Implications of Rising Inequality in Emerging Markets

From Brazil to China, many emerging markets have touted enormous progress over the past decade. However, this rapid growth, brought on by dismantling controls on economic activity, has often been associated with rising or high inequality.

High inequality may be undesirable for moral reasons, but it can also undermine social cohesion and lead to a backlash against market-oriented reforms—even in advanced countries, as the Occupy Wall Street protests illustrate. More directly, barriers to economic and social mobility, which are prevalent in major emerging markets, reduce efficiency. For example, labor market policies often encourage informality and a dual labor market of insiders and outsiders; widespread corruption and crony capitalism favor the powerful and the well-off; and pronounced class systems and low investment in education limit opportunities for the poor. Improving governance, eliminating constraints on economic activity, boosting investments in education, and providing public goods such as health and sanitation services would not only raise productivity and growth but also reduce inequality and the social tensions that can come with it.

Uneven Progress on Poverty and Inequality

Over the past two decades, major emerging markets have made impressive economic strides. According to the World Bank, GDP per capita in Brazil, China, India, Mexico, and Russia increased by an average of 67 percent from 2000 to 2010, about seven times the growth in industrial countries. Since the mid-1990s, the poverty rate has decreased by an average of more than 10 percentage points in these countries, and the number of people living in poverty has fallen by 450 million (see table).¹ However, nearly all this decline occurred in China. By contrast, despite the falling poverty rate in India, the poor population actually grew. Moreover, international poverty lines understate relative poverty—based on national poverty lines, the poverty rates in Brazil, Mexico, and Russia are on average fourteen times higher than their international rates.

Furthermore, the growth in emerging markets has not been equally shared among domestic populations. Lifting constraints on domestic economic activity and opening to the global economy—policies critical to successful development—are often associated with worsening of the income distribution. Removing limits on wages and profits in formerly socialist regimes, for example, and increasing economic opportunities and payoffs for small groups of educated and skilled workers have been part and parcel of this evolution. The juxtaposition of extraordinarily rich individuals and groups that enjoy advanced-country lifestyles in the midst of teeming slums and abject rural poverty can cause great resentment.²

How bad is it? While data are limited, since the 1990s, overall measures of inequality have increased in China and India and declined but remain stubbornly high in much of Latin America (see table).

In China, the top 10 percent of the urban population now consumes twenty times more than the bottom 10 percent of the rural population. In India, the most disadvantaged rural areas saw virtually no rise in per capita expenditure from the mid-1990s to 2000, despite a 20 to 30 percent increase in the urban areas of rich states. Though consumption inequality has declined in Russia, real incomes have fallen by almost half in the bottom quintile and nearly doubled in the top quintile. Rising oil wealth and government decentralization exacerbated differences among regions. Despite progress in Latin America, inequality remains high: 38.5 percent of urban households in Brazil are living in “precarious” situations, as defined by the UN, while in rural areas, a small group of landholders dominates millions of poor workers and small landowners. Inequality in Mexico declined in the last decade, but the top 10 percent’s average income is still twenty times that of the bottom 10 percent.

Contrast this with more equitable societies. In Bangladesh, Ethiopia, and Kazakhstan, three of the most equal developing countries, the top 10 percent consumes just over six times that of the bottom 10 percent. In a few advanced countries, the gap is even smaller. For example, the gap was only 5.6 times the bottom 10 percent in Finland in 2000, according to the most recent World Bank data. (In the United States, the ratio in 2000 was close to 16.)

Reason to Worry

A moderate level of inequality is inevitable and, particularly if average incomes are rising and poverty is declining, can improve efficiency by rewarding more productive workers. But inequality cannot be completely ignored: studies have found that more equal societies are better able to sustain growth. The reasons for this are unclear, but economists have speculated that inequality can lead to more frequent financial crises, political instability, and popular resentment of market reforms that results in their undoing.

High inequality can also reflect a deeper problem if it is caused by restrictions on opportunity, which are inefficient and can limit growth. Barriers to advancement that provide only a select class, rather than the most talented, access to highly remunerative employment undermine productivity, deter investment in education, and impair the ability of the educated to exercise their skills. This can be particularly dangerous if these barriers reflect regional (for example, Tibet in China) or ethnic (for example, India’s caste system) disparities.

Quantifying limits on opportunity is difficult, but it is often reflected in people’s ability to move—both across jobs and geographically—which has been critical in many emerging markets.

