The Environmental Kuznets Curve

A major topic in developmental and environmental economics surrounds the issue of income inequality, more specifically, the application and validity of an income inequality measure; The Kuznets curve. Fields (1999) argues the Kuznets curve to be the single most important event leading to the study of inequality and economic growth. Piketty (2004, p2) states that the Kuznets theory can be viewed as 'a sophisticated formulation of the standard, trickle-down view of development: innovations first benefit to a few individuals and eventually trickle down to the mass of the people'.

Within this paper I will to introduce a full and concise explanation of the Kuznets curve, covering both its background and theoretical application. Furthermore I will identify flaws in its validity touching on empirical research conducted as well as its subsequent policy implications to provide a rounded conclusion.

Hypothesized in 1955 by Simon Kuznets, the theory states that income inequality should follow an inverse-U shape along the development process, first rising with industrialization and then declining, as more and more workers join the high productivity sectors of the economy. It is important to note that Kuznets work was deemed as revolutionary as there was a lack of theoretical reasoning around the topic of income inequality prior to his publication. A fuller explanation of Kuznets hypothesis lies in Minalovic's September 2011 issue of Finance and Development p1, where he offers a deeper, more complete definition of Kuznets inequality measure;

'In preindustrial societies, almost everybody is equally poor so inequality is low. Inequality then rises as people move from low productivity agriculture to the more productive industrial sector, where average income is higher and wages are less uniform. But as a society matures and becomes richer, the urban rural gap is reduced and old age pensions, unemployment benefits, and other social transfers lower inequality'

Therefore we ascertain that the basic idea of the Kuznets curve is that as an economy develops and goes through industrialization, economic inequality increases. As the specified economy approaches maturity this income inequality decreases, hence the inverted U shaped graph shown in figure 1. His hypothesis is built upon the idea of inter sectoral mobility and the income distribution associated with it. Gallup (2012, p2) seems to reaffirm this contending that the theoretical application of the Kuznets curve itself was proposed as a 'law of motion for the distribution of income'.

Outlined by Figure 1; beyond a point, predominance of industrial employment will improve the distribution of income as employees earn more equal wages. The economic theory proposed by Kuznets was solid until a new body of data became available to scrutinize his findings. It is with the implementation of this new body of data that the validity of Kuznets findings has been called into question, although there are still many papers which confirm Kuznets original findings.

Incidentally furor that surrounds the Kuznets curve is not of its theoretical framework, but surrounding the validity of the data it was hypothesized upon as well as its econometric techniques. At face value, Kuznets 1955 address can be questioned, as Gallup (2012, p5) ascertains that his work was 'based on time-series data for just three countries and his intuition about the mechanisms of economic development'. Kuznets theory was based on data he obtained for changes in income distribution in the United States, United Kingdom and two states in Germany. He combined these observations with a certain level of perception citing a historical shift from agriculture to industry in the course of economic development. Essentially, he presumed that inequality grew in both the UK and the US before his time series data started, although he had no specific data to confirm this.

Periodically, Kuznets based his work on assumptions citing that his paper constituted; "perhaps 5 per cent empirical information and 95 per cent speculation, some of it possibly tainted by wishful thinking" (Kuznets.S, 1955, p26). An interesting work by Kanbur,R. & Anand,S. (1994) felt that the Kuznets hypothesis had become 'counterproductive' and a 'straight jacket to fresh thinking'. These comments, in reference to the idea that research was now essentially trying to generate an inverted U shape curve in order to confirm their work.

However, that is not to suggest that Kuznets hypothesis has been rebuffed on the face of new data. Ahluwalia (1976) seemed to confirm Kuznets hypothesis however it was centered on the applicability of the inverted U curve as a measure of inequality to developing countries. His findings were based on the income share of the top 20% of the 62 countries he used within his study of cross sectional data from 1960's and 1970's. He completed his findings using multiple regression techniques to outline the relationship between income inequality and the level of development. 'The central and striking estimation in Ahluwalia (1976) was that of a log-quadratic relationship between inequality and per capita income in the cross-section of countries' (Kanbur.S, 2012, p5).

His results agreed with Kuznets findings and many similar studies conducted such as Paukert (1973) & Ram (1988) also assimilated to the general conclusion provided by Barro (2000, p8) 'inequality first rises and then falls as an economy develops'. However later works such as Saith (1983, p377) disputes this, stating that they are found to be 'based on defective statistics and questionable methodological premise'. Saith goes on to state that the cross country U-hypothesis is more of a hindrance that an aid to our comprehension of the relationship between economic growth and income distribution.

The first such large scale data set available to test Kuznets hypothesis appropriately within countries was Deininger & Squire's (1996, p574) paper; 'A new data set measuring income inequality'. Within this paper, the authors immediately set out to outline the problems with the validity of Kuznets work, citing 'the lack of time series that are sufficiently long has prevented appropriate hypothesis testing'; further adding weight to its questionable validity by identifying such issues as data quality as reasons for empirical results to be affected. They elaborate by arguing that if the correct econometric techniques were followed, no such inverse U-curve was found when testing the cross sectional data that formed Ahluwalia's (1976) work. Consequently they postulate that if there is no Kuznets curve, the policy conclusions that may be drawn would be flawed and unreliable. (Adnan,S. & Kabur,R. 1993)

As previously stated, although there are a kaleidoscope of studies, who when using relevant up to date data, found robust support for Kuznets hypothesis, there are also many who did not. Gallup (2012, p2) again pertained that 'if other factors can influence the level of income distribution in each country, country characteristics rather than a Kuznets hypothesis may explain cross sectional patterns'. Namely, empirical evidence suggests that the Kuznets curve may not be strictly true for a specific country. However there is a growing body of evidence that suggests that it may hold true for a cross section of countries, at a specific point in time, (Gallup,J. 2012).

