Republic of Poland and the IMF
Inequality, Transfers, and Growth in Transition
Michael P. Keane and Eswar S. Prasad
Poland is one of the great success stories of transition. During the first decade of transition, it achieved high rates of GDP growth without a significant increase in income inequality. Poland's success can be attributed to its early stabilization program, the strength of its subsequent market-oriented reforms, and generous social programs.
It is well known that in most of the countries of Eastern Europe and the former Soviet Union making the shift from central planning to market economies, income inequality increased substantially during the first decade of transition. At the same time, many of these countries have experienced poor growth performance, with current GDP still far below pretransition levels. In Russia, for example, standard measures of income inequality have increased by roughly 75 percent since 1991, while GDP is less than two-thirds of its 1991 level. The combination of lower average income and greater inequality has led to truly dramatic increases in poverty in Russia and many other transition economies.
Poland's transition experience
Conventional wisdom suggests that the pattern of sharply rising inequality has been nearly universal in the transition economies—with the differences being only in degree. But our research shows that Poland's experience is a striking contrast to this pattern. The transition in Poland began with the so-called big bang reform of August 1989-January 1990. Using detailed household-level data from the Polish Household Budget Survey (HBS), we find that, after a brief spike in 1989, income inequality actually fell slightly below pretransition levels during 1990-92. After that, inequality began to increase only gradually, rising just slightly above pretransition levels by 1997. This pattern is evident in the evolution of the Gini coefficient for income—the most commonly used summary measure of inequality (see Chart 1). The Gini coefficient ranges from 0, if income is completely equal, to near 1, if almost all income is in the hands of a few individuals. Thus, the higher the value of this coefficient, the more unequal the distribution of income. Overall, inequality in Poland during the transition appears to have increased quite modestly—considerably less, for example, than it increased in industrial economies such as the United States and the United Kingdom during the 1980s.
However, Poland did experience a marked increase in labor earnings inequality. As in other transition economies, the returns to education increased, and labor earnings inequality, which had been artificially held down during communist rule, was allowed to rise. In particular, the wage premiums for workers with college and high school degrees (relative to workers with only a primary school degree) almost doubled from 1989 to 1996 (see Chart 2).
Poland is also the only transition economy that has experienced substantial growth: real GDP was 28 percent higher in 1999 than in 1989. In contrast, only a few other countries (including Albania, the Czech Republic, Hungary, the Slovak Republic, and Slovenia) managed even to keep GDP to within a few percent (above or below) of pretransition levels. This raises some important questions. What did Poland do right? Why did overall income inequality not increase despite the sharp increase in earnings inequality? As we argue below, the answers to these questions are closely related.
What Poland did right
Conditions in Poland were far from ideal at the start of the transition process; among other problems, there was a monetary overhang (an excess accumulation of savings) and a sizable fiscal deficit. However, Poland instituted a strong stabilization program very early on and has received relatively high marks for the extent of its subsequent market-oriented reforms, notably from the European Bank for Reconstruction and Development (EBRD). The EBRD's annual Transition Report uses 10 indicators to measure countries' progress in many areas of reform, including enterprise privatization and reform; price and trade liberalization; and establishment of the rule of law, property rights, and well-functioning financial markets. Poland has consistently ranked among the top reformers on these measures. One area where Poland has lagged behind is in privatizing state firms. In contrast, private sector growth through the creation of new firms has been exceptionally rapid in Poland.
A striking aspect of macroeconomic policies in the early years of the Polish transition was the sharp increase in the level of government cash transfers to individuals. In the first four years, transfer expenditures rose from about 10 percent of GDP to about 20 percent (see table). This increase in transfers mitigated the increase in overall income inequality that would have resulted from the increase in labor earnings inequality.
Note that much of the increase in transfers was due to increases in pension expenditures. Older workers had the most to lose from the privatization or closure of state-owned firms and would have been most adversely affected by enterprise restructuring. But the increase in the generosity of state pensions (relative to average wages) in 1991-92 induced large numbers of older workers to take early retirement. Thus, despite the negative implications of a large budget deficit, the expansion in pensions and other government transfers may, on balance, have actually facilitated transition, first, by removing potential political opposition to reforms by a powerful interest group and, second, by helping to reduce employment at enterprises to more efficient levels and promoting other aspects of enterprise restructuring. With the possible exception of Hungary, Poland has seen the strongest increases in labor productivity growth among the transition countries.
