metadata: authors: 0: author: Lopez-Calva,Luis-Felipe
1: author: Rodriguez Castelan,Carlos
count: World
docna: 0: docna: Pro-growth equity : a policy framework for
            the twin goals
docty: Policy Research Working Paper
subtopic: Governance Diagnostic Capacity Building,Macro-Fiscal Policy,Economic Theory & Research,Economic Adjustment and Lending,Industrial Economics,Public Sector Economics,Educational Sciences,Economic Forecasting,Economic Growth,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction,Inequality
teratopic: Poverty Reduction
abstracts: cdata!: Growth is an important channel for
            poverty reduction. Policies to make growth more
            "inclusive" have permeated the development debate
            and "pro-poor growth" has been the subject of a
            wide range of papers in the literature, including issues
            related to measurement, modeling, and policy. However, the
            analytical and particularly empirical literature to support
            the idea that equity-enhancing policies have a positive
            effect on growth is more scarce and limited, especially on
            the potential policy links. This paper proposes a simple
            conceptual framework to identify the main elements that
            contribute to the income generation of households, building
            on the notion that growth can be seen partly as the
            aggregate outcome of the income generation capacity of
            households. The framework relies on an asset-based approach,
            and offers insights on how a more equitable distribution of
            assets and opportunities for their productive use can feed
            back into higher growth in the long term. Using this
            framework, the paper links the World Bank's twin goals
            to specific policy channels that have direct impacts on the
            income generation capacity of households, with a particular
            focus on households at the bottom of the income
            distribution. The four key policy channels include (i)
            implementing equitable, efficient and sustainable fiscal
            policy and macroeconomic management, (ii) strengthening fair
            and transparent institutions capable of delivering quality
            basic services, (iii) enabling well-functioning markets, and
            (iv) establishing adequate risk management instruments at
            the macro and household levels.
repnme: repnme: Pro-growth equity : a policy framework for
            the twin goals
display_title: Pro-growth equity : a policy
            framework for the twin goals
listing_relative_url: /research/2016/11/26969417/pro-growth-equity-policy-framework-twin-goals
topicv3: Economic Growth m1326241 471,Poverty m1326687 695,Education m1327048 470,Fiscal Policy m1327144 445,Market Failures m1327149 1068
publishtoextweb_dt: 2016-11-23T00:00:00Z
historic_topic: Poverty Reduction
no_of_pages: 35
author_keys: 0: author_key: 435254
1: author_key: 1180219
model_extractions: WPS7897 Policy Research Working Paper 7897 Pro-Growth Equity A Policy Framework for the Twin Goals _Luis F. López-Calva Carlos Rodríguez-Castelán_ Poverty and Equity Global Practice Group November 2016
Policy Research Working Paper 7897

# **Abstract**

Growth is an important channel for poverty reduction. Policies to make growth more “inclusive” have permeated the development debate and “pro-poor growth” has been the subject of a wide range of papers in the literature, including issues related to measurement, modeling, and policy. However, the analytical and particularly empirical literature to support the idea that equity-enhancing policies have a positive effect on growth is more scarce and limited, especially on the potential policy links. This paper proposes a simple conceptual framework to identify the main elements that contribute to the income generation of households, building on the notion that growth can be seen partly as the aggregate outcome of the income generation capacity of households. The framework relies on an asset-based approach, and offers insights on how a more equitable distribution of assets and opportunities for their productive use can feed back into higher growth in the long term. Using this framework, the paper links the World Bank’s twin goals to specific policy channels that have direct impacts on the income generation capacity of households, with a particular focus on households at the bottom of the income distribution. The four key policy channels include (i) implementing equitable, efficient and sustainable fiscal policy and macroeconomic management, (ii) strengthening fair and transparent institutions capable of delivering quality basic services, (iii) enabling well-functioning markets, and (iv) establishing adequate risk management instruments at the macro and household levels.

