What’s next for Inequality? Kuznets’, Piketty’s and Milanovic’s Theories explained

Especially in the United States, the discussion surrounding income inequality sits at the forefront of public consciousness. From the 2011 ‘Occupy Wallstreet’ movements to ironic ‘Tax The Rich’ dresses – many seem to see the “Land of the Free” as a “Land of the Unequal”.

Though income inequality was exacerbated by the Great Recession and the COVID-19 crises, it has been on a steady rise already since the mid to late 1970s. After overcoming the economic stagnation of the 1970s, the top income groups have consistently been the beneficiaries of economic growth. For instance, a striking comparison can be made between CEO and worker pay: 20:1 in 1965 – now, an estimated 278:1 (2018).

These developments are of particular interest to scholars of economic development, as they force us to reconsider how economic growth impacts inequality. In the early 20th century, it was conventional wisdom that greater societal prosperity, and equality, could be achieved through growth. Nowadays, this relationship seems less clear than before. Why, after a period of relatively low inequality, did inequality rise again in the US, despite positive economic growth?

1. The Kuznets Curve

In 1955, Russian-American economist Simon Kuznets defined the ‘Kuznets Curve’, by which economic growth and inequality follow an inverted U-Shaped distribution (Figure 1). This model, albeit more philosophical than empirical, greatly shaped the traditional understanding of growth and inequality dynamics.

This model can be accurately applied to the process of industrialisation. In the first phase of the curve, inequality widens as industrialisation begins – investment opportunities arise, but generally only those who have the means to capitalise upon them benefit. Labour moves from the subsistence level or agricultural sector to the manufacturing sector, working for low wages as the number of ready workers exceed the amount of paying factories (excess labour). Profits are accumulated, so firms are inclined to expand and build more factories. Then, a turning point occurs. These additional firms will ‘soak up’ excess labour, until it is eliminated. At this point, wages will begin to rise as labour is scarcer than before, and accumulated capital is likely to be re-invested also into human capital. As workers gain higher incomes and educations, the gap between the wealthy and the poor narrows.

I. The Brazilian Kuznets Curve

We can take a look at an example to illustrate this concept – namely the development of Brazil in the 20th century. In the 1930s, the Brazil introduced protectionist measures to foster the growth of infant industries. This (initially) fostered a plethora of economic opportunities that were reaped by the Brazilian elite. The democratisation of the military dictatorship in the 1980s marked an important turning point – open-market and redistributive policies were introduced in the 1990s, resulting in an equalising effect. The following graph, created by researcher María Gómez León for her article “The Kuznets Curve in Brazil, 1850-2010”, illustrates the inverted U-shaped relationship between economic growth and inequality very clearly:

In this context, it is necessary to highlight the importance of political incentives. Latin America, presently the world’s most unequal continent, has historically struggled with its elitist governments – theorised to be a remnant of past extractive colonial authorities. While a turning point may have occurred without political intervention, it may have also been a dismantling of elitist structures which allowed for greater equality.

II. The East Asian Miracle

The Kuznets Curve is not, however, a ‘one-size-fits-all’ sort of model. It breaks down in certain cases, for instance when analysing the East Asian Miracle. In the second half of the 20th century, the four ‘Asian Tigers’ (Hong Kong, Singapore, South Korea and Taiwan) experienced an unprecedented amount of economic growth and industrialisation, transforming them into high-income economies by the turn of the century. The twist? They did so at relatively low, stable income inequality levels.

This break of the Kuznets Curve may be attributed to the active role of the government. For instance, economist Joseph Stiglitz argues that landholding reforms and the ensuring of primary education greatly benefited East Asian countries in providing the initial conditions for success. In fact, a research paper found that, in South Korea, almost 90% of growth since 1960 can be accredited to initial conditions in equality and human capital. Higher disposable income across social classes increased demand for domestic products alongside imports, whilst an educated workforce attracted investors. Once markets opened, equality consistently reinforced economic growth.

