Global Financial Integrity

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Globalisation, Illicit Financial Flows Widen Inequality

Dev Kar

This article was originally published by the Thomson Reuters Foundation.

By now, it is common knowledge that income inequality has been rising in many developed and developing countries across the world. The average layman attributes the factors driving inequality to increasing competition from abroad, globalisation, excessive compensation of company executives, tax breaks to the upper income groups and so on.

There is no question that globalisation impacts income inequality both within and across countries. However, the impact of trade-driven globalisation and financial globalisation need to be considered separately in order to understand the overall impact of closer global links on income inequality. Researchers find that these two aspects of globalisation impact income inequality in opposite directions at least in developing countries.

Unevenly Distributed Gains

The Stolper-Samuelson economic theorem on international trade states that in a two-country (developed and developing), two-product (involving low- and high-skill manufacturing) world, increasing trade between them would lead to a rise in income inequality in the developed country and a fall in inequality in the developing country.

This result comes about because increasing low-skill exports from the developing country would result in a rise in the wages of low-skilled workers. At the same time, as tariffs on the high-skill goods imported into the developing country are reduced, their prices will fall resulting in the decline of high-skilled workers’ wages.

In the case of the advanced economy, increasing trade brings about the opposite result in that the greater demand for high-skill products leads to increasing income of the highly skilled at the expense of low-skilled workers.  As a result, income inequality in the advanced country will increase.

While the two-country, two-product Stolper-Samuelson model seems unrealistic in real world applications, subsequent researchers have shown that relaxing the number of goods and countries does not necessarily upset the basic thrust of the analysis: The incomes of at least one group of workers will be hurt if relative prices change as a result of trade-driven globalisation, even if on the whole a country benefits from trade through a higher rate of economic growth. In other words, the traditional gains-from-trade argument says nothing about the impact of increasing trade on income distribution.

Widening Inequality

Financial globalisation, which has occurred much more rapidly in advanced countries, has worsened income inequality.

Let us take the case of foreign direct investment (FDI) outflows from the developed to the developing country. The high-skilled FDI will raise the demand for skilled workers in both the developed and developing countries, leading to an increase in the incomes of the relatively well off, thereby deteriorating income inequality. Moreover, as a result of increasing financial globalisation, the high-income groups and high net-worth individuals in both countries with greater access to financial markets worldwide, will be in a much better position to maximize rates of return leading to greater income inequality in both countries.

In short, the net impact of trade-driven and financial globalisation in different countries will vary. In developed countries, they may well act in unison to worsen income inequality, while in developing countries, the net impact may well be somewhat ambiguous.

That said, official data on income inequality published by China and India, for instance, tend to show that income inequality has in fact worsened.

Illicit Wealth from Abroad

One likely reason income inequality has worsened in developing countries more than in developed countries is unrecorded illicit financial flows.

The cross-border transmission of such capital means that high-income groups in developing countries have amassed illicit wealth abroad. These incomes are obviously not reported in official surveys, leading one to believe that official measures of income inequality such as the GINI coefficients, would in all probability understate income inequality.

In conclusion, there are strong reasons to believe that trade-driven globalisation and financial globalisation, as well as illicit financial flows, have led to increasing income inequality in both developed and developing countries. Both developing and developed countries would need to adopt strong policy measures to offset the adverse impact of globalisation and illicit flows by improving worker training, strengthening social safety nets and overall governance (so as to curtail illicit flows), and taking measures to reduce the scale and duration of unemployment.

Ignoring the problem of rising income inequality will risk social and political stability in both.

Dr. Dev Kar, a former senior economist at the International Monetary Fund, is lead economist at Global Financial Integrity.