Inequality and Social Welfare

High levels of inequality contribute to high levels of poverty in several ways. First, for any given level of economic development or mean income, higher inequality implies higher poverty, since a smaller share of resources is obtained by those at the bottom of the distribution of income or consumption. Second, higher initial inequality may result in lower subsequent growth and, therefore, in less poverty reduction. The negative impact of inequality on growth may result from various factors. For example, access to credit and other resources may be concentrated in the hands of privileged groups, thereby preventing the poor from investing. Third, higher levels of inequality may reduce the benefits of growth for the poor because a higher initial inequality may lower the share of the poor’s benefits from growth. At the extreme, if a single person has all the resources, then whatever the rate of growth, poverty will never be reduced through growth.

The rationale of this chapter is not principally related to the arguments above regarding the impact of inequality on growth. We argue that, independent of inequality’s impact on poverty, inequality has a direct, negative impact on social welfare. According to the theory of relative deprivation, individuals and households do not assess their levels of welfare in terms of their absolute levels of consumption or income only. Individuals also compare themselves with others. Therefore, for any given level of income in a country, high inequality has a direct, negative effect on welfare. There are good reasons to be interested in inequality and social welfare from the perspective of a comprehensive evaluation of public policies and social programs that go beyond their impact on poverty.

Policymakers constantly confront the problems inherent in evaluating social programs and policies. With an emphasis on poverty reduction, the countries preparing Poverty Reduction Strategy papers (PRSPs) may rely on poverty-derived distributional weights for assessing the effects of social programs and other public policies on welfare. The problem with distributional weights based on standard poverty measures is that they place no weight at all on the welfare of the nonpoor, even though those just above the poverty line may be highly vulnerable. The framework presented in this chapter provides an alternative in which the gains to all members of society are taken into account, although such gains are weighted differently. Using a flexible social welfare function, two summary parameters (one for growth, one for redistribution) can be estimated to assess the impact of a program or policy on social welfare. The parameters are flexible enough to take into account weighting schemes with various degrees of emphasis placed on poorer members of society. Decompositions of the distributional parameter provide insights into the targeting mechanisms of programs and policies. In other words, this chapter provides a simple yet flexible framework for evaluating social programs and public policies that differs from the traditional approach based on poverty measurement.

The chapter has four main sections. Section 2.2 presents the extended Gini index used for measuring inequality. It also presents and illustrates the source decomposition of the Gini used to analyze how changes in income and consumption sources affect overall inequality. Sections 2.3 and 2.4 provide a wide range of policy applications of the source decomposition of the extended Gini index. Section 2.3 shows applications of the basic framework. Section 2.4 presents extensions for testing the robustness of evaluation results for the social preferences implicit in the choice of a specific inequality measure. It also provides techniques for analyzing the impact on inequality of the targeting of programs as opposed to the rules for the allocation of benefits among program participants. Section 2.4 further presents extensions for analyzing the impact of programs on the poor and the nonpoor separately.

In very poor countries, economic growth rather than income redistribution is the key for long-term poverty reduction. Evaluating programs and policies according to their impact on distribution alone may lead to the rejection of interventions that may not be highly redistributive yet have strong growth potential. This may be detrimental not only to poverty reduction but also to the overall level of well-being in society. Section 2.5 demonstrates how to take into account the impact of programs and policies on growth while still considering their impact on inequality. The section introduces a flexible social welfare function for evaluating public policies. Section 2.5 analyzes changes in social welfare by distinguishing between the impact of programs and policies on the level of well-being achieved in a society (growth component) and the inequality in well-being among society’s members (redistribution component). The section also discusses the issues related to the financing of public interventions. This discussion is based on the concept of the marginal cost of funds used in public finance.

Section 2.6 summarizes the main advantages and potential drawbacks of the evaluation framework proposed in this chapter. Because the preparation of this chapter was funded in large part by the Regional Studies Program of the Office of the Chief Economist for the Latin America Region at the World Bank, many of the illustrations are based on data from Latin America. Yet examples from other regions are provided as well, and the tools can be applied to any region or country. Technical notes to this chapter detailing the methodologies are given in the annex to volume 1 of this book.

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