A Reassessment of the Relationship between Income Inequality and Poverty

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ABSTRACT

The paper challenges the belief that income inequality causes poverty. The state data set instead of international database is used to investigate whether or not a rise in income equality causes an increase or decrease in poverty rate. The methodology suggested by Learner (1983) and Levine et al (1991) is used to test the robustness of income inequality coefficient estimates by specifying and altering a set of other conditioning variables which explain poverty. The study finds support for the hypothesis that income inequality may cause economic growth and hence reduce poverty.

INTRODUCTION

One of the goals of the American economic system is equity. Indeed, if there is one area in which the role of government has expanded more rapidly, it is in the realm of income and wealth redistribution. And still, nothing arouses more emotions than the issues related to equity. While there is no scientific and objective way to define equity, it is generally accepted that government should not consciously engage in macroeconomic policies which make the income and wealth distribution more unequal.

Arguments in favor of more equal income distribution include: Reduced tension and envy between classes, higher economic growth, better resource allocation, reduced concentration of political power, greater equality of opportunities in social, political and economic arena, and a more cohesive society. As expected, income distribution also affects the poverty rate. Opinions on this subject, however, are mixed: Some scholars think that the income inequality accentuates poverty (Persson and Tabellini, 1994), others (Williams 1999, Kray 2002) believe that the relationship between income inequality and poverty is inverse.

The purpose of this study is to investigate the empirical relationship between poverty and income inequality. The policy implications of the study are significant. If the inverse relationship between poverty rate and income inequality is supported by data, it could shed new light on the conservative view-point that shift in income in favor of the rich is not necessarily at the expense of the poor. Indeed a macroeconomic policy which redistributes wealth and income away from the rich may be counter-productive in that it would shrink the size of pie and hurt the very poor that the policy seeks to protect. Similarly, the study would further support the conservative doctrine that tax break for the rich is good for everybody including the poor.

The case for an inverse relationship between income inequality and poverty can be made based on historical evidence. During the period of Industrial Revolution in Britain, rising income inequality was followed by falling poverty rates. During this period the wage gap between the skilled and unskilled workers widened. Jeffrey Williams (1999), for example, reports that the real wages of blue-collar workers nearly doubled between 1819 and 1851, but during the same period, the number of people in abject poverty declined dramatically. Similarly, in the United States, during the period of railroad construction, the concentration of income and wealth increased sharply because of a dramatic increase in the wages of engineers and machinists, but during the same period the inflation adjusted wages of the unskilled workers also increased at the annual rate of 1.8 percent. During the seven-year periods, 1993-2000, the U.S Census data shows that whereas the poverty rate declined from 14 percent to less than 10 percent, the percentage of income claimed by top fifth of households increased to 49.7 percent in 2000 from less than 49 percent in 1993. Indeed, during this period, the Pearson Correlation between income inequality and poverty is .867 and is significant at .001 level.

Similarly, at the global level, over the last 30 years, the income inequality has increased within and across countries (Barro, 2002). Curiously enough, during the same period the number of people living in poverty has also declined. …