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Causes and Consequences of Income Inequality: A Global Perspective

File Created On:
June, 2015

Widening income inequality is the defining challenge of our time. In advanced economies, the gap between the rich and poor is at its highest level in decades. Inequality trends have been more mixed in emerging markets and developing countries (EMDCsf), with some countries experiencing declining inequality, but pervasive inequities in access to education, health care, and finance remain.

Not surprisingly then, the extent of inequality, its drivers, and what to do about it have become
some of the most hotly debated issues by policymakers and researchers alike. Against this
background, the objective of this paper is two-fold.

First, we show why policymakers need to focus on the poor and the middle class. Earlier IMF work
has shown that income inequality matters for growth and its sustainability. Our analysis suggests
that the income distribution itself matters for growth as well. Specifically, if the income share of the
top 20 percent (the rich) increases, then GDP growth actually declines over the medium term,
suggesting that the benefits do not trickle down. In contrast, an increase in the income share of the
bottom 20 percent (the poor) is associated with higher GDP growth. The poor and the middle class
matter the most for growth via a number of interrelated economic, social, and political channels.
Second, we investigate what explains the divergent trends in inequality developments across
advanced economies and EMDCs, with a particular focus on the poor and the middle class. While
most existing studies have focused on advanced countries and looked at the drivers of the Gini
coefficient and the income of the rich, this study explores a more diverse group of countries and
pays particular attention to the income shares of the poor and the middle class¡Xthe main engines
of growth. Our analysis suggests that

- Technological progress and the resulting rise in the skill premium (positives for growth and
productivity) and the decline of some labor market institutions have contributed to inequality in
both advanced economies and EMDCs. Globalization has played a smaller but reinforcing role.
Interestingly, we find that rising skill premium is associated with widening income disparities in
advanced countries, while financial deepening is associated with rising inequality in EMDCs,
suggesting scope for policies that promote financial inclusion.

- Policies that focus on the poor and the middle class can mitigate inequality. Irrespective of the
level of economic development, better access to education and health care and well-targeted
social policies, while ensuring that labor market institutions do not excessively penalize the poor,
can help raise the income share for the poor and the middle class.

- There is no one-size-fits-all approach to tackling inequality. The nature of appropriate policies
depends on the underlying drivers and country-specific policy and institutional settings. In
advanced economies, policies should focus on reforms to increase human capital and skills,
coupled with making tax systems more progressive. In EMDCs, ensuring financial deepening is
accompanied with greater financial inclusion and creating incentives for lowering informality
would be important. More generally, complementarities between growth and income equality
objectives suggest that policies aimed at raising average living standards can also influence the
distribution of income and ensure a more inclusive prosperity.

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