This paper is a product of the Poverty and Equity Global Practice Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at lflopezcalva@worldbank.org and crodriguezc@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Pro-Growth Equity:**

# **A Policy Framework for the Twin Goals**<sup>**1**</sup>

Luis F. López-Calva<sup>†</sup> Carlos Rodríguez-Castelán<sup>‡</sup>

**Keywords:** Poverty, growth, inequality, assets, fiscal policy, markets, institutions, risk.

> 1 The authors have benefitted from discussions with many colleagues during the preparation of different tasks related to SCD preparation, operationalization of twin goals, and regional reports on shared prosperity in LAC and ECA. In particular, we would like to thank Montserrat Avila, Javier Baez, Kim Bolch, Maria Eugenia Genoni, Oscar BarrigaCabanillas, Ana Revenga, Louise Cord, Carolina Sanchez-Paramo, Maurizio Bussolo, Kaushik Basu, Hans Timmer and Samantha Lach for providing very helpful comments and suggestions to earlier versions of this paper. Research assistance by Montserrat Avila and Ali Sharman is gratefully acknowledged. The findings, interpretations and conclusions in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank Group, its Executive Directors, or the countries they represent.

> † World Bank. E-mail: lflopezcalva@worldbank.org

> ‡ World Bank. E-mail: crodriguezc@worldbank.org
# **1. Introduction**

In 2013 the World Bank adopted two overarching strategic goals, namely: (1) to end extreme poverty at the global level by 2030, and, (2) to promote shared prosperity in every country. The latter refers to a sustainable increase in the well-being of the poorer segments of society, roughly defined as the lowest 40 percent of the income distribution.<sup>2</sup> A central question to be answered in this context is: What are the constraints to progress? This question has typically been answered from a top-down perspective, by looking at how growth can be an important channel for poverty reduction (“pro-poor growth”). However, this paper takes a bottom-up perspective, building on the idea that policies that focus on the income generation capacity of households at the bottom of the income distribution can feed back into higher growth potential in the long run (“pro-growth equity”).

The purpose of this paper is to propose a simple conceptual framework that identifies the main elements that contribute to the income generation of households which can be intuitively related to poverty reduction and shared prosperity. This framework utilizes an asset-based approach and presents the realization of household market income as a function of four main components<sup>3</sup> : (i) the capacity of households to generate income based on the assets they own; (ii) the private transfers they receive that are independent of household income-earning assets; (iii) the set of prices of the basket of goods and services that the household consumes; and, (iv) the realization of exogenous shocks that generates variability of incomes.

This approach is particularly useful for linking equity-enhancing policies to growth. By looking at the impact of different policies on the income generation capacity of households, this paper links changes

> 2 Although the shared prosperity indicator focuses attention on the poorest segments of a country’s population, it does not completely ignore the rest of the segments. Those above the bottom 40 percent will fall back into the bottom of the distribution if growth occurs only there (Basu, 2013).

> 3 This approach is an extension of a framework that has been previously discussed in the literature (see Attanasio and Székely, 1999; Carter and Barrett, 2006, Bussolo and Lopez-Calva, 2014; Carter and Janzen, 2015).

2
in the welfare of households (particularly of those at the bottom) with their ability to contribute to aggregate growth (following Basu 2006). This paper focuses specifically on four key policy areas in this regard, also defined in previous studies (Bussolo and Lopez-Calva, 2014; Cord, Genoni and Rodriguez-Castelan, 2015): (i) Equitable, efficient and sustainable fiscal policy and macroeconomic stability (direct and indirect taxes and transfers, inflation targets); (ii) Fair and transparent institutions capable of delivering quality basic services (more and better supply of public goods, protection of property rights); (iii) Well-functioning markets (improved connectivity to markets, competition policy), and; (iv) Adequate risk management at the macro and household levels (safety nets, macro prudency).

The next section of the paper provides a brief discussion on the relationship between equity and growth. Section 3 presents a description of the asset-based conceptual framework. Section 4 explains its connection to poverty reduction and shared prosperity. Section 5 offers a simple model to connect the four policy areas to the twin goals through the asset-based approach. Section 6 presents conclusions.