China has an estimated 150 million migrants living in its urban areas, but its hukou system restrains mobility and, by limiting the rights of the “temporary migrants” that do move, creates an urban class of relatively disenfranchised workers. Moreover, because the government maintains a pervasive role in allocating resources through its control of the financial system and ownership of major enterprises, personal connections are critical to success, perpetuating inequality. For example, studies have found that incomes in China are strongly correlated to familial factors.⁴ Nepotism is similarly important in Russia, where pervasive corruption and oil wealth has made the government the ultimate arbiter of economic success.

India’s caste system may be more than three thousand years old, but rapid growth in recent years has highlighted the plight of the lower castes, fueling resentment and suggesting that opportunities for increasing productivity have been lost.

In Brazil, employers frequently discriminate against migrants from the northeast and workers in poor urban slums, who are often automatically associated with criminal behavior. Race is also a factor in job discrimination.⁵ Though Mexican social mobility is higher than in other Latin American countries, a lack of educational opportunity—education outcomes are strongly correlated with that of one’s parents—likely translates into a lack of income mobility, given the high returns to education.

Policy Implications

Given the economic—not to mention moral—objections to high inequality, policy makers in developing countries have an obligation to address it. Some may do so through redistributive policies. These reforms are needed, especially in countries like Brazil, where fiscal policies remain regressive.⁶ Well-tested and relatively affordable mechanisms such as the Bolsa Familla, a Brazilian conditional cash transfer program for the poor, exist. Though difficulties in enforcing income taxes and the influence of the rich on politics constrain the potential for direct transfers in many emerging markets, these obstacles should also be the object of concerted reforms.

In addition, policies should focus on promoting mobility. In order to limit the importance of influence and attack corruption, steps should be taken to reduce the state’s role in allocating resources. For example, removing interest rate ceilings and limiting directed credit should help channel finance to more productive rather than more influential players; ensuring that state enterprises face a hard budget constraint would increase incentives for managers to hire the most productive workers and to contract with the most efficient firms; and eliminating policies that raise the costs to employers of hiring new workers could bring more employees into the formal sector where they have access to benefits, greater social protections, and greater incentive to invest in their training and education.

But limiting the role of the state is not always the answer. In India, efforts to reduce the central government deficit led to cuts in rural investments while tax reform reduced transfers to poor states that help pay for public services. Brazil and Mexico have devoted considerable resources to increasing access to education and health services, but further investments in underserved areas would help address resentment over inequality and improve productivity.⁷ China has provided money for poor western provinces in an attempt to limit their income divergence from the East but has been slow to improve education levels in backward areas because of its highly decentralized fiscal system.

Market-oriented reforms in emerging markets have long faced a dilemma: removing constraints on growth has been associated with increased inequality, which over time could both create resistance to these policies and limit productivity gains. Having liberalized markets, emerging economies must now find ways to preserve these reforms while improving economic and social mobility. Doing so would boost productivity by improving the incentives for, and the capabilities of, poor workers, both increasing growth and reducing inequality.

William Shaw is a visiting scholar in Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.

^{1. Poverty is defined by the World Bank as living on less than $1.25 a day, adjusted for purchasing power.}

^{2. Almost 40 percent of the world’s 1,200 billionaires are from developing countries.}

^{3. The Gini coefficient is one of the most commonly used measures of income inequality; its value ranges from 0 to 1 (or equivalently, 0 to 100), with 0 representing complete income equality across a population (everyone has the same income) and 1 (or 100) representing perfect inequality (one person has all the income). See “Measuring Inequality” for how the Gini coefficient is calculated.}

^{4. One study concluded that nearly two-thirds of inequality in China is explained by the income and employer of a person’s parents, while another found the correlation between siblings’ incomes to be much stronger than in both Nordic countries and the United States. China’s one-child policy may distort this indicator by limiting the amount of data available and skewing the distribution of observations to the countryside, where limits on a second child were less binding than in the city.}

^{5. An estimated one-third of the difference in the probability of whites and blacks obtaining a formal sector job is due to discrimination.}

^{6. In Brazil, reliance on regressive indirect taxes means that the rich pay just over a quarter of their income in taxes, while the poor pay almost half. Retirement pensions that dominate social spending are heavily biased toward the rich, though other transfers are progressive.}

^{7. In the last decade, Brazil has increased its minimum wage, expanded social protection benefits, and improved family agriculture subsidies. In Mexico, an antipoverty transfer program, Progresa, was expanded from rural to urban areas.}