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Poverty Reduction and Economic Growth

by Nora Lustig

Developing countries need to return to a strong growth path. They also desperately need to reduce poverty. But where should countries begin? Should they set their sights entirely on boosting per capita income and productivity, or focus on actions to improve conditions for the poor? 

Recent research findings suggest yet again the importance of average growth in reducing poverty. They also demonstrate how pro-poor initiatives in turn can propel economic growth.

Economic Growth and Poverty Reduction

How quickly growth reduces poverty depends both on the initial income distribution and how it evolves over time. In societies with more unequal distributions the same growth rate makes far less of a dent in poverty. Latin America and the Caribbean, for example, have some of the widest income disparities in the world. Given these initial levels of inequality, the region would have to post a 3.4 percent annual growth rate in per capita income (twice that recorded in the past decade), on average, in order to halve the percentage of people living on less than two dollars a day (in purchasing power parity) by 2015.

How efficiently average growth will reduce poverty also depends on how the income distribution shifts as the economy grows. In Mexico, for example, per capita real income rose by 4.8 percent annually between 1996 and 1998, but there was virtually no change in extreme poverty. Yet in Costa Rica, where per capita real income edged up by barely 1 percent annually between 1990 and 1998, poverty was reduced significantly.

Which growth pattern is the most pro-poor? A recent study on India found that growth has a greater impact on poverty when it is concentrated in rural areas and the initial education and infrastructure conditions are more favorable. Generally, a sole focus on maximizing per capita income growth may be less than successful in reducing poverty if the growth bypasses geographic areas or sectors in which the poor are concentrated, or fails to make intensive use of the most abundant factor of production available to the poor, namely, unskilled labor. This is more than twice the 1.5 percent average per capita growth recorded in the past decade, and would call for annual per capita growth rates of between 2 percent and 6 percent depending on the country.

In sum, economic growth is a crucial factor in poverty reduction, but the level of inequality and its evolution affect its impact on poverty. We now offer theoretical and empirical evidence suggesting that the causation runs in the opposite direction as well; that is, reducing poverty can help boost economic growth rates.

Poverty Reduction and Growth

Poverty can dampen growth when market imperfections (market failures, incomplete or uncompetitive markets) combine with investment indivisibilities, fixed costs, and strategic complementarities.

Investment Capacity Constraints 

Investment is critical for growth and to escape from poverty. Since fixed costs and indivisibilities are the norm, the poor may run into problems when they wish to invest because they are unable to come up with enough cash savings of their own, and they usually find themselves shut out of lending markets. Low-income levels are a fundamental reason why the poor cannot save enough money to finance productive investments.

The poor run up against yet another obstacle when they want to borrow: steep transaction costs and high interest rates that make credit a losing proposition. An analysis of various microfinance institutions showed that those that are financially sustainable have nominal interest rates ranging from 30 percent to 50 percent.

Actions to foster the development of financial institutions and services that truly serve the needs of the poor are a potential growth booster as well. In some cases subsidies to help defray fixed costs for equipment, machinery and human capital can be a more efficient approach to encourage the poor to invest more. Also, actions to lessen the moral hazard and adverse selection problem would help: for example, bolstering property rights for the poor, land market reforms to give poor people readier access, and further development of institutional vehicles such as group credit.

Constraints for Human Capital Development

Human capital, in its broadest sense, comprises people's educational attainment, their health and nutrition.

There is solid evidence associating more schooling and better nutrition with higher income and with enhanced productivity. Education may generate other important externalities that can indirectly propel growth. For instance, how well a mother is educated is crucial for her children's learning and hence for human capital accumulation in the family.

The investment may hold little appeal for poor families primarily because of the opportunity cost of children and young people who could be working in their homes or bringing in outside paychecks.

Hence the importance of education and health interventions both on the supply side (such as public spending on infrastructure and improvements in service and quality) and on the demand side for these services, for instance subsidies tied to investment in human capital for the poor (two examples are Mexico's Progresa program now called Oportunidades , and Brazil's Bolsa Escola grants). Just as crucial are early-intervention programs in health and nutrition and basic infrastructure investment (running water, electricity, transportation) because of the synergies at work between sound nutrition and people's ability to use new learning technologies (distance learning institutes, distance high-school education). Reforms to overhaul the institutional apparatus for social services delivery need to make sure that the poor have access to these services.

Poverty, Social Instability and Social Ills

Another channel through which poverty can stall growth is by way of its relationship with social and political equilibria. Where social injustice is pervasive and people have no say in the political process poverty can trigger social upheaval and, ultimately, the kind of sustained violence that puts the brakes on growth. We know from the evidence that poverty and inequality associated with geographic, ethnic, racial and gender factors take an economic toll on society at large that thwarts a country's growth potential. Likewise, the frustration that poverty breeds can trigger dysfunctional behavior and social ills (crime, alcoholism, drug addition, domestic violence, early pregnancy), that trap the poor and exact high economic costs as well.

Recent growth theory has posited various links between poverty, social and political instability, and growth. This being the case, initiatives targeted at reducing poverty and fostering social mobility do more than benefit individuals and society at large; they can enhance an entire nation's growth potential.

In sum, clearly economic growth is good for the poor. As important, reducing poverty is good for growth.

Rather than being alternative paths, pro-growth actions and those directly targeted at improving the lives of the poor are very often mutually reinforcing. The more this complementarity is tapped the more effective economic growth can be in reducing poverty. And the more countries do to eliminate constraints that are keeping the poor from being active, constructive partners in society, the greater the potential for growth and efficiency.

This article is an abridged version of Poverty Reduction and Economic Growth: A Two-Way Causality, by Nora Lustig, Omar Arias, Jamele Rigolini; Inter-American Development Bank, Sustainable Development Department, Technical Papers Series, Washington, D.C.

Professor Nora Lustig delivered a public lecture on this topic in Helsinki on 17 June 2002.

Professor Nora Lustig is RectoralPresident of Universidad de las Americas-Puebla, Puebla, Mexico, and a member of the Board of WIDER.