# **2. From equity to growth: What does the literature tell us?**

What does the literature say about the relationship between equity and growth? Economic growth plays a key role in contributing to poverty reduction. Policy discussions to make growth more “inclusive” have permeated the development debate. The so-called “pro-poor growth” has been the subject of a wide range of papers in the economic development literature, including measurement, modeling and policy implications (see Foster, 2014, for a recent review of the concept). There are, for example, widely accepted empirical regularities about the growth elasticity of poverty in cross-country analysis (Dollar and Kraay, 2002; Dollar, Kleineberg and Kraay, 2013) and debates about how it varies as economies grow richer (Allwine, et al., 2013). However, the analytical and empirical literature to 3
<!-- Start of picture text --> ‘¢rt¢y Growth .Sy‘\‘‘<br>‘ ‘<br>/ ‘<br>/ \<br>i\<br>I/\\<br>i Household '<br>I market 1<br><!-- End of picture text --> <!-- Start of picture text --> ' income ‘<br>\ 1<br>\ !<br>\ !<br>\ i<br>\ /<br>\ ‘<br>~*~ i<br>‘ ¢<br>* 4<br>% 3f<br>Ss ~ . y 4<br>Equity<br><!-- End of picture text -->
economic growth, though the specific component of inequality of opportunity –that inequality that correlates with circumstances at birth—does not show a robust effect by itself. One of the main contributions of that paper is the attempt to distinguish between income inequality and indicators of equity –in this case, inequality of opportunity. Along the same lines, Marrero and Rodriguez (2013), using the PSID database for the U.S. in 1970, 1980 and 1990, find a robust support for a negative relationship between inequality of opportunity and growth, and a positive relationship between inequality of effort and growth. Thus, the indicator of inequality used in the empirical work –based on different notions of what is the inequality that “matters”—may lead to different results. On the other hand, equity indicators –such as access to basic services and access to markets—may have a more delayed effect on growth, as they affect the long-term productivity of the poor or previously excluded groups.

_Revisiting equity-efficiency trade-offs_ As discussed in Kanbur (2013), there is no shortage of theoretical models showing why equity is associated with growth.<sup>4</sup> If the economy is “distorted enough” –producing within its full productive capacity, lifting constraints to productivity might actually improve both efficiency and equity. Political economy considerations might also lead to a situation where redistribution enhances efficiency (Levy and Walton, 2005).

> 4 There are diverging views on the link between economic growth and equity.  Aghion et al. (1999) present three arguments that support the view that wealth inequality should be growth-enhancing. The first argument is Kaldor's hypothesis that the marginal propensity to save of the rich is higher than that of the poor. Stiglitz (1969) and later Bourguignon (1981) formalized this argument and demonstrated that more unequal economies will grow faster. The second argument has to do with investment indivisibilities. In the absence of a well-functioning market for shares, wealth needs to be sufficiently concentrated in order for economic agents to be able to cover large sunk costs and thereby engage in entrepreneurial activities. The third argument is based on incentive considerations. In an economy where all agents have the same preferences, greater taxation reduces the return to savings and thus lowers the incentives to accumulate capital and hence the rate of growth (see for instance, Basu 2006).

5
Most of these theoretical models rely on some form of market failure, which interacts with an unequal distribution of income to produce a negative effect on growth. Kanbur (2010) discusses, for example, how a threshold level of investment may be required for human capital investment. He argues that in the presence of imperfections in the credit market, the amount that can be invested is determined by one’s own wealth. Those with low wealth will not invest in their own human capital, and “...thus, if human capital investment by the wealthy is diminishing at the margin, a redistribution of wealth will increase overall investment in human capital and, where this mechanism is tacked on to an endogenous growth model, the steady-state growth rate as well”. These dynamics are consistent with traditional models on inequality and growth, like those discussed in Banerjee and Newman (1994) and Galor and Zeira (1993), which suggest that in the presence of failures in credit markets there are interventions that may enable people who are currently marginalized to improve their access to credit. These interventions could unlock the inherent economic potential by means of higher productivity, thus spurring growth.

Fiscal redistribution is another channel through which promoting equity could lead to higher growth in the presence of market failures. Following a simple model in Aguion et al. (1999), which assumes imperfect capital markets, it can be shown that redistribution to the poorly endowed, that is, to those individuals who exhibit the highest marginal returns to investment, will be growth-enhancing. The model can be extended to other kinds of market failures, and interacted with an unequal distribution of income, to reach a similar conclusion: more equitable fiscal policy could increase aggregate output and enhance growth. The well-functioning of markets thus becomes crucial for unleashing the productive potential of the less well-off. As a recent review by Duflo (2011) discusses: “In a world of perfect markets, the distribution of resources in an economy would not affect investment and growth, and the ability to benefit from growth would only depend on one’s 6
intrinsic talents. However, if financial, land, and human capital markets do not function very well, the identity of who holds resources in an economy matters for how they are used. The poor can stay poor even if the economy as a whole grows. And growth can be slowed down because resources are not used in the most efficient way possible. Our understanding of why growth suddenly catches on in a poor country, and even more of what type of growth is inherently “pro-poor” or not is very limited. A long term strategy to balance growth with equity is thus to put in place policies that maximizes the chance that the poor are able to fully participate in markets, so that when growth starts, they can benefit from it.” There could be also a <u>political economy</u> channel through which inequality induces inefficiency. Alessina and Rodrik (1994), as well as Persson and Tabellini (1994) were among the first to establish that inequality affects taxation through the political process where voters decide the tax rate of the economy. In particular, Alessina and Rodrik (1994) present a voting model in which more inequality induces more inefficient policies (e.g. a higher level of distortionary tax).

