Inequality: a new fork in the road?

Poverty - Inequality - Aid Effectiveness

Inequality is no longer falling in many countries, and the culprit is the labor market. Should something be done?

A fork in the road

This might be a “human-bites-dog” moment for Latin America. For about a decade, researchers and policymakers have been saying that the key lesson from the world’s most unequal region, is that inequality can -in fact did- decline. This is supported by a rigorous set of harmonized data that show that from 2000 up until around 2010, income inequality unambiguously declined in 16 of 17 countries. That’s why the publication of the updated series to 2012 on poverty and inequality, prepared by SEDLAC and released in the World Bank’s PREM February brief, is news .[1]

The brief, coordinated by Louise Cord, does a great job of setting the stage for a closer scrutiny of both the data and the implications of a plateauing inequality trend in the region. It also shares valuable fiscal data and analysis from the Commitment to Equity Project, coordinated by Nora Lustig at Tulane University and the Inter-American Dialogue.

Inequality trends

Let’s start with the inequality data. The news here is not that there is a reversal in the inequality trend, but that the rate of decline is slowing down -and, in some countries, stagnating. The evidence comes from SEDLAC’s latest revision of household data. The colleagues at CEDLAS-La Plata do a very thorough job of putting together a comparable data set on poverty and inequality trends in the region.

The income inequality data reported in the World Bank brief comes from a pooled data set. Regional Gini coefficients cannot be averaged from specific-country data (for decomposability reasons), so the only way to get at a regional inequality proxy is to pool the country-specific data into bins and derive a regional concentration coefficient from the available observations. The results show “stagnation” in the inequality trend between 2010 and 2012. Between 2000 and 2010, the regional Gini declined on average by 0.94 percent per year, while in 2011 it fell by just 0.33 percent, and in 2012 it fell a paltry 0.02 percent.

The trend can also be assessed through country-to-country comparisons. Here, our own estimates (done by my colleague Eduardo Ortiz) using the SEDLAC data, is that Mexico and Panama, and to a lesser degree, Brazil, saw a deceleration in their inequality trend when comparing 2002-2007 to 2007-2012. However, if we move the comparison period to 2007-2011, we can add Dominican Republic, Chile and Paraguay to the list of countries where inequality is plateauing.

A Fork in the Road

The key question is, of course, why inequality is stagnating in some countries. Given what we know about non-parametric decompositions of changes in income distribution, the critical factors would seem to be one or more of the following: (i) lower growth in labor income at the bottom of the income pyramid, (ii) a diminished effect of social transfers, either through fiscal constraints or changes in targeting, and/or (iii) a diminished impact of pensions, for either of the previous reasons.

Again, assuming not much has moved either on social transfers or pensions in the period 2010-2012, the culprit would seem to be the labor market -particularly the low-skilled segment of the labor market in the service sectors which created most of the new jobs during the boom. As “growth in labor income” is both a benefit for society (through poverty reduction) and a cost to business (through higher unit labor costs) another policy debate ensues:

  • One way to tackle stagnating inequality is to embark on structural reforms that improve the business environment -a relatively direct way of lowering unit labor costs is liberalizing labor markets and de-regulating labor benefits. A number of countries will in fact follow this path over the next few months and years. From a human development perspective, this is a “race to the bottom” strategy.
  • A second way to tackle stagnating inequality is to strengthen social protection networks, focusing specifically on how to bolster returns to education for different segments of the labor market. This is a “race between education and technology”, rather than a race to lower labor costs. It engages with the question of why some countries are able to sustain growth with increases in productivity, rather than through booming external prices. Some countries may actually follow this route.
  • A third way to deal with stagnating inequality is to do nothing. This is, in fact, the most likely scenario, as reforms that address inequality are intensive in political and institutional capital. In these cases, countries will attempt to sustain declines in poverty through higher economic growth. They are likely to find, by the year 2020, that “more of the same” does not often yield the same.

In any event, we will see a renewed appetite for structural reforms in the region. As Yogi Berra, the Yankees baseball manager, once said: “When you come to a fork in the road, take it”.

1. World Bank, 2014, Social Gains in the Balance: A Fiscal Policy Challenge for Latin America and the Caribbean, Washington: PREM: The World Bank.

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