The world is abuzz about inequality
- Pope Francis famously tweeted that inequality is the root of evil.
- As we witnessed in Davos in January, the media can’t get enough of Oxfam’s statistic that the richest 85, 80, 62 people have the same wealth as the poorest half of the planet.
- In 2014, a 700-page book on inequality by a French academic was a worldwide best seller.
But what exactly is this inequality everyone is talking about? It turns out that we might be measuring it all wrong. The Gini coefficient and (increasingly) the Palma Index are the most popular tools for measuring inequality within a country. These indicators calculate the ratio of the incomes of the rich over the poor. For instance, the Palma is a score calculated by dividing the share of income of the richest 10% by that of the poorest 40%.
The problem with these approaches is that they only measure relative inequality. If the incomes of the poor grow as fast as those of the rich, these measures will stay the same over time, but the difference in income from a one percent growth for the poor versus a one percent growth for someone already rich can be significant. As the Italian demographer, Livi Bacci, said ‘it is not much of a relief for somebody living on $1 day to see that his income, up by three cents, is growing as much as the income of the richest quintile’.
Unfortunately, relative inequality measures don’t tell us about the absolute gap in incomes between the rich and the poor.
Exploring the difference between relative versus absolute inequality
To explore the differences between absolute and relative inequality consider the example of the Philippines (see figure).
Over the last 25 years, relative inequality remained fairly stable in the country. This can be seen by the fact that the red line is quite flat across the income distribution as on average all people have experienced a growth rate in their incomes of around 2% a year. However, the green line shows that the additional income generated from this growth is massively weighted towards the rich end of the income distribution – they got the lion’s share of the dollars, a fact obscured if we stick to measures of relative inequality.
In other words, absolute inequality increased dramatically.
[Note: The slower average income growth for the top percentiles is largely due to the very richest people in the Philippines suffering considerable loss in incomes during the 2008 financial crisis.]
Why does this matter?
Politicians, pundits, and other voices often herald the impressive economic growth of developing countries in recent decades as a sign that the end of poverty and extreme inequality is near. And, in many countries relative inequality indicators are suggesting the poor are catching up with the rich.
For instance, using a relative inequality measure the World Bank boldly concluded that an era of shared prosperity is already upon us. According to its Global Monitoring Report, the poorest 40 percent fared better than the average in 58 of 86 countries. Yet, a recent paper shows that while the income of the poor may have grown faster, in a number of these countries they captured a smaller share of new income from growth compared to the richest 10 percent.
Even more shocking, a recent ODI paper shows that in the past 30 years absolute inequality always increased when countries experienced long periods of growth across income groups.
The insights gleaned from comparing relative versus absolute inequality tell us that growth needs to be even more intensively pro-poor than often suggested. In fact, closing the gap between the rich and poor requires the bottom 40 percent to grow around twice the country average.
A new measure of the gap between the rich and poor
Measuring how the gap between the rich and poor changes over time is an essential first step in addressing
inequality. The ODI paper proposes a new measure called the ‘Absolute’ Palma, which is the average income of the top 10 percent minus the average of the bottom 40 percent.
This is a modification of the Palma ratio that was first proposed on this blog. As mentioned above, the Palma is a relative measure, calculating the ratio of the share of income of the top 10% to that of the bottom 40%. In contrast, the ‘Absolute Palma’ captures what this means in terms of the actual income gap between the top 10% and bottom 40%.
People scoffed at the initial proposal for the Palma ratio, (which was a big improvement on the Gini), but it has caught on rapidly. We think an Absolute Palma would be an even better measure of inequality – let’s hope it catches on just as quickly.