# **3. An asset-based approach to market income**

Indeed, strategies that break traditional equity-efficiency trade-offs are needed. The framework presented here suggests that such trade-offs can be overcome by enhancing the productive capacity of the poor via policies that promote a diversification of their asset-base and a more intensive use of those assets, in a market environment in which returns are not systematically distorted.

The proposed framework is based on Attanasio and Székely (1999) and Bussolo and Lopez-Calva (2014). It defines a household’s market income potential as a function of four main components: (i) the capacity of households to generate income based on the _assets_ they own; (ii) the _transfers_ they receive that are independent of household income-earning assets; (iii) the set of _prices_ of the basket of goods 7
<!-- Start of picture text --> ’/7¢¢¢¢¢¢¢o*_¥ Growth msSS~~~ssxsS‘\<br>4 ¥ ‘<br>’/ Safe} XN\<br>/ ~? \<br>/ e a ‘<br>i G ¢ 4 3 \<br>! & = % 2 \<br>H wo >, Sn \<br>! IY On D, Qe 1<br>1 JOS0 oOn 2 s 1<br>! Tw S, On ‘<br>I as) © 1<br>I v o % i<br><!-- End of picture text --> <!-- Start of picture text --> H income 1<br>1!<br>11<br>11<br>\1<br>\i<br>\\ /<br>x Returnsassetsto //<br>\‘<br>\/<br>.;<br>.:<br>‘4<br>‘4<br>. 4<br>sx . 4<br>SS Prices -<br>. o”<br>>See ~-* ?<br>Equity<br><!-- End of picture text --> <!-- Start of picture text --> Returns Transf<br>- to assets rans TerS<br>Household . Intensity<br>market _ Accumulaof asse t ions X Chereaires Xx + x ExternalShocks<br>income Prices Prices<br><!-- End of picture text -->
utilized by each individual to produce income, and the returns to these assets. _Income-earning assets_ may include human capital, such as education and years of experience in the labor market; financial and physical assets like ownership of machinery, or bonds and stocks; social capital such as the set of norms and social networks that facilitate collective action; and natural capital, which can refer to land, soil, forest and water. Examples of the _intensity of use_ of assets include labor market participation, utilization of machinery and exploitation of land through agricultural production. The _returns to household assets_ consist of the nominal price of factors of production such as wages, interest rates, rents from property rentals, prices of land and time devoted to collective action.

The household market income, generated from the use of productive assets and its corresponding reward in the market, is complemented by _transfers_ received by households, which may include domestic and international remittances, and in-kind transfers from other households, or public transfers. The market income of households is also directly affected by a set of _prices_ of the goods and services they consume. Finally, the stock, utilization and returns to households’ productive assets, as well as consumer prices and private transfers can be directly affected by the realization of _external shocks_ , such as health shocks, natural disasters, loss of employment, financial crisis, civil conflict, such that the realization of market income may be different from the potential market income.

The following sections present a way to model the constraints that prevent the poor and those at the bottom of the income distribution from contributing more actively to economic growth through these different channels.

_Asset-based income generation_ 9
|Ag<br>C+tip<br>S f(A)<br>(1)<br>Atay = Ar + tt (2)<br>cateDPUe) 3)<br>Arai = f(At) — ce +At (4)<br>CpSA,<br>+f(AL)GS)|
|---|
A, = 0 (6) VA) = prepnnaJU() +A 41+ BVA 1) U'(o) = BUC DIF'(A)+1) @B) fa) FMA)
the high productivity technology, individuals require a minimum level of asset �<sup>�</sup> , which is associated with a fixed cost �. On the other hand, the low productivity technology has zero cost. The analysis assumes throughout that if a household is able to access the high productivity technology, its capacity to generate income is enough to reach above-poverty-threshold consumption levels. The opposite occurs if the household is using the low productivity technology. Given that this is a general framework, the specific threshold �<sup>�</sup> is contingent to the type of activity and asset each household is using. For example, it is equivalent to have access to low quality education, with returns that prevent the household from earning wages above poverty standards. It could also mean lacking the land titles that would allow the household to engage in long term farming projects.

