Why the Palma ratio can accelerate efforts to tackle global inequality

Over the past decade, leading economists and global institutions such as the United Nations (UN), the International Monetary Fund (IMF) and World Bank have taken a keen interest in economic inequality.

In 2015 the UN adopted inequality as part of its sustainable development goals (SDGs), enabling the global community to pay enhanced attention to inequality. The World Bank has been working on inequality through its twin goal on poverty and shared prosperity for the over 10 years. The IMF has produced several ground-breaking publications touching on distribution, giving inequality a renewed impetus in the Bretton Woods Institutions.

Global inequality rising despite international efforts

Yet that hasn’t dented economic inequality in many parts of the world. The UN Secretary-General has reported that inequality (SDG10) is one of the SDG measures that has improved least. The world is experiencing growing extreme inequality both within and between countries supercharged by increasing global challenges including Covid-19, the cost-of-living crisis and the climate emergency. The richest 10% of the global population now gobbles up 52% of global income while the poorest 50% take home a meagre 8.5%.

I was involved in coordinating an open letter from leading world economists and other world leaders fighting against extreme inequalities. The letter was addressed to the UN Secretary-General Antonio Guterres and World Bank President Ajay Banga. It was encouraging to see five former World Bank chief economists, the former UN Secretary-General Ban Ki-Moon, and leading economists such as Thomas Piketty join more than 230 global economists and others in calling on both the UN and the World Bank to support urgent action to reduce widening inequality and adopt better metrics for measuring it.

The letter seized on two critical but unrelated processes at the UN and the World Bank. In September, the UN will undertake mid-term reviews of the SDGs. For its part, the World Bank is currently aligning its mission to better respond to a set of increasingly global challenges. This is a crucial moment to strengthen SDG10 at the UN and enable the World Bank to combat inequality.

"Shared prosperity" is the current measure of income inequality in SDG10 and is what the World Bank has been using. Shared prosperity measures the income or consumption growth of the bottom 40% compared to the whole population. It is positive if the income of the bottom 40% increases at a faster rate than the entire population.

This indicator was a compromise, and it falls short of being a true inequality measure. It doesn’t really measure inequality but income growth for the bottom 40%. Income or wealth changes occur predominantly at the top and the bottom of the distribution. The share of the middle half is always roughly a half. If you are interested in examining the evolution of inequality, you should pay keen attention to both tails – the top 10% and the bottom 40%.

Shared prosperity is still useful in tracking the income growth of the poorest, but it needs to be augmented with true inequality measures. Two widely known measurements can do this. The Gini index is the most widely used measure of inequality. It decomposes everything into a single number but says nothing about distribution at the top and the bottom. While still useful it too needs to be complemented by another measure of inequality.

Why the Palma ratio offers a clearer picture of inequality

That takes us to Gabriel Palma, the brains behind the Palma ratio. The Palma ratio compares the income of the top 10% to that of the bottom 40%. The simplicity of the Palma measurements makes life easier for all of us and places it ahead of the pack: I can clearly explain it to my mother in her rural village who never got past primary school; my member of parliament would get it; for the technocrats at the Parliamentary Budget Office, I merely need to mention the Palma ratio and they get the point.

No indicator of inequality is perfect. The Palma ratio has its shortcomings. There is huge income inequality within the richest 10% and within the bottom 40%. We cannot also ignore the middle half completely. However, it is difficult to reduce inequality by dwelling on the poorest without reducing the concentration at the top. Both the UN SDG10, and the World Bank need to adopt the Palma ratio and Gini as additional official measurements of inequality on top of the shared prosperity indicator.

The need for better data on wealth inequality

The Gini and Palma ratio would allow countries to set ambitious targets to lower inequality. Every country should aim for a Palma ratio of one and below, and a Gini of no more than 30% to avoid a corrosive level of inequality. This is the type of inequality observed in the most equal countries. Analysis from the IMF shows that a Gini of 25-27% is optimal for economic growth.

The availability of data on the Gini and the top 10% and bottom 40% from households’ surveys means that we don’t have to re-invent the wheel. However, we need to go further. We need to go beyond the richest 10% to the richest 5% and 1%. Wealth is even more concentrated than income. Wealth inequality data remains a considerable gap for most countries.

Correctly measuring inequality will not bring inequality down on its own, of course. That requires political commitment. But the World Bank and IMF need to assess the implications of economic, social and environmental policies on inequality: tracking the Palma ratio will be a big step forward to doing that more comprehensively and to supporting policies that really deliver on economic justice.