Study by Vito Tanzi: Distribution of Human Capital Is Key Element In Tackling Problems of Income Inequality

International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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Traditionally, economists have paid scant attention to the social and cultural roots of inequality. But the pervasive role of social norms and attitudes in closed and traditional societies, or the growing role of human capital formation in determining wealth in more open and developed econ-omies, is a key element in the dynamic of development and the roots of inequality. In a recent IMF Working Paper, Fundamental Determinants of Inequality and the Role of Government, Vito Tanzi, Director of the IMF’s Fiscal Affairs Department, examines the economic and policy implications of the progressive replacement of real assets (such as land) with human capital (such as education) in the development process. Once human capital becomes a key determinant in the creation of incomes and wealth in developed economies, access to human capital and the government’s role in ensuring that access become vital issues, he argues, in tackling income inequality.

Social Norms and Inequality

Social norms influence income distribution in both traditional and more developed societies, and changes in these norms can alter the sources and dynamic of wealth accumulation. Tanzi cites, as examples, the impact of rental and labor contracts, marriage conventions, inheritance rules, and “positional rents”

Rental Contracts. Significant in countries where the ownership of assets is highly concentrated, traditional rental contracts, such as those dictating the division of output between landlord and tenant, play an important role in the use of land and other assets.

Labor Contracts. In several societies, notably in Asia, employers may assume a paternalistic attitude toward employees. During recessions, profits may fluctuate sharply, but unemployment rates do not. These economies commonly feature lower income inequality than those with less paternalistic labor arrangements.

Marriage Conventions. Customs influencing the size of dowries, the choice of spouse, the cost of marriages, the age of marriage, and the gifts associated with marriage all have significant implications for income and wealth distribution. When the rich and the poor marry only within their own social stratum, income distribution tends to remain static. Modernization, mobility, and globalization can break down the status quo, with major implications for the formation of wealth and for income inequality.

Inheritance Rules. In traditional societies, where real wealth is the principal determinant of income, rules governing the transfer of wealth between generations are critically important. Inheritance rules, for example, might dictate the conveyance of property to the firstborn son. In societies where human capital is crucial in determining wealth, the holding (and transfer) of real capital declines in importance. (Wealth, however, may be a crucial ingredient in obtaining human capital.)

Positional Rents. Social capital—that is, family name, prestige, contacts, and, in some societies, claims to certain positions or occupations—is a key element in determining the distribution of income and privilege in many these societies. (Such positional rents may also dictate the basis for promotions and determine to whom priority will be given.)

In the absence of major upheavals, such as war or severe economic dislocation, social norms tend to be stable over time in traditional societies. The deep and pervasive economic changes wrought by development and globalization, however, have the power to induce profound changes in social norms, which, in turn, have implications for the economy. Modernization, for example, can induce greater labor mobility, influence the choice of marriage partner, and ultimately reduce the influence of positional rents.

In traditional societies, income inequality is essentially determined by the distribution of real wealth and by positional rents (with real wealth also a key contributor to positional rents). To address income inequality issues in these societies, governments must alter the distribution of real capital (land reform, for example) or influence positional rents (through social and structural reforms). By contrast, in more open and developed societies, where human capital plays a significant role in wealth accumulation and where globalization has a continuing and potent impact, government can address income inequality and other inequities through its role in generating and distributing human capital.

Government’s Traditional Role

What government can, and cannot, accomplish—and the means it uses—is conditioned by the level of a country’s economic and institutional development, according to Tanzi. Ironically, where government is most needed—that is, in developing economies where the markets are most underdeveloped and flawed—it is least likely to have the tools needed to carry out this corrective function efficiently. Developing countries often lack the capacity to collect sufficient revenue, and the tools they do wield tend to produce distortions. By contrast, advanced industrial countries, with their efficient markets, tend to have much larger governments and are less likely to have to address market failures—primarily because they are better able to collect taxes.

Even countries highly concerned about inequality, Tanzi stresses, must first promote macroeconomic stability and efficiency. Stability is the foundation of economic growth, and growth is the basis for jobs and public resources. Efficiency complements this, ensuring that limited resources are put to best use. Beyond stability, growth, and efficiency, government has two major tools at its disposal: taxation and spending.

Taxation. Because of the importance of real wealth in poorer countries, governments often seek to tax land and property to achieve redistrib-utive ends. For political and administrative reasons, however, this form of taxation has rarely been effective. Progressive income tax schemes have been seized upon as an alternative, but high marginal rates have encouraged evasion, and a multitude of loopholes and poor administration have undercut both their progressivity and efficiency. Experience suggests that effective taxation can make a major contribution to the reduction of income inequality if it provides revenue for essential expenditures and avoids taxing similar incomes at very different effective tax rates. Taxation, Tanzi advises, should be broad based, offer limited exemptions and special treatments, and use rates low enough to satisfy the need for revenue and avoid inequities within the tax system.

Spending. But collecting revenues is only part of the equation. Adequate revenues, once collected, must be used efficiently and effectively. “Public spending, justified in the name of equity, has at times contributed little to equity and much to macroeconomic instability,” Tanzi observes. He cites two problems that often characterize public spending and reduce its contribution to equity:

  • Hijacking of expenditure programs by special interest groups. Political pressures often push spending away from its desired targets and toward either the general public or less needy, but more politically influential, groups. Education spending, for example, may start with a focus on primary education but increasingly find itself targeting secondary and tertiary education, where the spending is more likely to benefit higher-income groups. Likewise, health spending may be diverted from primary care to hospitals in urban centers. The level of social spending is thus not an accurate reflection of its impact. If redressing inequity is the goal, it matters who the real beneficiaries are.
  • Hijacking of expenditure programs by their providers. Certain public services, notably in education and health, are labor intensive; much of the spending actually goes to the providers of the services in the form of wages and salaries. If that labor force is underproductive or overpaid, that investment may generate limited returns for its intended beneficiaries. Ensuring the cost-effectiveness of social investment may necessitate deep and complex administrative and legal reforms.

Ultimately, it is what citizens receive—not what governments spend—that determines the impact on inequality. But without social spending, Tanzi adds, there is little hope that the government will affect income distribution in a positive way.

Role of Government

Both human capital and the share of wages and salaries in national income grow with economic development— with important implications for public policy in both poor and developed countries. In poor countries, the distribution of real assets determines not only incomes but access to scarce resources. Real assets provide collateral for credit, and social capital provides valuable connections that facilitate gathering critical information and obtaining access to credit, foreign exchange, and positional rents. In traditional societies, clubs and associations share a common characteristic—real wealth.

At higher levels of development, information is more readily available and important networks tend to revolve around human capital rather than the possession of real assets. Income from employment, not family name and holdings, provides collateral. And the establishment of a market—with its arm’s length relationships and rules of law—reduces both the importance of personal connections and the value of social capital.

Ultimately, Tanzi concludes, the distribution of human capital is the most important factor determining the distribution of income in developed economies. There are pitfalls, but governments can improve the quantity and quality of human capital and ensure that all citizens, especially individuals at the lower end of the income distribution, have full access to the means to develop human capital.

Copies of IMF Working Paper 98/178, Fundamental Determinants of Inequality and the Role of Government, by Vito Tanzi, are available for $7.00 each from IMF Publication Services. See page 40 for ordering information.

Ian S. McDonald


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