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The advantages of globalization and greater degree of openness in trade seem to have been the center of economic literature in the recent past. Empirical studies have shown different results for developing countries. Some of them advocate that greater trade and economic intensity tend to make a developing economy’s fundamentals stronger. There is however an equally opposing school of thought that believes that trade has made no difference, and on the contrary, it has worsened the poverty and inequality situations in developing nations. Empirical literature is divided between these two schools (McMillan, 2001). This can be further elaborated by stating that there are two major components in research in the area of economic intensity, one is its relationship with GDP and the other is its determinants.
It has been empirically tested and proven that for low-income countries, trade and economic openness may not improve the inequality in income distribution. On the contrary, it may worsen the distribution of income in such nations (Ahluwalia et al., 1979). Trade may thus be the devil in the angel’s garb for poor nations. This extreme view has not been proven consistently for all countries and periods. So the divided literature enthuses one to look at the cause of trade and foreign investment in low-income nations.
Another feature often ignored in economic literature is the nature of the political environment. Economic theorists seem to look at the economic happenings in isolation, but the nature of the political regime and its dynamics do make a significant impact on the economic and business environment. This is especially important when we study issues like welfare, poverty, and income inequality. The politico-economic structures when studied in a comprehensive manner go a long way in explaining the fundamentals of growth more clearly.
This paper is an attempt at explaining such a comprehensive framework. The basis of this paper is a study by Reuveny and Li (2003). Their paper was the first systematic statistical study done to capture the effects of both economic intensity and democracy on income inequality. Economic intensity is measured in terms of trade flows, FDI inflows and financial capital flows. Gini coefficient is used to measure income inequality.
The idea of using the level of democracy as a parameter in this study was influenced by the work of Reuveny and Li. Literature is divided on the definition of intensity, but to a large extent it is summarized in the intensity of countries to trade, FDI inflows, financial capital inflows and labor productivity (Hughes, 2000). Literature is also divided on the issue of effects of democracy. The claim that democracy reduces income inequality has not been proven conclusively.
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