Bacha (1977, p3) argues that the biggest issue with Kuznets hypothesis is 'the applicability of cross country results to particular country experiences'. Furthermore a number of more recent papers have found little support for a Kuznets curve once country fixed effects have been accounted for, (Deininger & Squire, 1998, Higgins and Williamson, 1999, and Barro, 2000). Interestingly as Higgins and Williamson point out, the emergence of a Kuznets curve disappears when dummy variables are added. This was outlined by Anand.S & Kabur (1993) where GDP was used as the only explanatory variable. This study found that the Kuznets curve disappeared with the inclusion of dummy variables for Asia and Latin America. This was found to be due to Latin American countries having high inequality as well as being located near the middle of the per capita ranking. Counterintuitively, Asian countries had lower levels of inequality whilst being located closer to the lower end of the income per capita rankings.

Moreover, both Kuznets (1955) and Ahluwalia (1976) show a narrowing income gap between the agricultural and non-agricultural sectors would be sufficient to stem inequality. One idea is the movement of labour from the agricultural sector would eventually lead to a shortage and thus incomes would begin to rise in that sector. A second explanation could lie in the implementation of policies to improve income within lagging sectors.

Banerjee et.al, (2005), argue that Kuznets theory has strong and optimistic policy consequences, stating that if LDC's are patient enough, they should soon reach a world where growth and inequality reduction go hand in hand, and where poverty rates drop sharply. Kanbur (2000) outlines two possible lines of thinking, one for a so called natural tendency for inequality to be prevalent in the early stages of economic development. Within this school of thought, policy implications were necessary in order to negate the negative consequences they entailed. The second ideology suggested as Kuznets did, that eventually the inequality would drop, and thus no policy measures were necessary to control or manipulate it. This second thought process also appeared in Ahluwalia's (1976, p132) work, 'despite inequality increase the absolute incomes of the poor did increase because of the effects of growth'.

Conclusively we can ascertain that although there exists a minefield of economic theory, empirical evidence shows that Kuznets curve may not be strictly true for a country in an individual context. However, as aforementioned, there is evidence that it holds true for a cross section of countries at a given point. Equally as many studies have outlined, a swelling body of research has stipulated that other factors besides income have more significant effects on inequality. The vast amount of theoretical criticisms that have been drawn upon in this paper draws attention to the questionable validity of the Kuznets curve, and whether given new data, its implications can be confirmed within a cross section of countries, as well as on an individualistic basis.

References:

Ahluwalia, M.S. (1976) Income distribution and development: Some stylized facts, American Economic Review 66(2):128-135

Anand, S. and R. Kanbur. (1993) Inequality and development: A critique; Journal of Development Economics 41:19-43. Bacha.L (1977) Issues and Evidence on Recent Brazilian Economic Growth: Volume 12 of Development Discussion Papers, Harvard Institute for International Development, Harvard University.

Banerjee,A. & Duflo,E. (2001) Inequality and Growth: What can the data say?, MIT press, 2001.

Barro,R. (2000) Inequality and Growth in a Panel of Countries: Journal of Economic Growth, 5: 5-32 (March 2000).

Bhattari,M. Yandle, B. Vijayaraghauam. (2001) The environmental Kuznets curve, A primer. [Figure 1].

Deininger, K,Squire, L: (1996) A New Data Set Measuring Income Inequality,World Bank Economic Review 10(3): 565-91.

Fields,S,G. (1999) Distribution and development: A summary of the evidence for the developing world, Russell Sage Foundation and the MIT Press.

Gallup, J. L. (2012). Is there a Kuznets curve? : Working paper.

Higgins, M. & Williamson,G, (2002) Explaining Inequality the World Round: Cohort Size, Kuznets Curves, and Openness. Southeast Asian Studies 40, 3 (December 2002): 268-302.

Kanbur,R. (2012) Does Kuznets still matter? : Ithaca, NY : Cornell Univ., Dep. of Applied Economics and Management, working paper.

Kuznets,S. (1955) Economic Growth and Economic Inequality: American Economic Review 45 (1955): 1-28.

Minalovic,B. (2011) More or less; Income inequality has risen over the past quarter century instead of falling as predicted. Finance & Development: September 2011. Available at: http://www.imf.org/external/pubs/ft/fandd/2011/09/pdf/milanovi.pdf

Piketty,T. (2003) The Kuznets' Curve, Yesterday and Tomorrow, Quarterly Journal of Economics 118, pp.1-39.

Saith, A. (1983) Development and distribution: A critique of the cross-country U Hypothesis; Journal of Development Economics 13:367-382.