Development Economics Lecture Notes 4

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1 Development Economics Lecture Notes 4 April 2, 2009

2 Hausmann-Rodrik-Velasco Growth Diagnostics 1. Low return on economic activity 1.1 Low Social returns 1.2 Low Appropriability 2. High cost of Finance 2.1 Bad international finance 2.2 Bad local finance

3 The point is that people keep doing inefficient things because it is individually rational to do. i.e. Borrowing from moneylenders at usury rates. As long as others do not change their behavior, this will lead to coordination failures. For example, firms failing to consider the income effects of the wages they pay can cause major distortions, in some cases they may bring about though unwillingly the failure to industrialize. Government should coordinate. However, it should be noted that government officials are also constrained by their information sets as well as rent-seeking behaviors.

4 According to the latest OECD study, Growing Unequal Turkey is second to none other than Mexico in terms of income inequality among OECD member countries. Has Turkey been always unequal as such throughout its history? The wealth inequality matters more. For wealth means consumption now or in the future. Wealth also provides an insurance for consumption smoothing and against adverse shocks. The last but not the least, wealth can be used either directly finance entrepreneurial activities or be collateral to obtain credit.

5 Note that wealth is more unevenly distributed than income. 1 Table 1 demonstrates that wealth gini for Turkey, is considerably higher than officia income gini, Table: Wealth Inequality in 2000 Country Adult Pop. Wealth per Adult $ Gini Turkey USA South Korea Brazil India Source: Davies et. al. 2008

6 What about real income inequality? Inequality of wealth and income in a society make a huge difference. The government as well as the international organizations such as OECD and World Bank claim that income inequality has norrowed from 1994 to 2003; the gini coefficient decreased from 0.49 to This is too good to be true. Indeed we argue that it is not true. A simple fact should make all suspicious. The contribution of direct taxes to total tax revenues declined from 63 percent in 1980 to 18.7 percent in Furthermore, the share of wealth-related taxation in total tax revenues dropped from 10.5 percent to meager 2.3 percent within the same time period.

7 The Table 2 illustrate the distribution of income since The survey data quality is regarded as ambigious according to the OECD standards. The discrepancy of the survey results for total income and the GDP for the corresponding years is as large as 60 percent. Table: Historical Trends in Income Distribution Quintiles Lowest Next Next Next Highest Gini Coefficient n/a n/a

8 The following Table 3 demonstrate our argument that there exist a significant underestimation of the income covered by the Household Budget Survey, on which the income distribution statistics are calculated. Table: Coverage Ratio of Total Declared Income (in billion TL) GDP Household Budget Surveys Coverage Ratio of HBS

9 The Household Budget Survey of 2003 could only capture 50.6 percent of the GDP. The reasons are manifold but one important factor is methodogical. Enterprise surplus covers all the following items in the GDP measures: (1) corporate income, (2) entrepreneurs income, (3) taxes, (4) social security contributions, (5) interest income, (6) implicit rents and (7) real rents. HBS include only (2), (5), (6) and (7). The difference is substantial. Moreover once disaggregated the undeclared income differ in terms of the income earners. A recent survey undertaken by Revenue Administration Department reveals that 60 percent of surveyed taxpapyers believe that the tax system in Turkey is lax, allowing taxpayers to avoid their liabilities. 72 percent of the respondents argue that there are many people who are not paying taxes without seeing any consequences. Moreover, 40 percent say that they would also consider tax evasion if they see a person doing it without being caught.

10 MEASURING INEQUALITY Size Distribution: Quintiles or deciles Lorenz Curves Gini coefficients Functional Distribution of Income

11 MEASURING POVERTY Headount Index: The ratio of the population with an income less than poverty line to the total population Total Poverty Gap (TPG): the total amount of income necessary to raise everyone who is below the poverty line up to that line. Foster-Greer-Thorbecke (FGT) Index P α = 1 N H i=1 ( Y p Y i Y p ) (1) where Y i is the income of ith poor person, Y p is the poverty line and N is the population. Human Poverty Index (HPI): HPI value indicates the proportion of population adversely affected by three key deprivations (survival, knowledge and economic provisions).

12 WHAT IS WRONG WITH HIGH INEQUALITY 1. Extreme income inequality leads to economic inefficiency. i.e. remember credit market model (small versus large firms). 2. Extreme income disparaties undermine social stability and solidarity. 3. Extreme ineqaulity is generally viewed as unfair. i.e. some has ship-cik others dig trash to get food.

13 Kuznet s Inverted-U Hypothesis Rational for Kuznet s Curve Evidence? : For many countries there is no particular tendency for inequality to change in the process of economic development.

14 GROWTH and POVERTY 1. Widespread poverty creates conditions in which the poor have no access to credit and hence are unable to finance their children s education and instead have many children as an insurance -depressing the gdp per capita. 2. The rich in many underdeveloped countries do not save and invest in domestic economy. 3. Low incomes mean lower levels of education and health, and hence productivity 4. Raising the incomes of the poor stimulates demand for locally produced goods and services. 5. Reduction in mass poverty will stir spirit of solidarity and participation in social affairs.

15 ECONOMIC CHARACTERISTICS of POVERTY GROUPS Rural Poverty Women and Poverty Ethnic Minorities, Indigenous Populations and Poverty

16 Policies to Alleviate Income Distribution and Poverty 1. Altering the Functional Distribution of Income through Policies Designed to Change Relative Prices a. increase minimum wages b. tax imported capital goods 2. Modifying the Size Distribution through Progressive Redistribution of Asset Ownership a. land reform b. savings transfer, redistribution from growth c. upgrading the human capital of lower classes 3. Reducing the Size Distribution at the Upper Levels through Progressive Income and Wealth Taxes a. eliminate regressive taxes such as indirect taxes b. increase and enforce wealth (stocks, real estate, deposits) based taxation 4. Direct Transfer Payments and the Public Provision of Goods and Servicies

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