III. Kuznets Curve Conclusions

While the Kuznets Curve may be useful for understanding what one of the leading theories that scholars of economic development subscribed to in the 20th century was, it is too inconsistent to provide a comprehensive solution. In fact, Kuznets himself admitted to the fallibility of his own theory: “[…] I am acutely conscious of the meagreness of reliable information presented. The paper is perhaps 5 per cent empirical information and 95 per cent speculation, some of it possibly tainted by wishful thinking.” As we have seen, the model simply does not hold in certain cases, such as when analysing the East Asian Miracle.

Additionally, developed countries such as the US experienced a rise in inequality post-1970, even though a Kuznets Curve model predicts economic growth to lead to a decline in inequality for high-income nations. The next part of this article aims to develop alternative theories to explain this phenomenon.

2. Alternative Theories: Post-1970 Inequality

I. Piketty’s “Capital in the Twenty-First Century”

One of the most influential books to come out in recent years is French economist Thomas Piketty’s “Capital in the Twenty-First Century” (2013). In it, he argues that inequality is the product of capital having grown faster than the economy. Intuitively, we can think of this in terms of capital earnings and labour earnings. Wealthy individuals are more likely to own investments which produce a return, whilst labour is dispersed within the economy. Thus, if the rate of return on capital is higher than the growth rate of the economy (on which wages depend on), it means that wealthy individuals gain a higher share of income than the rest of the population.

Piketty predicts that inequality is bound to rise in the twenty-first century as the rate of return on capital increases. He argues that relative equality was seen up until 1970 due to the destruction of capital during the world wars as well as the introduction of high taxes and welfare states (in Europe more than the US). Now, capital has recovered.

He also argues that a different factor influenced increases in inequality within the US. He attributes the fact that 60% of the top 0.1% of income earners are managers or financial professionals to a phenomenon called ‘supermanagers’, whose high pay is the product of declining top marginal tax rates.

Piketty’s solution for keeping inequality within bounds, which he himself dubs as ‘utopian’, is a global wealth tax, akin to the progressive taxation that was abandoned from the early 1980s onwards. For the US, a higher top marginal tax rate would be appropriate to consider. While the economic and political feasibilities of Piketty’s solution may be contested, one may once again point to political incentives and redistribute policies being at the heart of enabling greater equality.

However, several flaws have been pointed out in Piketty’s data, undermining his argument. For instance, the Financial Times pointed out ‘simple fat-finger errors of transcription; suboptimal averaging techniques; multiple unexplained adjustments to the numbers; data entries with no sourcing, unexplained use of different time periods and inconsistent uses of source data.’ Once the Financial Times’ specialists cleaned this data, they found no evidence that inequality should have risen post-1970.

II. Milanovic’s Kuznets ‘waves’

A new proposal by Serbian-American economist Branko Milanovic introduces the concept of continuous, sinusoid Kuznets ‘waves’. Milanovic argues that, for high-income countries, inequality may move from decreasing to increasing, forming new Kuznets Curves with each structural shift in the economy. In the second half of the twentieth century, developed economies shifted from manufacturing to service-based industries. Thus, the same process repeats as when the manufacturing sector attracted labour from the agricultural sector/subsistence level, taking time until the surplus is soaked up and accumulated capital is reinvested.

A significant implication of this theory could be the reconciliation of the Kuznets Curve, an inverted U-curve, with Piketty’s empirical work, which implies a U-curve. Additionally, in contrast to Piketty, this theory would imply inequality to eventually decrease. However, additional research into the theoretical implications and empirical proofs would have to be conducted to evaluate its accuracy.

Conclusion

Traditionally, the Kuznets Curve was used to describe the dynamics of inequality and economic growth – however, this relationship breaks down when considering the East Asian Miracle as well as post-1970 inequality trends amongst developed nations. Piketty argues that it is the rate of return on capital compared to the growth of the economy which determines the income share owned by the wealthy. However, faults in Piketty’s data have been found. Milanovic attempts to reconcile Kuznets with Piketty through his definition of Kuznets ‘waves’ – though the implications and evidence for this theory are unclear.

As we can see, there is no sole, clear theory on the relationship between inequality and economic growth – thus, it is difficult to predict whether inequality will fall or rise in the coming decades. Throughout the examples outlined above, both the preservation of free-market, open-market policies, to encourage capital to accumulate, as well as the introduction of redistributive policies seem essential in enhancing both equality and well-being.