Inflation and Income Inequality: The Dynamic from Institutional Quality

Prepared by Law Chee-Hong^a and Soon Siew-Voon^b

^aSchool of Social Sciences, Universiti Sains Malaysia, Gelugor 11800 Penang, Malaysia

^bDepartment of Applied Statistics, Faculty of Economics and Administration, University of Malaya, 50603 Kuala Lumpur, Wilayah Persekutuan, Malaysia

Highlights

• Income inequality has social and economic impacts
• Inflation has an ambiguous effect on income inequality
• The quality of the institutional system in a country has a direct and indirect effect on income inequality

Income inequality

The implications of income inequality have been extensively discussed as it influences the society socially and economically. For example, income inequality will undermine the opportunity for the poor to gain access to facilities that could improve their social status. Among the facilities is tertiary education. Moreover, the feeling of deprivation could create social unrest. The uneven income distribution could also reduce economic growth if a considerable portion of the population earns low income.

Hence, there are consistent efforts to study the determinants of income inequality.[1] The need to examine this aspect has become even more pressing since the 2008 Global Financial Crisis. In general, the 2008 Global Financial Crisis has reduced the income level of the ordinary people while the large financial institutions received bailouts from the governments. Besides, the political turmoil in the UK and EU, and oil price fluctuations also shook the economy in 2015-2016; See Table 1 for the percentage changes in income for selected countries and regions. As a result, many countries, especially the high-income countries, are badly hit by the global financial crisis was full of the sentiment that the wealth has been unequally distributed. The implication of this feeling of unfairness has even contributed to the rise of the populist leaders.

Table 1: The percentage changes in the income per capita  (selected countries and regions)

	2008	2009	2010	2014	2015	2016
High income	5.503453	-6.93096	4.111091	1.597618	-6.05914	1.513541
Low income	17.82489	0.064179	8.050096	4.520237	-2.6473	-10.0005
Middle income	18.60895	-3.37633	20.33538	2.603289	-6.18685	-0.53531
United Kingdom	-6.48613	-18.1315	1.866815	9.16358	-5.16762	-8.6953
United States	0.847488	-2.65091	2.903473	3.633551	3.224099	1.944648

(Source: Authors calculation)

Figure 1 below illustrates the changes in income inequality in some countries in 1990 and 2015 to give readers an idea about the condition in income distribution. Countries located above (below) the 45-degree line experience an increase (decrease) in income inequality. This figure points out that the vast majority of the countries in Figure 1 experienced a rise in income inequality. Besides, income inequality is more severe in less developed countries in Africa and Latin America. In contrast, the countries in the European, especially those in the Scandinavia region, have a lower degree of income inequality.

Figure 1: Income inequality in 1990 and 2015

(Source: Adapted from https://www.weforum.org/agenda/2018/11/is-income-inequality-rising-around-the-world)

How does inflation affect income inequality?

According to the studies conducted by Monnin (2014), Nantob (2015), Balcilar et al. (2018), and Saimi-Namini and Hudson (2019), inflation has affected income inequality. There are two opposite views about the implication of inflation on income inequality. On the one hand, a rise in the price level will lower the purchasing power, especially the poor. Besides, the real value of government aid could be negatively affected as well since the financial aid will not be adjusted upward to compensate for inflation. On the other hand, rising inflation will narrow down income inequality by taxing the rich more since the nominal income moves in tandem with inflation (Yue, 2011).

Institutional role in the nexus between income inequality and inflation

Empirically, the impact of income inequality on inflation is inconclusive. In other words, the link between income inequality and inflation depends on a specific condition. This article discussed the role of institutional quality in that nexus. Generally, institutional quality should have a positive direct effect on reducing income inequality (Chong and Calderón, 2000). However, good institutional quality could increase income inequality, as argued by Amendola, Easaw, and Savoia (2013). A government with better institutional quality could have a higher tendency to close down the income gap by launching inclusive economic planning. However, Dobson and Ramlogan-Dobson (2010) argue that institutional quality does not guarantee that. Instead, the income redistribution could be halted, amplifying the negative association between inflation and income inequality.

Income inequality and inflation: An empirical study

Law and Soon (2020) has explored the dynamics between inflation and income inequality, and the impacts of institutional quality in that nexus on a set of unbalanced panel data that involves 65 countries. The relationship is verified by estimating a model with interaction terms between inflation and income inequality. Among the notable findings are that the sign of the institutional quality and inflation is negative and positive, respectively. Additionally, the interaction term is negative and statistically significant, suggesting that better institutional quality will mediate the effect of inflation. Equally important, the calculation of the marginal impact of institutional quality and inflation indicates that both variables will reduce the income inequality in the sample. Furthermore, the comparison of marginal effects demonstrates that the former has a more significant role in lowering income inequality compared to the latter. In sum, the nexus between inflation and income inequality is influenced by the level of institutional quality, and the institutional quality is more influential compare to the inflation rate in affecting income inequality.

Conclusion

The purpose of reducing income inequality is to avoid oppression and the denial of opportunity to enjoy the fruits of economic progress. Apart from political factors, economic factors such as inflation could play a role in the income inequality of a nation. The empirical results released by Law and Soon (2020) reckon that inflation will lower income inequality but at a small magnitude. Institutional quality, otherwise, not only mitigates the impact of inflation on income inequality, but it also has a more substantial direct effect in lowering income inequality. We could summarise that while inflation could reduce the purchasing power, the rising tax revenue following inflation enables the government to allocate more funding for social-related expenditure. Eventually, inflation has a marginal effect on cutting down income inequality. More importantly, improvement in the institutional quality, such as bureaucracy quality, could be a critical factor in the fight against income inequality.

References

Amendola, A., J. Easaw, and A. Savoia. 2013. “Inequality in Developing Economies: The Role of Institutional Development.” Public Choice 155 (1–2): 43–60.

Balcilar, M., S. Chang, R. Gupta, and S. M. Miller. 2018. “The Relationship between the Inflation Rate and Inequality across U.S. States: A Semiparametric Approach.” Quality & Quantity 52: 2413–2425.

Chong, A., and C. Calderón. 2000. “Institutional Quality and Income Distribution.” Economic Development and Culture Change 48 (4):761–786.

Colciago, A., A. Samarina, and J. de Haan. 2019. “Central Bank Policies and Income and Wealth Inequality: A Survey.” Journal of Economic Surveys 33 (4): 1199–1231.

Dobson, S., and C. Ramlogan-Dobson. 2010. “Is There a Trade-off between Income Inequality and Corruption? Evidence from Latin America.” Economics Letters 107 (2):102–104.

Law C. -H., and S.-V. Soon. 2020. “The Impact of Inflation on Income Inequality: The Role of Institutional Quality.” Applied Economics Letters. [Paper in Press]

Monnin, P. 2014. “Inflation and Income Inequality in Developed Economies.” Council on Economic Policies Working Paper No. 1401.

Nantob, N. 2015. “Income Inequality and Inflation in Developing Countries: An Empirical Investigation.” Economics Bulletin 35 (4): 2888–2902.

Saimi-Namini, S., and D. Hudson. 2019. “Inflation and Income Inequality in Developed and Developing Countries.” Journal of Economic Studies 46 (3): 611–632.

Yue, H. -Y. 2011. “Income Inequality, Economic Growth and Inflation: A Study of Korea.” International Journal of Economics Research 2 (5): 14–21.

Footnotes

[1] Colciago, Samarina and de Haan (2019) produce a detail reports about the previous studies related to income inequality.