Introduction
Sustainable development goal ten (10) speaks to the need for reduced inequality within and amongst countries around the world. But before I delve into my thoughts it is perhaps apropos to inquire whether financial development leads to economic growth? To be frank, this question has indeed sparked a lot of interest amongst academic circles and policymakers alike in the past decade or so. In this economist view, the question is indeed axiomatic. Economists agree overwhelmingly that a well-functioning and properly regulated financial sector induces growth (Christopoulos and Tsionas, 2004); (Greenwood et al. 2013). To be sure, financial markets and financial intermediaries are the best positioned to play this role, thanks to their unique role of being able to move funds throughout the economy. Levine (2005) describes several channels through which financial development can foster economic growth. Firstly, by (i) enabling the exchange of goods and services via the delivery of payment services, (ii) allocating savings to their most productive use, (iii) monitoring investment and carrying out corporate governance, and (iv) diversifying, increasing liquidity and reducing intertemporal risk.
Africa witnessed a strong economic performance over the past two decades, which led to the eminent narrative of an “Africa rising”. However, one could have thought of this growth to be more inclusive, leading to a significant reduction in poverty. Contrary to expectations, Africa’s growth story has wretchedly not been pro-poor, and subsequently little impact felt on poverty reduction. Income inequality has also not ensued fast enough, and remains stubbornly high, suggesting that the strong growth has largely been enjoyed by the richest Africans, thereby causing the gap between the rich and the poor to become wider. This, therefore, stands as a major cause for concern. In a scenario where access to financial services is solely limited to individuals based on their level of income, there is a prospect that financial sector development could bring about uneven growth, which in turn may lead to a wider income gap. To this end, the trend of rising income inequality is one of the most central challenges for policymakers in both developed and developing countries alike, albeit more apparent and severe in the latter group.
Income inequality carries several implications and is harmful to the macroeconomic stability of the overall economy. Explicitly, reducing income inequality will suggest an uneven increase in the income of the poor relative to that of the rich. How can this be effectively attained without any detrimental effects? This is the puzzling question that continues to glow economic debates. Nevertheless, the central thrust of this exposition is to identify potential policies to reduce economic inequality in Nigeria and by extension amongst other countries.
Theoretical Overview and Stylised Facts
The financial development-income inequality nexus draws its origin from the pioneer work of Kuznets (1955), who established the famous Kuznets curve, advocating a non-linear relationship between financial development and income inequality. Kuznets’ argument supports that in the early stages of development, income disparities increase due to the rapid rate of urbanization (as the population move from low agricultural productivity jobs to high productivity jobs in industries where the average income is higher). In the intermediate phase of development however, the relationship is expected to stabilize and should then start to decline in the advanced stage as a result of public redistribution policies.
Three main theories underpin the work on the relationship between financial development and income inequality. The first theory by Greenwood and Jovanovic (1990) postulates an inverted U-shaped nexus. The study built a model of financial development, growth and wage distribution where the use of financial intermediaries generally enhances trade, as it is well known that transacting through these intermediaries entails both greater and secure profits. Nonetheless, it was accentuated that transacting through intermediaries usually comes at a cost, which is often higher in the early phase of development. Due to constraints of high associated costs and low income, the poor population group might not be able to use the services; and this may only benefit the rich, causing income inequality to widen. As the economy approaches the intermediate phase, financial intermediaries begin to develop. Consequently, the national savings rate will increase, causing the income disparity to widen given the poor capacity of the underprivileged to save. As the economy transitions to the intermediate phase and then to the advanced stage, income inequality will start to decline, as more agents will see their income grow given easier access to financial intermediaries.
The above reasoning, which concurs with that of Kuznets (1955), translates into an inverted U-shaped relationship, with income inequality increasing at the early stage of financial development and dropping at the advanced stage of financial development.
In later years, this school of thought was challenged by another strand of literature which posits a negative linear relationship between financial development and income inequality. The model built by Banerjee and Newman (1993) is based on the initial assumption that finance can provide entrepreneurship opportunities. However, several financial market imperfections such as high transaction costs and contract enforcement hinder the low-income group from making investment and becoming entrepreneurs, as they often have no credit histories and lack the requisite collateral needed by financial institutions. Within this context, it goes without saying that the poor will have limited access to credit even if they are in the possession of high-profitability projects and are therefore most likely to work for better-off employers, earning much lesser than what they should. This, in turn, proposes that should financial markets become accessible, efficient and stable, regardless of the background, entrepreneurs will be able to gain access to capital, thus translating to a decrease in income inequality.
At the other end of the spectrum, the third strand of the literature, initiated by Galor and Zeira (1993) is based on the assertion that with imperfect credit markets, income inequalities prevent an efficient allocation of resources by reducing the ability of poor households to invest in human and physical capital. The model by Galor and Zeira (2003) is centered on the argument that individuals are on par in terms of their capacities or potential abilities yet tend to differ in terms of their inherited wealth. Due to imperfect information and high transaction costs, the poor are usually faced with lending constraints and are therefore likely to invest less in human capital as opposed to the rich. In the model, the inheritance received by each individual defines whether he/she will invest in human capital (education) to become skilled. As such, the future of a household will consequently be defined by its initial wealth. Rich families will, therefore, tend to invest in human capital and become skilled, amass enough and leave large inheritances for the future while poor families, with little bequests will remain unskilled and amass little for the future generations. Even if it becomes possible for the poor to finance human capital, the hindrances related to financial market imperfections prevent them from doing so. Consequently, in the long run, the distribution of income will therefore be determined by the level of investment in human capital, with the latter being contingent on the initial wealth inheritance. Considering the above theoretical discussions, it goes without saying that for each theory, there is a unique mechanism through which financial development impacts income inequality.
