On Economic Development, Corruption, and Income Inequality: The Role of the Informal Sector

What explains the trends of income inequality in the process of economic
development? A classic explanation is the Kuznets curve, which predicts an inverted-
U relationship between development and inequality. Inequality is low at low levels of
development as the majority of the population is poor. As industrialization
progresses inequality rises, before it decreases with state redistribution and the
spread of education. In other words, inequality is expected to be highest in mid-level
income countries. Of course, such a model leaves many nuances unexplained, and a
recent study, to be published in Politics, Mathew Y. H. Wong examines how
corruption and the informal sector might condition the effect of economic
development on inequality.
Corruption is traditionally believed to be detrimental to inequality since it
concentrates income in the hands of those powerful. However, a recent branch of
literature challenges this assumption by suggesting that the relationship might be
conditional, and the existence of an informal sector might be pivotal. While many
consider the informal sector to be a stagnant part of the economy, on the flip side it
is also an efficient sector for those otherwise have little opportunity in the formal
economy. The same argument can be applied on corruption: it provides ways for
businessmen to bypass cumbersome regulations. In short, the gains of economic
development can be more evenly shared by more people when corruption and the
informal sector are viable. If not, economic gains would be concentrated on big
businesses with good connections to the government, and the income gains would
be exclusive to those in the formal employment.
With a statistical analysis of 127 countries spanning about 40 years, the study finds
evidence in favor of the hypotheses. Economic development (measured as GDP per
capita) would increase inequality at low levels of corruption/when the informal
sector is small, and the reverse is true when corruption is rampant/the informal
sector is large. While the study relies mainly on the statistical testing of the
arguments, it is also noted that it fits with the patterns of the Asian Newly
Industrializing Economies (Hong Kong, Singapore, South Korea, Japan, Taiwan) in the
past quite well. Having all enjoyed decades of double digits GDP growth, they all
transformed from third world economies to some of the richest within a generation.
Interestingly, although Hong Kong and Singapore have always been critically
acclaimed for their low levels of corruption, they are also notorious for their high
levels of income inequality. On the contrary, the other three economies are
relatively more corrupt, but with a more egalitarian income distribution. The findings
of this study argues that this pattern might not be a mere coincidence.


Dr WONG Yee Hang Mathew


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