The introduction of two technologies effectively creates a non-convexity that allows for two equilibria; either below or above the poverty line. More importantly, and as will be discussed later, the access to the high productivity technology is not guaranteed since there can be other constraints (such as market failures or institutional constraints) that limit the possibility of accessing the more productive technology and therefore generating sufficient income to move above the poverty line.

Finally, consider the existence of credit constraints. In the extreme –for households with no access to credit whatsoever-- this implies that the consumption level and the saving capacity are restricted to be no greater than the current income generation capacity, given the current level of assets.

The introduction of these two technologies modifies the basic problem in (3)-(6) by adding the following constraint: ������max��<sup>�</sup> ������, �<sup>�</sup> ����� �9� 12
Thus, the Bellman and Euler equations remain similar, but will now depend upon the type of technology used.

As shown by Carter and Janzen (2015), there is a critical value of assets, called �<sup>��</sup> , such that if a household’s initial level of assets is below �<sup>�</sup> but above �<sup>��</sup> , the accumulation dynamics determine that the household will accumulate assets over time to reach �<sup>�</sup> and therefore be able to access the more productive technology.

Figure 3 illustrates how this process of accumulation takes place. In particular, a household has two technologies available and an optimal level of asset accumulation of �∗� and �∗� for the low and high productive technology respectively. As mentioned before, being above the threshold �<sup>��</sup> determines if the household is willing to accumulate assets up to �<sup>�</sup> where it will be able to use the high productive technology and accumulate capital up to �∗�.

13
<!-- Start of picture text --> Marginal return to assets<br>f (Ad)<br>ZL<br>Ay AMT i Aj, Assets<br><!-- End of picture text --> Next period assets
<!-- Start of picture text -->
|<br>{wi}iZ0<br>A; t = Yt — wrAtA, (10)<br>vw< f(A;)A.) ( (11)<br>S 12)<br>{cr} gue) (<br>t=0<br>Cr + Ars A. +Tk, t= 0,1,... ( 13)<br>At .<br>;;<br>.<br>>, BY (cr) (14)<br>{ce}9 t=<br>Ce + Ay 15< (1+ w;,)Ap, t = 0,1,... (15)<br>Ct Ars_— ;<br><!-- End of picture text -->
The first order conditions are given by: Where �� is the multiplier of the budget constraint.

Thus the competitive equilibrium consists of quantities and prices ����, ����, ��������. In general, it is possible to show that the competitive equilibrium allocations are Pareto optimal, since the household’s problem is the same as the planner’s problem. Later we will see that in the presence of distorting taxes this may not be the case.

# _External shocks_

There are multiple external risks, including macroeconomic crisis, natural disasters, weather-related events, health-related shocks, crime and violence, that individuals and societies as a whole face over time which can have pernicious consequences for the income generation capacity of households (World Bank, 2013b). Risks turned into shocks could potentially lead to asset loss, disinvestment, unemployment, malnutrition, and child labor, when people lack means to effectively manage and cope with risks. The realization of a household’s market income may then vary due to such external shocks.

Uncertainty can be added to the basic model in several ways. For instance, by directly affecting the stock of productive asset at, or the technology f�at�. We follow the second specification. Building upon the definition of market income given in (1), the first constraint can be modified to include the presence of a random i.i.d. shock ��. As mentioned above, shocks could be aggregate such as weather shocks, financial crisis, or idiosyncratic; through machinery destruction, health shocks, etc.

16
<!-- Start of picture text --> max E » pute) (19)<br>Ary = (1 — 8)f (At) — ce + At (20)<br>Cp SA, + f(A) (21)<br>CrAt = 0 (22)<br>V(A,@) = o<A'<(1-6)f(A)4A {U[(1 — 6)f(A) + A — A’] + BEV(A’, 6’)} (23)<br>U'[(1 — @) f(A) + A — g(A, 8)] = BEV, [9 (A, 8), 8] (24)<br>A' = g(A,8@)<br>6=0<br><!-- End of picture text -->
consumption is contingent on the expected value of assets, and therefore depends on the probability of a shock realization. Specifically, the incentives for renouncing consumption today are reduced because households are uncertain about the possibility of profiting in the future from their sacrifices today.