In the case of Nigeria, inequality amongst the socio-economic class continues to expand. In layman terms, the rich appear to be getting richer and the poor continue to get poorer without any effective safety net. In more sophisticated parts of the world, the notion of automatic stabilizers would be activated to ensure the effects are not so detrimental. Unfortunately, in Nigeria those mechanisms are nonexistent.
Since the Great Financial crisis of 2008/2009, the Nigerian economy has witnessed growing disparities in income levels. Indeed, other countries such as the United States, the Euro Area and a host of other countries have witnessed the same fate. However, one cannot overlook the effects of the disparity in developing and emerging economies such as Nigeria where the minimum wage hovered around $50 a month or just under $2 per day. Unlike in other countries where benefits such as healthcare, retirement among other entitlements are paid to the employees consistently, in Nigeria, the same cannot be said.
In 2019 the minimum wage was revised upwards to thirty-thousand Naira or ($83) per month using 360 Naira as the exchange rate, only to be partially accepted by a few states in the federation. Some states have argued that the affordability of the hike in wages eludes the state’s capacity to pay. In short, permit me to restate the point of this discourse is to proffer some policy interventions that can address poverty and inequality in Nigeria but perhaps in Africa in general.
Policies to reduce economic inequality
- Increase the minimum wage.
There have been several published studies that show that higher wages for the lowest-paid workers have the potential to help nearly millions of people out of poverty and add billions of Naira to the nation’s overall real income. Perhaps more importantly, increasing the minimum wage does not hurt employment nor does it erode economic growth. Although the federal government of Nigeria along with the Nigerian Labor Congress (NLC) have gone back and forth on the subject matter, the consensus agreement was reached that the new minimum wage would move upwards to thirty thousand Naira from eighteen thousand. In this economist view, the new wage figure is unsatisfactory because the increase to the minimum wage vis a vis cost of living remains inadequate giving the average family size of 5 children in the country. However, it is noteworthy to state that the policy is moving in the right direction.
- Build assets for working families.
Policies that encourage higher savings rates and lower the cost of building assets for working- and middle-class households can provide better economic security for struggling families. New programs that automatically enroll workers in retirement plans and provide a savings credit or a federal match for retirement savings accounts could help lower-income households build wealth. Access to fair, low-cost financial services and homeownership are also important pathways to wealth.
- Invest in education.
Let me emphasize this point because I firmly believe in the case of Nigeria, we have ridiculed what it means to be educated. From my personal experience in the education sector in the United States of America, I have witnessed the benefits of government programs aimed at ensuring all children are educated. Programs such as “No child left behind”, Head Start, and Universal Pre -K all come to mind. Differences in early education and school quality are the most important components contributing to persistent inequality across generations. Investments in education, beginning with programs at the Creche, Kindergarten, Primary and Secondary levels can increase economic mobility, contribute to increased productivity and decrease inequality. In other words, the federal and state government should create laws that ensure all children have access and are compelled to gain an education.
- Make the tax code more progressive.
The Palma ratio is a measure of inequality. Simply put, it is the ratio of the richest 10% of the population’s share of gross national income (GNI) divided by the poorest 40 % share. According to the United Nations Development Program, Nigeria ranks among the bottom 30 countries in terms of human development and equality. Ironically, tax rates for those at the top have been declining even as their share of income and wealth has increased dramatically. The data show we have created bad tax policy by giving capital gains — profits from the sale of property or investments — special privileges in our country’s tax code; privileges that give investment income more value than actual work. Capital gains tax rates are currently 10% however, this must be adjusted so that they are in line with income tax rates which are certainly much higher. Savings incentives structured as refundable tax credits, which treat every Naira saved equally, can provide equal benefits for lower-income families.
- End residential segregation.
All over the country, we continue to witness higher levels of residential segregation by income within a metropolitan region. Whether it is in Lagos (Island) or in Abuja, highbrow neighborhoods are strongly correlated with significantly reduced levels of intergenerational upward mobility for all residents of that area. Segregation by income, particularly the isolation of low-income households, also correlates with significantly reduced levels of upward mobility. Eliminating residential segregation by income can boost economic mobility for all. To achieve this, the federal government may opt to conceive an affordable housing scheme that will enable the bottom half to have an opportunity for upward mobility across generations.
Conclusion
This article set out to examine the finance inequality nexus on reducing inequality. I put forward a hand full of policies that if carefully implemented has the potential to lift working families out of poverty, support greater economic mobility and/or reduce the growth of inequality. In my humble opinion, all these policies could be enacted at the local, state and federal levels if there is political will. While there are still some disagreements of the best way to reduce inequality, there is a growing consensus even amongst the top 1% of earners globally that inequality should be reduced.
Prof. Joseph Nnanna
Works with the Development Bank of Nigeria Plc
