9/3/2020 Growth, Top Incomes, and Social Welfare

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Growth, Top Incom s, nd Soci l

W lf r
AART KRAAY (/TEAM/AART-KRAAY) | APRIL 30, 2014
This page in: English

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Trends in income inequality are at the center of development policy discussions

these days.  Part of this renewed attention is no doubt a tribute to Thomas
Piketty’s pioneering work to measure top income shares using income tax data
(http://topincomes.g-mond.parisschoolofeconomics.eu/), as well as his much-
discussed new book (http://www.amazon.com/Capital-Twenty-First-Century-
Thomas-Piketty/dp/067443000X).  Piketty’s work shows some dramatic trends in
inequality at the top end of the income distribution.  For example, in countries
such as China, Singapore, and the United States, the share of income earned by
the top 10% has increased by more than 10 percentage points over the past 30
years.

How much do these trends in inequality at the top end of the income distribution
matter?  While there are many channels through which inequality may a ect
economic outcomes, a useful rst step is to go back to basics and consider the
implication of changes in top income shares for changes in social welfare. 
Economists have long relied on social welfare functions as tools for describing
preferences for how income is distributed across individuals in a society.  
Roughly speaking, social welfare functions are weighted averages of individuals’
incomes, with weights that re ects societal preferences for equity.  A common
social welfare function rst introduced by Atkinson (1970) is

where Yi  and si  are the average income and population share of group i, and a>0
is a parameter capturing social preferences for equity.  Higher values of a place

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9/3/2020 Growth, Top Incomes, and Social Welfare

more weight on lower incomes, and so correspond to greater preferences for

equity. 

Piketty’s data includes the income shares of the top 90%, 95%, 99%, 99.5% and
99.9% percent for many countries, so this gives us six groups over which to
calculate social welfare.  While there are many di erent possible values of a that
could be used, a useful starting point is to consider the case of extreme inequality
aversion, i.e. a is arbitrarily large.  In this case all the weight in the social welfare
function is assigned to the poorest group, i.e. the social welfare function re ects
only average incomes in the bottom 90% of the income distribution, and
discounts entirely the incomes of the richest 10%. This in turn implies that social
welfare would be unchanged if all of the income of the top 10 percent were taken
away and none of it were redistributed to the bottom 90%.  While this is of course
unrealistic, it is a useful benchmark because it sets an upper bound on the
importance that the social welfare function assigns to inequality at the high end
of the income distribution.

Growth in social welfare can be decomposed into growth in average incomes, and
growth in a particular measure of inequality – in this case, the income share of
the bottom 90%.  If the income share of the top 10% is rising, the share of the
bottom 90% is falling and social welfare increases more slowly than average
incomes.  On the other hand, if the income share of the top 10% is falling, the
income share of the bottom 90% is increasing and social welfare grows faster
than average incomes.  The di erence between the growth rate of social welfare
and the growth rate of average income can be interpreted as the welfare loss (or
gain) of rising (or falling) inequality, measured in percentage points of growth in
average incomes.

How big are these di erences between growth in social welfare and growth in
average incomes? The graph below shows growth in social welfare (on the vertical
axis), and growth in average incomes (on the horizontal axis). Each point is a
country, observed over either 1950-1980 (coloured red) or 1980-2010 (coloured
blue), over available years in the Piketty data. Countries above the 45-degree line
are cases where inequality has been falling, so that social welfare increases faster
than average incomes, while in countries below the 45-degree line, social welfare
has been increasing more slowly than average incomes since inequality is
increasing. The vertical di erences between each data point and the 45-degree
line measure the welfare costs/bene ts of rising/falling inequality, in percentage
points of growth per year.

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9/3/2020 Growth, Top Incomes, and Social Welfare

Most of the red-coloured dots fall above the 45-degree line, while the blue dots
fall below, indicating that increases in inequality have been more pervasive in the
past 30 years than in the 30 before that.  However, the most striking feature of
this graph is that the cross-country di erences in average growth performance
(the variation along the horizontal axis) are much larger than the gaps between
social welfare growth and average income growth (the deviations from the 45-
degree line).  Take Japan as an example.  Between 1950 and 1980, social welfare
grew at 5.4% per year, but between 1980 and 2010 social welfare fell at -0.7% per
year.  Nearly all of this di erence in social welfare performance has to do with the
fact that Japan’s growth in average incomes was also 5.4% in the rst period, but
average incomes fell at 0.2% per year in the second period.  More generally,
annual growth in average incomes ranges from around 0% to 6% percent per
year, across the di erent country-periods included in the graph.  On the other
hand, average annual growth in the income share of the bottom 90 percent
ranges from around -1% to 0.5%.

Overall, the contribution of changes in inequality to growth in social welfare is on

average much smaller than the contribution of growth di erences across
countries.  This is true even though the graph is constructed under the strong
assumption of extreme inequality aversion.  If we construct the same graph, but
using less extreme assumptions about inequality aversion, the data points in the
graph move even closer to the 45-degree line.  For example if a=1, growth in
inequality ranges from -0.7% to 0.4% per year, while for a=0.5, growth in
inequality varies between -0.4% and 0.3% per year.

In a new working paper, “Growth, Inequality, and Social Welfare:  Cross-Country

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9/3/2020 Growth, Top Incomes, and Social Welfare

Evidence” (http://go.worldbank.org/7E3XGPVFC0), David Dollar, Tatjana

Kleineberg and I perform similar decompositions of growth in social welfare into
growth in average incomes and changes in inequality.  We consider a range of
di erent social welfare functions, and use a di erent  dataset covering a much
larger set of 117 countries (based on the merger of POVCALNET
(http://iresearch.worldbank.org/PovcalNet/index.htm) and data from the
Luxembourg Income Study (http://www.lisdatacenter.org/)) that re ects inequality
throughout the entire income distribution, and not just at the high end.  While the
data, country sample, and time periods considered are di erent, the same basic
message emerges:  cross-country di erences in growth in social welfare are
mostly attributable to cross-country di erences in growth in average incomes,
while changes in inequality play a much smaller role.

Authors

(/team/aart-kraay) (/team/aart-kraay)
A rt Kr (/t m/ rt-kr )
Acting Vice President of Development Economics and World Bank Chief Economist

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paul novosad
MAY 02, 2014

Thanks Aart! Very nice paper, and very timely. Figure 3 is fascinating. It would be
interesting to add a time dimension, and draw this gure in sets of 5 years - would
address the question of whether this time is di erent.
REPLY (/COMMENT/REPLY/NODE/23611/FIELD_COMMENTS/29459)

paul novosad
APRIL 30, 2014

Aart, thanks for the excellent post - the decomposition is highly illuminating. It is clear
that growth has been a bigger story than inequality for most of the world. But most of
the debate around Piketty is focused on rich countries (stagnant / declining median
incomes, occupy wall street, the 1%, etc.). Can we trouble you to repeat this
growth/inequality...

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David McKenzie (/team/david-mckenzie)

David McKenzie
MAY 01, 2014

Aart has kindly prepared a detailed response with a couple of graphs to show this for
the US, Britain and France: Paul, Thanks for the comment.  This graph is the same as

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9/3/2020 Growth, Top Incomes, and Social Welfare

in my original post, but I’ve labelled only the United States, the United Kingdom, and
France (the names are just to the right of the corresponding data points).  While
there...

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