**4. Implications for the twin goals: Linking the framework to poverty reduction and**

# **shared prosperity**

There are several advantages to selecting a simple framework. In addition to its relevance for unpacking the components which influence the income generation capacity of households, the framework allows us to analyze how this capacity differs across socioeconomic and demographic groups (e.g. bottom 40 percent and top 60 percent, or poor and non-poor, indigenous and nonindigenous, urban and rural).

As mentioned earlier, a shared characteristic of the World Bank’s twin goals is that they both focus on the welfare of those at the bottom of the income distribution. The first goal _to end extreme poverty at the global level by 2030_ is about moving the vast majority of those individuals currently living below the $1.25/day line, out of extreme poverty. The second goal _to promote shared prosperity in every country_ is related to a sustainable increase in the well-being of the poorer segments of society, defined as the lowest 40 percent in the income distribution.

# _The poverty headcount ratio_

To identify those who are poor, the World Bank uses the family of poverty measures defined by Foster et al. (1984), which satisfy both the monotonicity and transfer axioms proposed by Sen (1976), and the decomposability property. In general, the Foster-Greer-Thorbecke (FGT) Index (also known as the �� measure) has the property of subgroup decomposability and can represent several commonly 18
used poverty metrics that take into account the intensity and severity of poverty. The FGT estimates the weighted sum of the poverty gap ratios of a group of observations under an arbitrary poverty line, and includes a parameter � that measures the sensitivity of the income distribution within those observations. Based on the final market income aggregate defined in (1) and (4), the poverty rate can be defined as: where _N_ is equal to the total number of individuals in the economy. _z_ is an scalar-valued poverty line. ��� is the final market income of individual _i._ �� is an indicator value taking the value of one if ��� �� and zero otherwise. � is a parameter reflecting the weight placed in the severity of poverty.

In particular, when ��0, this index becomes the poverty headcount ratio. This metric represents the number of households under the poverty line but fails to capture the extent to which each household income falls below the poverty line. When, ��1 this index becomes the income-gap ratio for the mean poor income. This ratio measures the total shortfall of the poor households with respect to the poverty line. However, the income-gap ratio is not sensitive to the distribution of income among the poor. When ��2, the FGT Index becomes the squared income-gap ratio. This index computes the severity of poverty more accurately, since it represents the squared income-gap ratio for the mean poor income. In this form, the index incorporates information on both poverty and income inequality among the poor households. Higher order classes of poverty indices can be derived as � becomes larger. Finally, as �→∞ the FGT family of poverty measures tends to a Rawlsian social welfare function, i.e. the index depends only on the welfare of the poorest household in the population.

_Shared Prosperity_ 19
> S(Vp40) = ~~eT[yityot--+¥rl~~ (26)

Vi S(V¥p40) y ~~“~~ ~<04 M y YBa0 = ~~(2a)~~ S(¥p40)\ ‘y_ (27) ¥B40 ShP = ~~————-YBa0,t+1~~ —1 (28) ¥B40,t
Individuals --no matter how poor they might be—may have options that would allow them to improve their economic situation, but sometimes they find limitations on the best use of whatever assets they have. These external constraints make it harder for them to reach their full economic potential and therefore overcome poverty. The role of policy is to help alleviate these constraints.

It is important to identify policy variables that directly affect the income generating function of households defined in (1) and (4). The poverty headcount ratio defined in (25) is a non-increasing function of market income and shared prosperity defined in (28) is a non-decreasing function of market income. Then, policy variables that (i) increase the accumulation of assets, (ii) increase the use of assets, (iii) increase the returns to assets, (iv) decrease the consumer prices paid by households, (v) increase the monetary value of private transfers, and, (vi) decrease the probability of risks faced by households, are expected to have a direct impact on poverty reduction and shared prosperity. The next section defines and discusses the policy areas that directly impact the World Bank’s goals.

