Achieving the twin goals: Growth with equity

'It is now clear that more than a decade of rapid growth in underdeveloped countries has been of little or no benefit to perhaps a third of their population. Although the average per capita income of the Third World has increased by 50 per cent since 1960, this growth has been very unequally distributed among countries, regions within countries and socio-economic groups. Paradoxically, while growth policies have succeeded beyond the expectations of the first development decade, the very idea of aggregate growth as a social objective has increasingly been called into question.'
The above quotation is from the introduction to the report on 'Redistribution with growth' by Holis Chenary who was a co-author of a study sponsored by the World Bank and the Institute of Development Studies (IDS), Sussex in 1973. It is interesting that the issue of inequality in the presence of successful growth policies drew the attention of the World Bank as early as the 1970s and it felt necessary to constitute a high-powered team of reputed economists including Holis Chenary, Montek, Ahluwalia, C. L. G. Bell, John Duloy and Richard Jolly for an enquiry and analysis of the conundrum of growth generating inequality and for recommendations of what measures could be taken to alleviate the situation.
The seemingly puzzling problem should have come as no surprise to the World Bank and the team of economists as Simon Kuznets, an eminent economist, had already (1955) found a U-shaped relationship between growth and distribution based on time series data and cross-sectional evidence in a study covering a number of countries. According to his study, at the early stages of growth distribution of income tends to become more concentrated among a few and then gradually tapers out showing a reduction in inequality as exemplified by the U-shape curve. The first part of his conclusion has held true to some extent because as the World Bank study in 1973 showed, inequality not only appeared at the early stages but persisted well beyond that while the second part of his finding did not turn out to be true as borne out again, by the 1973 study report.
Recent findings and reports by international institutions (IMF), civil societies (Oxfam) and individual economists (Thomas Picketty) have shown that income inequality has deteriorated alarmingly in the 21st century all over the world even as economic growth has taken place, albeit at differing rates across countries. The positive co-relation between growth and income inequality is now a given, making it a long-term trend. What is worrying is its steady worsening that has given rise to public unrest and movement by angry masses in developed countries like UK and America and concerns among economists in developing countries like Bangladesh.
Increases in income based on production output (this excludes income from inherited wealth which has become a major problem in some developed countries with little or no inheritance tax) tends to come disproportionately from relatively small modern sectors of production in developing countries (as it did earlier in developed countries) and absorb a high proportion of total investment with a high degree of productivity growth. This pattern of concentrated growth in developing countries is perpetuated by limited access to land, credit, education and modern sector employment. As the modern sector in the economy expands wage employment increases, engaging the asset less poor but the wage offered is barely above subsistence level. Collective bargaining, where allowed, manages to raise the wage level but the income differential between the workers and owners of capital and managers not only remains wide, it magnifies as aggregate growth moves up. This is because the modern economy (compared to feudal economy) in both developed and developing countries operating under free market system determines distribution of income ostensibly by the market but in fact by the owners of capital and managers. As a result, income inequality becomes well entrenched.
It is not defensible either on moral or economic grounds. There is no question that growth is indispensable for higher standard of living but it is also necessary to alleviate income inequality to sustain growth with skilled and healthy manpower who seeks higher consumption giving rise to greater demand for goods and services. The question is, how can this dual objectives seemingly at odds with each other, can be achieved.
Experiences in almost all countries show that it is not the 'invisible hand' of market but the visible hand of government that has historically influenced the distribution of income through taxes, fees, etc., on business, industries and individuals to finance public expenditures. To begin with, these expenditures were for routine activities like maintenance of law and order, revenue administration and defence. Infrastructure development gradually became important both for administrative purposes and to promote economic development and this added another group of public goods (having externalities and indivisibility) which had to be provided by the government for which the tax level was raised. When it become apparent that the growth process leaves many people behind in terms of income distribution depriving them of basic needs the government had to provide another set of public goods like education, health care and social welfare benefits which, in turn, necessitated further raising of the tax level. For poverty reduction and development of human resource it is the government which had to take up necessary programmes as the free market did not respond to these need being public goods in nature. Volume of revenue through tax depended on all these expenditures to be incurred by the government (for routine activities and provision of public goods) and on the optimum level of taxes that could be imposed without creating disincentives for producers who contribute to growth. Reconciliation of these seemingly irreconcilable objectives was sought  through the fiscal instrument of annual budget by the government, supplemented by monetary policy.
The optimum level of taxation can be determined on the basis of past experiences of public finance, trend in the growth rate of gross domestic product (GDP), consultation with representatives of business and industries and a rule of thumb that indicated what is the threshold of tax that allows a reasonable rate of return on capital after deduction of depreciation, amortisation of debt (for business firms this calculation omits depreciation). The reasonable rate of profit in this rough and ready calculation has usually been found to be 10 per cent on net income of business and industries. Leaving this amount untouched the government levy taxes at levels that it deems necessary. If the requirement of revenue income through tax to meet all obligatory expenditures is above the optimum level as defined above the government has to resort to borrowing from banks and external sources, which almost all governments do in case of deficit budget.
As regards corporate fat cats, who garner hefty amount in salary, bonus and other allowances, a formula and recommendation based on it was made by Ursula Hicks long ago (1965) even when income inequality had not assumed an acute form. According to her the exemption level for income tax should be set at a point which includes income at lower end representing the lower middle class. From this level, progressive tax should proceed by incremental stages up to a final increment of 80-85 per cent of net income. In Scandinavian countries this is mostly the case which takes care of a comprehensive welfare system.
To sum up, a country needs growth and cannot afford to put a brake on it through disincentives of a high burden of taxation on producers. It also needs to address the problem of income inequality for which public sector expenditures to provide public goods and services to the low-paid employees and the poor have to be ensured by the government along with implementation of the development projects that do not attract the private sector for their externalities. As has been discussed above, there is no conflict between these two when the government remains aware about the need to impose the optimum level of taxation for provision of public goods and services. With a pragmatic budget and a complementary monetary policy both the objectives can be achieved. Using this strategy, growth with equity will not appear as a chimera. What is more, when alarm is raised over growing income inequality 'growth' should not be seen as under siege. It is a call for growth to contribute its bit to help correct the inevitable inequality of income created by the growth process. The fact that this correction is based on public choice and not on market mechanism only goes to prove that the worst case of market failure is seen in the case of distribution of income.                           
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