Credit: Unemployed day laborers in South Africa: the country has relatively high income, but also high inequality (photo: Rogan Ward/Newscom).

Inequality: Tools from the Old Masters to Help Today’s Policymakers

October 3, 2017 [caption id="attachment_21564" align="alignnone" width="1024"] Unemployed day laborers in South Africa: the country has relatively high income, but also high inequality (photo: Rogan Ward/Newscom).[/caption]

With inequality rising in many countries, policymakers need to choose the best fiscal policies that will help share the benefits of economic growth, and in so doing, make it more inclusive.

The early 20th century English economist Arthur Pigou, among others, saw economic welfare as influenced by both “the size of the national dividend” and “the way in which it is distributed among the members of the community.”

Fortunately, economists since then have developed tools that realized Pigou’s vision by combining a country’s total income and its distribution in a single measure of economic welfare. For example, Anthony Atkinson in the 1970s developed an easy-to-interpret measure expressed in a country’s currency, just like income.

Such tools are well known in academia but underutilized in policymaking. To encourage their greater use by policymakers, our new paper provides a refresher.

Considering inequality in measurement of economic welfare

Atkinson’s measure involves weighing equity and efficiency that result from a country’s policy choices. Consider two individuals, one rich, earning, say, $250,000 a year, and one poor, earning, say, $10,000 a year. Total income is thus $260,000. Look at this fictitious two-person society as an external observer. If you really dislike inequality, you might say that giving an equal income of $20,000 to both people is an acceptable alternative to the status quo. You would tolerate an efficiency loss of $220,000 to attain equality of incomes. From your perspective as an external observer, $20,000 would be the summary measure of welfare in that society.

We used  this measure of economic welfare, considering both incomes and levels of inequality, for all countries. We repeated the exercise for different degrees of aversion to inequality—how large a loss of efficiency  you will tolerate in exchange for less inequality.

The figure below positions countries based on their income (horizontal axis) and their Atkinson measure of welfare, which combines both income and its distribution (vertical axis).

It shows that richer countries tend to enjoy greater welfare, in the economic sense, but inequality also matters. The further below the dotted line a country appears in the figure, the higher a country’s inequality. For a given level of inequality, Atkinson’s measure of welfare is lower the more the external observer dislikes inequality.

When comparing countries, it is appropriate to apply the same degree of aversion to inequality to all countries, so that they are viewed using a common standard. The first screen of the figure shows the results for a high aversion to inequality.  Readers can view the figure with results for a lower aversion to inequality by clicking on the tabs in the figure.

We find that the ranking of countries often differs significantly from that based on income alone. For instance, South Africa’s mean income is more than double that of the Kyrgyz Republic, and substantially above that of Albania. However, inequality is higher in South Africa. An external observer that abhors inequality will consider that, on balance, welfare is significantly higher in the Kyrgyz Republic and Albania than in South Africa.

Similarly, mean incomes are higher in the United States, for example, than in Sweden or the United Kingdom. But inequality is higher in the United States. Thus, a highly inequality-averse observer will consider that welfare is higher in Sweden and the United Kingdom than in the United States.

With inequality rising in many countries and people worried about its social and economic impact, policymakers need the best tools to analyze their policies, and their implications for both efficiency and equity in a society. The old masters devised tools that we think can help today’s policymakers make the best choices for their country. 

Next week on October 11 we will publish new data and analysis in the Fiscal Monitor about how fiscal policy can help reduce inequality.