# **5. Policies for poverty reduction and shared prosperity**

The asset–based model presented above assumes that all agents are rational; however, there is no equality of opportunities given the heterogeneous initial level of assets �� and, at the same time, they face some market failures, limiting their ability to take full advantage of their assets. In the absence of these factors that affect the income generation capacity of households, including lack of access to specific markets or assets --inequality of opportunities, when initial asset holdings is a circumstance individuals cannot control-- exposure to uninsurable risks and market failures, we would expect that all individuals will be able to accumulate the most productive assets.

Based on the discussion of interventions that correct inequality of opportunity, risks and market imperfections—widely used in microeconomic theory—the asset-based approach adopted here is 21
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economic agents with respect to asset accumulation and more (or less) intensive use of assets. Also, these policies directly and indirectly affect returns to factors of production, the consumer price index and non-labor incomes comprised by private and public transfers. Finally, these interventions can mitigate the effects of external shocks.

It is clear that there is no single policy that solves all the restrictions on the use of resources. On the contrary, there are a multiplicity of policies that depend on the specific constraint, the type of assets involved and the initial condition of the households. The policies that we present are only examples that are used to illustrate the policy channels that are playing a role in the reduction of poverty by allowing households to make a better use of their resources. Next, we present a simple model to link these four policy areas to the income-generation function of households, and to poverty eradication and the promotion of shared prosperity.

_Equitable and sustainable fiscal policy_ Equitable and sustainable fiscal policy affects the full income generation capacity through direct taxation. It also affects the decisions of individuals with respect to the intensity of use of their assets by affecting returns—also through direct taxes and public transfers. Indirect taxes such as the valueadded tax (VAT) can have a direct effect on consumer prices and thus affect the relative returns of households. Similarly, parameters of monetary policy related to macroeconomic stability, such as inflation targets linked to interest rates, directly affect the relative prices of the economy and thus the income generation capacity of all households. Prudent fiscal and monetary policies that are conductive to sustainable and acceptable trends of fiscal deficits and inflation are also very important to mitigate potential external shocks such as fiscal and financial crisis.

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�<sup>�</sup> ������<sup>�</sup> �����1 ����<sup>�</sup> ��<sup>�</sup> ��1� (32) In this case, the government’s sole activity is to transfer income from the rich (skilled/using high productive technology) to the poor (unskilled/using low productive technology). Additionally, we assume that in this particular case, the tax � is not large enough as to make the high productive technology unappealing. As can be seen clearly now, the presence of the tax affects the perceived future benefit from accumulation of capital. In this manner, the presence of � will affect the relative position of the critical thresholds �<sup>�</sup> and �<sup>��</sup> shifting them to the right.

It can be proven that if the number of people using the high productive technology reaches a certain threshold, there is redistribution such that it is possible to subsidize the accumulation of assets of individuals below �<sup>��</sup> favoring that they are able to access the more productive technology. Thus, equitable fiscal policy that redistributes income to households trapped in a long-term low-productivity path of production can have long-term positive effects on welfare.

# _Fair and transparent institutions_

Fair and transparent institutions capable of delivering quality basic services could directly affect the decision of individuals to accumulate assets. Strong institutional capacity linked to the delivery of good quality services, such as education and health, can enhance the ability of poorer households to improve the accumulation of net assets. In addition, more and better health services as well as employment systems are fundamental for mitigating risks for households, such as health related shocks and loss of employment. Moreover, institutions that promote the protection of property rights can improve the investment climate in the economy, increasing the availability of well-paid employment opportunities and thus affecting the returns to the factors of production. Strong regulatory entities are also important 25
to oversee private behaviors in markets and thus minimize the risks of potential financial and sectoral macroeconomic crisis.

To illustrate the role of the government in improving access to quality services, we can consider an example following the previous model. Recall the fixed cost to access the high productive technology given by �. This may represent the access to quality education. In this sense, households will want to accumulate human capital, but only if the cost of it is not too high. Similarly as in the fiscal policy model, the government would collect taxes but direct them towards lowering the cost of the productive technology, �, instead of giving direct transfers, thus making quality education more accessible for low-income households.

Given that the objective of the government is poverty eradication, and assuming that the government decision is to provide an in-kind transfer in the form of better quality of education instead of a direct cash transfer, an optimal taxation can be found such that the cost of education can be subsidized for people with an initial endowment below �<sup>��</sup> , effectively allowing them to become more productive.

