax Policy – Though there are capitalist class, labour class, rich and poor and high inequality, an appropriate tax policy can reduce inequality. A more progressive tax policy will reduce inequality because in this system, the more you earn, the more you pay as tax whereas in the regressive system, the richest get tax breaks or pay less. When the richer class is also the lawmaker, they would bring policies that are better for them. One can look at the US. President Bush for example is a business man. There are many senators who are business tycoons. Hence they fight for less government, more tax reliefs for big corporations etc. Consequently, inequality will remain higher. In Western Europe where there is predominantly progressive tax system, the rich subsidises the poor and inequality is lower. So, the form of tax policy in a given country will contribute to the level of inequality.

Having a close look at the origin of inequality, it will now be easier to analyse why inequality matters. First is the economy itself. Imagine a country with a regressive tax system that grants tax reliefs for the ultra-rich and pressures the poor. In such system, tax collection will be lower. With lower tax collection, they can invest less in education, infra-structure, health and other sectors that are fundamental to raise the living standard of the poor. By failing to grant this, the poor will remain poor and the rich will get richer and richer. This will affect the economy in long term as most talents go wasted, a phenomenon we see in a typical developing country. The cause of financial crisis lies in such culture. The ever widening divide between the rich and poor can fuel societal violence which we see in the form of street protests all over the world.

The rich reside in a wealthy neighbourhood whereas the poor will move to the ghettos and go to school there. This causes a social divide and their chances of rising up remains low. The distance between the people will be larger and at last result in even more inequality. From the argument, we can say that inequality impede equity and social mobility in the long run.

Bad health is another consequence of inequality. The book called 'Price of inequality' by Joseph Stiglitz gives a detailed account of the impact on health. Status anxiety has become a normal problem recently which contributed to ill health of people. The famous 'Glasgow Effect' shows this in a creative way. Two parts of the city of Glasgow, one rich and another poor have different health indicators. In rich part, normal citizens live and in poor part, most drug addicts and people on benefits. The rich live 77 years on average whereas the poor less than 65. And then border of these two areas, it can be observed, if you live 10 meters away to another street, you will live 77 years on average and if you live in the poor side, your life expectancy will be well below 70. Inequality will have negative effects on health.

I gave the example of regressive tax form where the rich pay lower taxes. Another consequence of having rich individuals is they can have tremendous influence on policy making. The rich sponsor the political campaign for a certain politician and once he is elected, he will give his best to bring laws that favours the rich. The rich then give their best to avoid redistribution of their wealth. Hence, a just policy is endangered. There will be a democratic deficit when the laws are made by the rich to fulfil their own interests which are against the will of the poor. The matter of justice is itself a problem. When a government is not spending on our children, inequality will be transferred to their generation and further and further. This is simply not right. Inequality is morally wrong.

Evidences from developing countries show some psychological effects of inequality. We live in a society. We compare ourselves with people around us. How much we have achieved, how much money do we have, how many houses we have etc. It is a natural phenomenon to compare ourselves with people. But sometimes we cross the limit to show up. Even we cannot afford a motorcycle, we buy it just to show our neighbours or friends. Having done that, we are ignoring our other needs.

When a person is struggling to fulfill the basic needs of his family but buys a motor cycle will have to abandon things that are necessary. People even fall into debt to finance this. Hence, the presence of inequality will cause negative societal effects.

We live in a world of over 7 billion people with three billion extreme rich , 1 billion extreme poor and the remaining marching towards the rich. The rich and those marching towards them are consuming goods at a rate that earth alone cannot sustain. Researchers say that 4 other Earth is required to keep up with the pace. In addition to this, food waste is a serious problem in richer world, and of course obesity. This caused an immense burden on the planet. Inequality resulted in overconsumption in one part and mal nutrition in the other. Again, ths means a waste of talents of those who are not being able to bring it out.

Looking at some real world example, places where there is very high inequality, namely South Africa, India, few countries of South America, there is high political and economic instability. In order to avoid any violence, they invest heavy amount in security, in police and army. The crime rate ig higher and for the rich, it is difficult to secure their property. As a result, many rich have brought their wealth to safer countries impacting the economy of places where they are from. In such a scenario, both rich and poor are affected. That is why, inequality is bad for everybody.

Now let us move to the measurement of inequality, the Gini-coefficient. Before we start, let us underline again that inequality per se is not bad itself rather the particular kind of inequality that is bad. The Gini-coefficient measures the inequality among and between nations that gives us a framework for analyzing. But our analysis based on Gini should be carefully dealt as there are many issues that Gini doesn’t and cannot answer. So, let us begin with a short introduction of what is Gini co-efficient.

