What is a limitation of using gross domestic product GDP per capita as a measure of a countrys level of development?

“Development can be seen as a process of expanding the real freedoms that people enjoy.” Amartya Sen

Economic growth assesses the expansion of a country’s economy. Today, it is most popularly measured by policymaker and academics alike by increasing gross domestic product, or GDP. This indicator estimates the value added in a country which is the total value of all goods and services produced in a country minus the value of the goods and services needed to produce them. It is common to divide this indicator by a country’s population to better gauge how productive and developed an economy is – the GDP per capita.

A brief history of growth and GDP

The idea of economic growth stems from classical economics where growth in national income represents the growth in the wealth of a nation – the classical hallmark of success. The concept of economic growth gained popularity during the industrial revolution, when market economies flourished. In the 1930s, Nobel laureate, Simon Kuznets wrote extensively about national statistics and propagated the use of GDP as the measure of the national income of the US. However, Kuznets took this measure with a pinch of salt and wrote, “The national income total is thus an amalgam of relatively accurate and only approximate estimates rather than a unique, highly precise measurement” (Kuznets, 1934).

Against the backdrop of a bloody world war, governments were on the look for analytical tools to raise taxes to finance the newly minted war machine. It was at the 1944 Bretton Woods conference that GDP became the standard tool for measuring a country’s economy. Right from the classicals to the neo-classicals, the idea of development was intertwined with economic growth, i.e. accumulation of wealth and production of goods and services.

Finally, it was at the end of World War II in 1945 that the notion of developing nations came to the fore of public policy. US President Harry Truman, at his inaugural address in 1949, defined a larger part of the world as “underdeveloped areas” and stated that development should be based on “democratic fair-dealing” (Truman announces Point Four program).

Today, the predominance of GDP as a measure of economic growth is partly because it is easier to quantify the production of goods and services than a multi-dimensional index can measure other welfare achievements. Precisely because of this, GDP is not, on its own, an adequate gauge of a country’s development. Development is a multi-dimensional concept, which includes not only an economic dimension, but also involves social, environmental, and emotional dimensions.

Towards inclusive and sustainable growth

One of the limitations of GDP is that it only addresses average income, failing to reflect how most people actually live or who benefits from economic growth. Thomas Piketty (2014) presents a two-fold theory on how the wealth of a society becomes more concentrated and why this is counterproductive to development:

1. The first law posits that inequality rises when the rate of return of capital (profits, dividends, interests and rents) is larger than the rate of economic growth.
2. The second law posits that sustained increases in the capital-to-output ratio concentrates income in the hands of the owners of capital to the detriment of workers (return of capital surpasses the return of labour, i.e. wages).

Piketty analyses an extensive trove of data sets, although limited to developed countries only. He claims that these laws explain the market failures inherent to capitalism. These failures should be corrected through government intervention in the form of:

• increasing the public provision of goods and services,
• a robust social safety net, and
• progressive taxation of income and wealth.

If left unchecked, growing inequalities can not only slow down growth, but also generate instability and disorder in society, posing a threat to the very foundation of liberal democracy. The consequence of the rich accumulating ever more capital and wealth, is that economic and, consequently, political power become increasingly concentrated in the hands of a wealthy few. This skews policy making processes towards overly representing the interests of these wealthy elites.

Therefore, a growing GDP cannot be assumed to necessarily lead to sustainable development. On the other hand, there is good criticism of Piketty’s so called ‘fundamental laws of capitalism’ on the grounds of savings and depreciation rates miscalculations (Mankiw, 2015; Milanovic, 2016).

Alternate measures

The Human Development Index

One expanded indicator, which attempts to measure the multi-dimensional aspect of development, is the Human Development Index (HDI), conceived by the United Nations Development Programme (UNDP). Mahbud ul Haq and Amartya Sen developed the index, which is better suited to track the progress, not only of rich, but also of poor nations.

The first report on HDI was conducted in 1990. It incorporates the traditional approach to measuring economic growth, as well as education and health, which are crucial variables in determining how developed a society is. This is calculated through a geometric mean of GDP per capita, life expectancy at birth, and the average between mean years of schooling and expected years of schooling.

The Human Capital Index

On 11th October 2018, The World Bank launched the Human Capital Index (HCI). This newly created index ranks 157 countries’ performances on a set of four health and education indicators according to an estimate of the economic productivity lost due to poor social outcomes. The main benefit is that it focuses on outcomes, rather on inputs, analogously to the Social Progress Index (SPI) and unlike GDP. For example, educational quality as measured by actual adjusted learning is weighted more appropriately against years of schooling. The main criticism to the HCI is that it might end up overvaluing the material benefits of education and health, thus commoditising people, instead of their societal contributions and their inherent aspect of being basic human rights. Notwithstanding, it is expected that mainly developing countries will make use of the HCI in order to quantify the results of social sector investments, thus increasing spending on human development (health, education, social security, etc.), which the World Bank argues have been forgotten at the expense of infrastructure and institutional development.

The Social Progress Index

There is arguably a better way of measuring societal development: the SPI. The SPI was developed by the non-profit, Social Progress Imperative. It is one of the outcomes of the Commission on the Measurement of Economic Performance and Social Progress – or simply, Stiglitz-Sen-Fitoussi, after its leaders. The main objective of the Commission was to investigate how the wealth and social development of countries could be measured beyond the uni-dimensional GDP measure. It is still a relatively new indicator, with data only for four years, however it covers a wide span of more than 130 countries.