# _Well-functioning markets_

Well-functioning markets directly related to improved connectivity and competition are central for reducing barriers to a more efficient utilization of households’ productive assets, and can be conductive to improving the relative returns to assets. Enhanced transport infrastructure that allows disadvantaged groups to connect to markets, for instance, is an example of an opportunity to directly increase the utilization of assets, which can create additional income. Furthermore, a robust competition policy that reduces entry barriers for new firms to certain markets directly affects the relative prices of all households by reducing consumer prices.

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One example of how well-functioning markets work is access to credit in a competitive credit market. The presence of the credit market will reduce the threshold �<sup>��</sup> , which determines that a household finds it optimal to accumulate capital. However, credit requirements such as collaterals or high interest rates can leave a large part of the population with low initial levels of assets unable to access the high productivity technology.

Since the objective of the government is to eradicate extreme poverty, its role is to promote the existence of a competitive credit market with information systems that foster good credit behavior by reducing moral hazard. In this sense, competition in the credit market increases access to credit by lowering interest rates and fostering the development of bank branches that are closer to consumers that traditionally have not had easy access to the formal banking system. Moreover, when the credit history is centralized, the reduction of moral hazard can further expand access.

It is important to highlight that this policy does not suit the circumstances of the population whose level of assets is too low. But it can allow for an important part of the population to access higher levels of assets without direct government assistance.

# _Risk management_

Finally, risk management can reduce the exposure to and impact of shocks for all the households in an economy but particularly for those poor and vulnerable, who usually have a higher probability of risk ‘realization’, forcing them to engage in negative coping mechanisms. In this way, public safety nets, such as public cash transfer schemes that are flexible so that they can be scaled up during crisis and scaled down during recovery, are important instruments that can support households affected by external shocks by providing temporary income support. Another relevant policy that can both mitigate risk and increase the intensity of use of assets is the insurance of crops that offers a payout 27
|0, = (ef, €f)<br>Ef<br>6<br>O(ef) = maxfef — d,0}<br>(33)<br>d>0<br>I;<br>p<br>E»pute) (34)<br>Celt<br>t=0<br>Cet+Atyr<br>+pie=(1—&)f(At)+Ae+6(EZ)I(35)|
|---|
More interestingly, even when insurance is available for these vulnerable households, if they are to the right of the threshold �<sup>��</sup> but not very far away from it, the household’s optimal decision is not to insure against potential losses. This happens as a consequence of the fact that they face a very difficult decision. If they decide to buy insurance, the premium could be large enough that it puts them to the left of �<sup>��</sup> , making certain that they will remain below the poverty line. On the other hand, if they decide not to buy insurance, there is a positive probability that an actual shock happens and drives them to the left of �<sup>��</sup> and into poverty. At the same time, as has been discussed in the literature, it is often the case that by endogenous reasons, individuals that start with low levels of capital are actually the ones that face higher probabilities of facing risks.

In order to achieve the goal of eliminating poverty, the government should implement a system that is able to cover risks, especially for those households that are vulnerable. As was discussed by Janzen et al (2013), a safety net scheme that provides transfers to the poor and also insures the risks of the vulnerable has lower fiscal costs in the long term as it is more efficient in reducing the long-term poverty rates.

# **6. Conclusions**

Policies to make growth more “inclusive” have permeated the development debate and “pro-poor growth” has been the subject of a wide range of papers in the literature, including issues related to measurement, modeling, and policy. However, the analytical and –particularly— empirical literature to support the idea that equity-enhancing policies have a positive effect on growth is more scarce and limited, particularly in terms of potential policy links. This paper proposes a simple conceptual framework using an asset-based approach that helps to explain the capital accumulation dynamics of households and how it is affected by the role of government and markets. This framework is useful 29
for unpacking the components of household market income generation capacity and is also useful to analyze how that capacity differs across socioeconomic and demographic groups. It provides an intuitive framework to argue that equity-enhancing policies have a positive effect on the capacity of those at the bottom to contribute to growth.

More importantly, this asset-based approach represents a bridge between the World Bank’s goals and specific policies that could have direct impacts on the income generation capacity of households. Using this framework and presenting a simple model (building on Janzen et al. (2013), this note links the World Bank’s goals of poverty reduction and fostering the income growth of the bottom 40% of the income distribution to four fundamental policy areas that directly affect the generation of income.

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