Rather than speculate about which aspects of the Polish experience account for the country's exceptional success, we can conduct a systematic investigation by comparing the experiences of transition economies. As a first step, we correlated annual real GDP growth in the first eight years of transition with various factors that might predict growth in the transition economies. This analysis revealed one particularly strong pattern: countries where income inequality increased more also suffered slower growth.
This relationship is shown graphically in Chart 3, which plots data on both GDP growth and changes in inequality for 14 transition economies for which data are available for the first eight years of transition. Average annual GDP growth is measured along the horizontal axis. Poland is the only country with growth solidly above zero, while Slovenia and the Czech Republic, with values close to zero, are the next best performers. Ukraine—where GDP fell, on average, by 11 percent a year—is the worst performer.
Growth in income inequality, shown on the vertical axis, is measured by the change in the Gini coefficient during the first several years of transition. Again, Poland does the best, with only a small increase in inequality, and Ukraine the worst, with a huge increase of about 0.23 (this represents more than a doubling of income inequality during the transition). Although summary measures like the Gini coefficient do not capture changes in income mobility and other aspects of inequality, the broad ranking of countries in this dimension is unlikely to be much affected.
It is remarkable how strong the negative relationship between GDP growth and changes in inequality was in early transition. Besides Poland, the countries that had relatively good growth performance (Slovenia and the Czech Republic) also experienced little growth in inequality. And, besides Ukraine, the countries that experienced the most massive increases in inequality (such as Kyrgyzstan, Russia, Lithuania, and Latvia) also had dismal growth performance.
Link between income equality and growth
This raises a number of intriguing questions. Are policies that foster income equality also beneficial for growth? Or does growth itself generate more equality? Or does some third factor account for good performance on both the growth and inequality dimensions?
A theoretical case can be made that high levels of income inequality, such as those that have developed in Russia and Ukraine, are detrimental to growth and that "the development of a solid, property-owning middle class is essential to the consolidation of capitalism" (Kornai, 2000). High levels of inequality could prevent the middle class from becoming large, and there are important sociopolitical reasons for thinking that the size of the middle class matters for the success of transition. In some countries, such as Russia, insider privatization created a new class of rich special interest groups. As argued recently by Havrylyshyn and Odling-Smee (2000), it is in the interests of such groups to stall transition after privatization, which benefits them, has been accomplished but before such key reforms as enterprise restructuring and establishment of the rule of law, which would interfere with their ability to extract rents, can be carried out. Typically, it is in the interests of the middle class to push for these further reforms that allow the transition to continue. The poor, in contrast, might favor a return to communism because their relative economic position tends to deteriorate in the early stages of transition.
There are also more basic economic arguments for thinking that maintenance of a certain degree of income equality is good for economic growth. A contrasting view is that development initially requires a sufficient amount of inequality. That is, wealth must be concentrated in the hands of a few so that they can invest in capital and build industry. This view is rooted in the traditional notion that large-scale industrial activity is the main engine of development. But recent work in economic growth theory, taking a very different tack, argues essentially that small-scale entrepreneurial activity and broad societal investment in education and health care are the main engines of growth. The concentration of wealth in a few hands is detrimental, because the number of people who can engage in such activity is then limited. Thus, greater income equality can enhance growth. In Poland, which had almost 2 million private entrepreneurs and more than 125,000 private commercial companies by 1996, small-scale entrepreneurial activity has clearly been a key engine of growth.
If a plausible case can be made that equality is beneficial for growth, can the alternative explanation—that growth itself generates more equality—be ruled out? Poland's experience, at least, seems inconsistent with the view that growth drives changes in inequality. Income distribution actually improved in Poland during 1990-92, the very period when GDP fell substantially because social transfers were expanded. The expansion of social transfers (relative to GDP) was halted in 1993, and the result was a gradual increase in inequality in Poland from 1993 onward—a period of rapid GDP growth. Thus, during the first decade of transition in Poland, changes in inequality over time appear to be explained by changes in government transfer programs and do not appear to be systematically related to GDP growth performance.