The SPI is a refinement of the HDI because it expands the number of composite indicators from only four to fifty-four in a wide array of areas, including basic human needs, foundations of well-being, and opportunities to progress. Therefore, this index is capable of synthesising the most relevant aspects that determine development. For example, access to water and sanitation, educational and health outcomes, public criminality, housing, access to information, and communication. Naturally, the main drawback of the SPI is its comparatively large complexity and lack of practicality when used to inform policy making.

Facets of the SPI

1. Economic growth as freedom

The view underlying the SPI pays tribute to Sen’s (2000) conceptualisation of economic growth as not an end in itself, but rather, an effective means of expanding personal and societal freedoms – the impact it has on people’s lives. For example:

• political liberties in the form of freedom of expression and free elections,
• government transparency and accountability,
• personal security/safety, and
• access to economic opportunities such as participation in trade and production.

Therefore, development consists of the elimination of deprivations of liberty that limit the choices and opportunities of persons to exercise their agency in their own lives.

2. A multi-dimensional development perspective

The great added value of the SPI is that it combines various indicators of subjective components that are often eschewed from the economic debate. These include: political rights, freedom of expression, assembly and religion, the level of corruption, tolerance for, and discrimination and violence against, minorities and immigrants.

No single aspect of the index demotes a country. Instead, a combination of variables provides expanded insight into the level of development of a country. It is not surprising that developed countries top the table, however, some of the richest countries in terms of GDP are still lagging behind in certain developmental variables. Some disappointing scores come from the US, France, Italy, Russia, Brazil and China.

3. Economic growth versus development

There are three main explanations why countries underperform in relation to the size of their economies:

1. They have a sizeable contingent of poor people,
2. Wealth and income inequality is high and/or growing, and
3. Environmental degradation has not been properly addressed.

Although the third is captured by the SPI, the two former explanations are not. Poverty and inequality are increasingly being debated in academic literature, not only due to their negative impacts on human development, but because they drag GDP growth.

Policy choices, like tax reforms that mostly benefit the rich and non-wage earners (Sammartino, 2017; Burman et al., 2006), are aggravated by recent stylised facts such as a growing gap between real wage growth and labour productivity growth (Mishel, 2012) and stock market bull runs whose proceeds are largely accrued by the rich (Matthew, 2008).

Economic growth: for whom?

Is the average worker’s life getting any better? Economic growth, measured popularly via GDP, is a complementary indicator to development, but not an adequate indicator when considered on its own. The challenge of modern capitalism is to balance its role as an efficient and effective mode of production with its tendency to concentrate income, wealth and, thus, power. In fact, social progress will lead to economic progress and that is where the SPI is a welcome improvement to development metrics.

The measurement of GDP could also be made more robust if it captured, not only physical capital, but also natural and human capital. When dissociated from social progress, economic growth in its pure accounting format (GDP expansion) will inevitably result in less inclusivity and a generalised sense of social discontent, pernicious in democratic societies.

Therefore, the current measure of economic growth as GDP has many limitations when used to assess development. Given the multi-dimensional nature of development, the SPI can be seen as a more adequate indicator.

In what regards the IGC’s work, in the end of the day, the creation of new indexes and methodologies to measure human and economic development are very welcome, since it will provide us with a wider toolkit to analyse our main subject: economic growth.

References

Burman, L., Rohaly, J. and Shiller, R. (2006). The Rising Tide Tax System: Indexing (at Least Partially) for Changes in Inequality. Accessible: http://www.econ.yale.edu//~shiller/behmacro/2006-11/burman-rohaly-shiller.pdf

History.com. Truman announces Point Four program. Accessible: https://www.history.com/this-day-in-history/truman-announces-point-four-program

Kuznets, S. (1934). “National Income, 1929-1932”, National Bureau of Economic Research, pp. 1-12. Accessible: http://www.nber.org/chapters/c2258.pdf

Mankiw, N. G. (2015). “Yes, r > g. So What?”, American Economic Review, Vol. 105, No. 5, pp. 43-47.

Matthew, E. (2008). Stock Markets and Income Inequality: A Cross-Country Study, Masters Dissertation, Singapore Management University.

Milanovic, B. (2016). Increasing Capital Income Share and its Effect on Personal Income Inequality, LIS Working Papers No. 663, LIS Cross-National Data Center in Luxembourg.

Mishel, L. (2012). “The Wedges Between Productivity and Median Compensation Growth”, Issue Brief #330, Economic Policy Institute.

Piketty, T. (2014). Capital in the Twenty-First Century, translated by Arthur Goldhammer, Cambridge, USA: Harvard University Press.

Piketty, T. and Zucman, G. (2015). Wealth and Inheritance in the Long Run, Handbook of Income Distribution, Vol. 2. Edited by Anthony B. Atkinson and François Bourguignon. Amsterdam: Elsevier. Chap. 15, pp. 1303–1368.

Sen, A. (2000). Development as Freedom, New York, USA: Anchor Books.

Sammartino, F. (2017). “Taxes and Income Inequality”, the Tax Policy Center.