An N-Shaped Kuznets Curve?

by Arpit Gupta

Via Economic Logic, there’s new research on the Kuznets Curve. As originally formulated, the idea is that income inequality in a society grows as economies initially transition from agricultural to industrial societies, but falls later as they develop further.

But what about when societies transform from industrial to post-industrial societies based on service-sector employment? Jordi Guilera examines the issue and argues that inequality tends to rise again as societies continue developing. The Kuznets Curve, in other words, is really “N”-shaped.

The basic outline is supported by an examination of inequality trends in Portugal. The initial wave of development as the country transitioned into an industrial economy was accompanied by rising inequality. The large difference in income between the agricultural and industrial sectors results in growing inequality. As the country continues developing, there are few remaining farmers, all workers gain in bargaining power, and inequality falls. As Portugal continued developing — its inequality started to rise again. In this case, the driving force was different — rather, it was the wage gap between skilled and unskilled workers. Skill-directed technological change grows the returns to human capital, but not everyone is skilled. So income gains are umbalanced, and economy-wide inequality continues to grow.

Guilera finds that the manner in which inequality shifts is consistent with this story. When inequality initially rises, it is due to greater inequalities between sectors of the economy. One way of thinking about this is through Dani Rodrik’s graph:

This shows the correlation between initial and future labor productivity in the manufacturing sector. The conclusion is that there is convergence in manufacturing labor productivity. If you are a poor country; your manufacturing sector over time will reach the productivity level of a rich country. This is different from the case of ordinary income — which only starts to converge to rich country levels in response to some set of conditions.

In other words — industry is an enormous lever of growth for poor countries. Seemingly automatically, industrial productivity will rise over time and generate rising incomes. In the short-run, this will generate inequality as the industrial sector is dramatically more productive than other sectors of the economy. But in the longer-run, the economy overall has higher productivity and then lower inequality.

When inequality rises again after a country has already industrialized, it is due to a different set of pressures — greater inequalities within sectors of the economy. The pressure here comes from differential access to skills. Another graph Dani Rodrik presents illustrates this issue:

Here, you see that while labor productivity grew dramatically in the US over 1980-2009; real compensation (including fringe benefits) was stagnant for those with a high school degree only (and presumably even worse for those without a high school degree). Yet there was an enormous growth in compensation for those with higher education. Modern service economies prize above all else the ability to accumulate and capitalize on human capital skills regardless of sector. And this results in growing inequality.

I suppose the question is whether this second spike in inequality will ever run into reasons to go down again due to changing labor force composition. Presumably, if we did a better job of spreading skills throughout the population, inequality would fall again. But there appear to be durable problems in making that happen.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.