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Inequality and reforms

Arvind Panagariya

The debate on whether or not liberalisation helped reduce poverty is now essentially over. Sustained reduction in the proportion of the population living below the poverty line (or the poverty ratio) since the early 1980s stands in sharp contrast to no reduction in this poverty measure between 1950 and 1980. Unsurprisingly, the reform critics have changed the topic. They now say that reforms are to be resisted because they give rise to vast inequalities.

Before we consider the empirical basis of this argument, let me note that in evaluating the desirability of the reforms, a clear distinction between poverty and inequality must be made. An increase in inequality is more acceptable if it is accompanied by poverty reduction. By the same token, policies that hold the line on inequality but deny the poor the opportunities to improve their lot are to be discarded. When measured against this criterion, liberal policies have delivered a vastly superior outcome than the dirigist policies of the 1960s and 1970s.

Indeed, if we look at the measures of inequality across households, evidence that inequality has gone up under the reforms is far from compelling. Given the substantial decline in rural poverty and the absence of massive gains for large farmers, it is not surprising that rural inequality has remained, at worst, unchanged. Inequality among urban households has perhaps gone up, but the magnitude of this increase is small and surely not alarming once we take into account the reduction in urban poverty that has accompanied it.

Two forms of inequality that have gone up significantly and deserve closer examination, however, are regional and rural-urban inequality. Differences in per-capita incomes across the states have shown a clearly rising trend during the decades of rapid growth. For example, per-capita income in Bihar, the poorest state in India, was 34% of that in Punjab in 1980-81 but fell to 27% in 2002-03.

The commonest summary measure of inequality used by economists is the Gini coefficient. Despite some serious deficiencies, this measure has some attractive properties. It takes a value of zero if per-capita incomes are identical across states (the case of perfect equality) and one if all income is concentrated in one state with per-capita incomes in all other states being zero (the case of perfect inequality). In less extreme situations, the coefficient takes a value between zero and one.

According to an article by economist S L Shetty, published in 2003, the Gini coefficient for real per-capita gross state domestic product for all states rose from 0.209 in 1980-81 to 0.217 in 1987-88, 0.237 in 1993-94 and 0.292 in 2000-01. These changes represent an almost 40% increase between 1980-81 and 2000-01.

While the alarmist assertions by reform critics that these rising regional inequalities will sooner or later lead to violent reactions by the poor states such as Bihar or attempts at separation from the Indian Republic by the fast-growing richer states, especially in the south, cannot be taken seriously, the question whether this inequality requires a major redirection of policy on social grounds must be addressed. There are at least five reasons why it is a mistake to shift the focus away from poverty reduction and growth towards inequality.

First, the broad evidence is that per-capita incomes even in the states at the bottom have risen faster since the late 1980s when the richer states grew faster. Rajasthan, Madhya Pradesh and Orissa, which are all among the large bottom six states on the basis of per-capita incomes, experienced significant acceleration in per-capita income growth between 1988 and 2004 over that between 1980-81 and 1987-88. Bihar suffered a decline in the growth rate of per-capita incomes during 1988-94 but more than recovered during 1994-04. Uttar Pradesh is a significant exception, but it too is doing much better in the last two or three years.

Second, the states that exhibit lower per-capita incomes also exhibit high poverty ratios. Therefore, focusing poverty reduction efforts on the states with high poverty ratios or large concentrations of the poor will automatically help bring regional inequalities down. States of Bihar, Orissa, Madhya Pradesh and Uttar Pradesh, which are among the poorest large states according to per-capita incomes, also exhibit the highest poverty ratios.

Third, inequality in growth rates across states may lead to beneficial demonstration effects. Thus, for instance, fast growth in Tamil Nadu and Karnataka may inspire the leadership in Bihar and Uttar Pradesh to play catch up, as has already happened in the case of Rajasthan and West Bengal. When it comes to rapid growth in South Korea or China, the lagging states may be inclined to think that the Chinese are special or that the Indian conditions are not conducive to East-Asian levels of growth. But when some of the states within India begin to grow at the East-Asian rates, the lagging states are more likely to shed their pessimism.

Fourth, it bears reminding that the activist policies to promote regional balance during the investment-licensing era did not yield particularly encouraging results. The central government used licensing policy to distribute industries across states. But these efforts only fostered inefficiency and hampered growth and poverty reduction.

Finally, given interstate mobility of workers, migration is likely to help alleviate regional inequality. On the one hand, such movements reduce the pressure on land in regions of emigration and on the other hand, they bring remittances to the families of emigrants.

But what about urban-rural inequality, which has also risen sharply in recent times? From an economic standpoint, this form of increase in inequality should be least disturbing. A key aspect of the process of economic transformation is the movement of workers from farm to non-farm activities. Therefore, it should be no surprise that rapid economic transformation is usually accompanied by increased urban-rural inequality. It is the faster growth in incomes in the urban areas that pulls rural workers into gainful employment in the urban areas.

(The author is professor at Columbia University and Non-resident Senior Fellow at the Brookings Institution)

Economic Times October 29 2007