The False Curve

Must we wait for things to get worse before they get better?

Economics is a land of fables. One of the most fascinating stories that a student of economics might have come across, is the story of the Kuznets Curve. The story goes back to 1955, when a brilliant American economist, Simon Kuznets, gathered data on the UK, the US and Germany. He wanted to observe how income inequality had changed over time as these countries grew. When he plotted this data on a page, he was astonished by what he found! The graph seemed to suggest that income inequality in these countries initially increased and then decreased. This upside-down U-shaped curve got drawn and labelled as the Kuznets curve and then took on a life of its own. 

Source:  Thoughtco

But why call it the false curve? If it is on the graph, is it not true? The fascinating thing is that it is indeed true for those three countries at that particular point in time. The only catch is that it was an immensely and exceptionally particular point in time. This period was rife with all kinds of shocks, be it the Great Depression, the World Wars or the high taxes imposed to finance the war expenses. All of these processes emptied the purses of the capital owners, afflicting both their wealth and current income. As a result, this period witnessed reduced income inequality. 

Yet, the Kuznets curve was disproved in both the UK and the US in the years that followed. Both the countries witnessed an alarming hike in the levels of income inequality, primarily because both Margaret Thatcher and Ronald Reagan lifted the high rates of taxes in 1974 and 1986 respectively. Unfortunately, data from this period was not projected on the Kuznets curve.

In this regard, Thomas Piketty’s book ‘Capital in the 21st Century’ has developed on the Kuznets’ theory significantly. Piketty gathered extensive datasets on inequality in the US for a period of 100 years from 1910 to 2010. According to this data, the share of the top income decile out of the total US national income changed in the same manner as Kuznets’ paper until 1955. However, the share increased dramatically during the 1980s when deregulation and privatisation policies were announced. The curve took an S-shape, initially dipping frontwards and then mirroring the inverted U against a horizontal straight line, suggesting that the Kuznets Curve told us only half the story.

Source: Rikello liberty

Further, the central variable in Piketty’s book is capital, which Kuznets did not take into account in his review of income inequality. Capital, which is distributed more unevenly than labor income, has a significant impact on the overall household income. Thus it wields a major influence over income inequality.

This contradicted not only Kuznets’ inverted U-curve of the correlation between economic growth and income inequality but also the very mechanism for connecting the two phenomena. Moreover, the reduced levels of inequality witnessed by the three countries in Kuznets’s paper were not merely a result of the inherent workings of the market. The curve bent down in these three countries as a result of government spending and redistribution of income in the post war period. This suggests that the context of the statistical correlation discovered by Kuznets was more of a shock and merely incidental than evolutionary in nature.

It becomes pertinent to mention here that Kuznets himself gave these caveats when he first published his paper.  The trouble arose when these caveats got pushed to the side and the curve came to be used almost as a mantra in policymaking. The widespread belief that things are going to get worse before they get better again, pervaded largely due to this little inverted U-shaped curve. The sway that this curve held over the economists of the time is evident in the manner in which development economics emerged. The founding fathers of development economics were of the view that development must be an inegalitarian process. Equality almost became a privilege that only developed countries like the UK, the US and Germany could enjoy. 

Subsequently, when economists have gone looking for this Kuznets curve, they haven’t been able to find it. Although extensive literature emerged in the later years, verifying the existence of a supposed upside down U curve in developing countries, these papers were largely restricted in the terms of the extent of their data. There existed a lack of indices on the inequality levels of developing countries and any empirical study of the time had to rely upon cross sectional data, that is, data collected at one particular point in time. This means that these papers failed to emulate Kuznets own analysis by not considering the evolution of inequality based on historical data from any particular country. 

On the other hand, the experience of East Asia since the 1980s (which has come to be known as the ‘East Asian Miracle’) shows that some very low income countries, that grew at an alarming pace, were successful in reducing the levels of inequality in tandem with their ascent. This defied the Kuznets curve and also the notion that equality is something that the  developing countries have to wait for until later.  Moreover if we look at some of the OECD countries, we observe inequality has widened again. In fact income inequality in OECD countries is at its highest level for the past half century. The average income of the richest 10% of the population is about nine times that of the poorest 10% across the OECD, a far cry from the levels that prevailed some 25 years ago.

It turns out that this curve does not exist in all actuality. Different countries can experience different patterns of interaction between income inequality and growth. There is no law of economic motion at work here. The real question is one of economic design. Part of the effort lies in not believing that it is normal for inequality to get worse, rather treating it as an outcome of the economic institutions that we create. Further, in the 21st century, we must go deeper than just redistributing income. We must look at ways in which sources of wealth creation can be distributed in an equitable manner. Most importantly, we mustn’t have to wait for things to get worse before they get better. 

– Shreya Singh (Editor, Econ Declassified)

References

Inequality – Income inequality – OECD Data. (2020). Retrieved from https://data.oecd.org/inequality/income-inequality.htm

Kuznets, S. (1955). Economic Growth and Income Inequality. The American Economic Review, 45(1). Retrieved from https://www.jstor.org/stable/1811581?seq=1#metadata_info_tab_contents

Piketty, T. (2014). Capital in the 21st Century. London: The Belknap Press of Harvard University Press.

Lyubimov, I. (2017). Income inequality revisited 60 years later: Piketty vs Kuznets. Russian Journal Of Economics, 3(1). doi: https://rujec.org/article/27981/

Raworth, K. (2017). Doughnut economics : seven ways to think like a 21st-century economist.

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