Gini Co-efficient and the limits of it

Gini-coefficient is the measure of income dispersion. It shows the difference between the rich and poor which we call inequality. When you read that a Gini of a country is 0, it means there is perfect equality and a Gini of 1 means highest inequality which implies that one person has all the wealth and another has nothing at all. In some cases, Gini can even go higher than 1, when the income is negative for example. Many organisations use in the form of 0 to 100 as well but it is the same thing when we convert. A Gini index between 0.24 and 0.5 can be regarded as normal and above that, one can say that the society is unequal. The statistical data shows that in fact, African countries are most unequal since most of them have Gini above 0.6. However, it is also important to see before tax and after tax Gini index. A country can have a Gini index of 0.7 before tax (highly unequal) but due to better taxation, the income will be redistributed which will lower the inequality hence moving the Gini index downwards. Statistics shows that Latin America has the highest Gini after tax. It shows that inequality and tax systems are not pro poor there. The graphical representation of Gini could be done with the help of Lorenz Curve which shows how much wealth does the bottom 10% of the population possess, how much the next 20% or 10% or so do. When the curve is 45 degree, it means that bottom 10% possess exactly 10% of wealth, top 20% will possess exactly 20%, meaning everything is equal. Lower the curve goes in the middle, higher the inequality.

Until now, we talked about the Gini-coefficient in general. However, it is necessary to be focused and apply Gini-coefficient in wider area. For example, the Gini-coefficient of education, Gini of Opportunity, Gini of social mobility etc will give us a better picture about where the problem lies. If we only focus on income inequality and try to fight for the cause, we might end up worsening the situation of a country because income inequality can also rise when one person works really hard and the other doesn’t work at all. Bill Gates and Steve Jobs didn’t inherit their wealth, they worked hard for it, they spent lifetime learning and at last made so much money. Though they possess lots of wealth and drove the inequality index higher, this is not necessary a bad thing. We all profit from their idea and innovation.  That is why we should see the Gini of education and opportunity here, either everybody else had the same education levels or opportunity as Gates and Jobs.

Many newspaper articles and some academic journals have based their research on the data represented by Gini-coefficient to explain the issue of inequality. However, careful examination is required. Let us start from developing countries for example South Africa which has among the highest Gini index. While Gini index has risen, the number of poor people has in fact decreased. This is because the rich are getting richer in a higher pace than the poor. Growth of income of rich is growing at the rate of 10% annually whereas the income of poor is growing at the rate of 5%. In this case inequality increased but poverty has decreased. From this fact, we can conclude that Gini is just a relative and not an absolute measure. Moreover, socio economic factors like the population growth, immigration or emigration affects the index as well. Coming back to the relative and absolute numbers, suppose a country has 10 trillion $ wealth and top 10% have 50% of this amount or 5 trillion. Suppose another country which has 10 million $ as total wealth and also the top 10% have 50% of wealth or 5 million. The Gini index of both of them will be same. However, we can easily notice that their wealth is not the same. The Gini index of Afghanistan and Denmark is same but this doesn’t mean that both of them are equal. Denmark is much richer than Afghanistan and when we focus on Gini index of Opportunity or Education, people in Denmark enjoy free education in all levels while people in Afghanistan do not. Similar examples could be seen in countries like Norway where the Gini index is low but wealth is very high.

Mathematically, taking the example of Afghanistan and Denmark, Afghanistan has an unemployment rate of about 50% and the 50% wealth belongs to the remaining 50% of the population. In this case, the calculation of Gini would exactly give a coefficient of 0.5. In Denmark on the other hand top 25% possess 75% of wealth and lowest 75% people possess only 25% of the wealth. Using the formula to calculate Gini index, in this case, Denmark will also have the Gini index of 0.5. So, is it the same? Absolutely not. I mentioned the effect of population growth above. Population growth either by birth or by immigration will affect inequality. Immigrants either come with lots of wealth or very little wealth to work, both will affect Gini index. For example the international students come to Germany, bring their own money to pay for living cost or live in a subsistence level and the inequality within Germany will rise. However, once they finish their studies and enter the job market with above average salary, the Gini will approach to the level it was before their arrival. Calculating the Gini across ages gives us a picture about the inequality of a country but it is normal that people are relatively poor in their twenties when they are still studying or participating in vocational trainings but get slowly richer once they enter the job market. A country with lots of young people, like the developing countries these days will show a high Gini index than a country that has an ageing society like Japan and Western Europe. Which one is good, depends on your analysis. In the same case, when these young people find no job and still get poorer in the long term, Gini falls further. Finally, more than half of   developing countries economy is regarded as informal. There is no monetary value of goods produced, the jobs done in agriculture are not really regarded as jobs which makes difficult to calculate their income and hence the inequality level. A household where the husband goes to work, wife works in the household will have a Gini index of 0.5 but that they share the income equally cannot be taken into consideration and will bias our analysis of inequality measure. Informal economy is hard to measure even in developed countries because there is no data. So, the inequality measures cannot be fully accurate.

Considering all the above mentioned facts, it becomes clear that Gini-coefficient cannot and should not be used as a measure to analyse the inequality within a country. It can be used to gain a quick overlook but the uses of this should be carefully examined before making any assumptions. However, the issue of inequality is a major concern of today that will engage us intensively in the coming decades. The article started with the origin of inequality, explained why inequality matters or why it is an important topic and why it is better to have a just society with fair opportunity for everybody and finally mentioned the limits of the most important inequality measurement tool. I would like to repeat that inequality matters but we should be careful with studying it. The wrong use of instrument will cause fraudulent policy and we all are worse off by this. Hence, to avoid this catastrophe, we need intelligent tools.