A reverse pattern holds in Russia. There, although transition led to large increases in earnings inequality and job destruction, as in Poland, government transfers have been highly regressive, thus exacerbating the increase in income inequality. And transfers of state assets to insiders at below-market prices have further widened the distribution of income. Again, it seems that specific government policies, rather than macroeconomic performance itself, largely determined whether income inequality increased or decreased in early transition.
Other determinants of growth and inequality
Finally, we ask whether some third factor (or set of factors) accounts for good performance in terms of both growth and income distribution. Such third factors might include the extent of market-oriented reforms and countries' initial conditions. Specifically, it is plausible that countries that pursued poor policies (for example, that failed to implement significant reforms) suffered both slow growth and large increases in inequality as a result. It is also plausible that poor initial conditions (for example, large initial macroeconomic imbalances) led to both slow growth and large increases in inequality.
To explore the role of such third factors, it is necessary to go beyond simple correlation analysis and to use multiple regression analysis in order to sort out the effects of several different factors on the outcome. In our regression analysis, GDP growth in the first eight years of transition is the outcome to be explained. The potential determinants included the change in inequality, several measures of government policy during the transition, and measures of the difficulty of the initial conditions that faced each country at the start of its transition.
We find that these variables, taken together, can explain much of the variation across countries in GDP growth during the first eight years of transition. Interestingly, though, even after government policy variables and the initial conditions facing each country are accounted for, a highly significant relationship between GDP growth and the change in inequality remains. Our regression estimates indicate that if two countries had the same extent of reform (as measured by the EBRD transition indicators) and the same initial conditions, the country that permitted a 10 percent greater increase in inequality in terms of the Gini measure (corresponding to an increase that is greater by about 0.03 in terms of the absolute value of the Gini coefficient) would experience a real GDP growth rate that was about 1 percentage point lower.
These figures certainly fall in the range of the observed data. For instance, the Czech Republic did slightly better than Poland, according to the EBRD's measure of reforms, and also had slightly better initial conditions. But other aspects of policies in the Czech Republic allowed the Gini coefficient to rise by 0.03 more than in Poland, and the Czech Republic's annual GDP growth rate was about 1.6 percentage points lower than Poland's. Hungary looks very similar to the Czech Republic on the EBRD and initial-condition measures, yet it experienced an increase in inequality similar to that observed in the Czech Republic and had an average annual GDP growth rate about 2.4 percentage points lower than Poland's.
Our finding of a negative relationship between inequality and growth is not new, although it had not been documented earlier for the transition economies. A number of recent studies have examined the relationship between inequality and growth using regression analyses for much broader groups of countries. Although the evidence is not decisive, the pattern of a negative relationship between inequality and growth generally appears to hold up in these much broader international comparisons, lending credence to the finding. Still, important caveats are in order. In particular, in this type of analysis, one can never rule out the possibility that some third factor that we (and others) have missed is accounting for good performance on both the growth and inequality dimensions.
Of the transition countries, Poland has achieved the highest rate of GDP growth along with the smallest increase in inequality. It implemented market liberalization at a more rapid pace than most of the other transition economies. The transition process did lead to great increases in labor earnings inequality and significant job destruction. However, through a generous and well-targeted system of social transfers—especially pensions—the government mitigated the rise in income inequality and facilitated enterprise restructuring and other market-oriented reforms. The cloud on the horizon is that this high level of social spending has also led to budget deficits of about 3 percent of GDP, a level that is probably not sustainable. Poland now faces the challenge of restoring fiscal balance while keeping the social security system effective and preserving the important gains of the 1990s.
This article is based on two papers by the authors: "Inequality, Growth and Transfers: New Evidence from the Economic Transition in Poland," IMF Working Paper 00/125 (Washington: International Monetary Fund, 2000), and "Changes in the Structure of Wages During the Economic Transition in Poland," forthcoming in the IMF Working Paper series. See these papers for more detailed information on the data and sources used in this article.