# **1. Introduction**

According to the World Bank’s _World Development Report 2006,_ Latin America ranks at the top among world regions in terms of inequality, second only to Sub-Saharan Africa. Inequality in Latin America is pervasive – it extends to every aspect of life, from the distribution of income and assets to access to education and health services, and political voice and influence.

High inequality is viewed by many as intrinsically bad on moral and ethical grounds.<sup>1</sup> But in addition high inequality can be a powerful drag on development and prosperity, for several reasons. First, for given average income levels, higher income inequality means higher poverty. And the magnitude of this effect is far from negligible: according to Perry et al. (2006), if Latin America had the levels of inequality found in developed countries, its current poverty rate would be more than halved. High poverty is not only a tragedy in itself but, as a rapidly expanding literature has argued, it can also be a source of underdevelopment traps in which financial market imperfections and institutional constraints prevent the poor from contributing to the growth process.<sup>2</sup> This in turn retards growth and makes poverty self-perpetuating. Indeed, the international evidence is consistent with this growth-deterring effect of poverty (e.g., López and Servén 2006b).

Second, the other side of the coin is that higher inequality also weakens the impact of aggregate income growth on poverty: the more unequal income distribution is, the faster the rate of growth required to achieve a given reduction in poverty.<sup>3</sup> Combined with the mechanism described above, the result is that inequality lies at the core of the vicious circles of stagnation and poverty in which many developing countries appear to be stuck.

Third, high inequality can also be a source of distributive conflict and social tension, which tend to undermine the legitimacy of policies and institutions as well as their stability, and in particular weaken property rights, thus discouraging investment and thereby growth.<sup>4</sup> These considerations have brought social equity to center stage in the Latin American policy debate. Indeed, recent major contributions to that debate portray social equity as one, or even the, key organizing principle for the region’s development strategy, and some retrospective assessments of Latin America’s performance under the so-called ‘Washington Consensus’ of the 1990s blame the reforms’ neglect of equity considerations for the region’s limited achievements over the last decade.<sup>5</sup> On both

> 1 See World Bank (2006) for a review of the philosophical arguments for equity.

> 2 See for example Azariadis and Stachurski  (2005).

> 3 See Bourguignon (2004) and López and Servén (2006a) for some quantitative estimates of the order of magnitude of this effect.

> 4 Alesina and Rodrik (1994) and Alesina and Perotti (1996) present empirical evidence of the adverse effect of inequality on investment through these channels.

> 5 Among major recent contributions see Birdsall and de la Torre (2001), Kuczynski and Williamson (2003), De Ferranti et al (2004) and Perry et al (2006).

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