Palma Ratio

Palma Ratio Definition

The Palma ratio is a statistical tool that measures the income inequality of a nation. It considers the weighted income distribution for evaluation. The gross national income (GNI) contribution of the richest 10% of the population is divided by the GNI share of the poorest 40% population.

This method was introduced to overcome the shortcomings of the Gini coefficient. The Gini index relied heavily on the middle class. The Palma method focuses on the extremely rich and extremely poor income brackets as they are more sensitive to government policies and other factors. Any change in the earnings of these two income groups affects the country's economy drastically.

• Palma ratio refers to the economic measure of a nation's income inequality by emphasizing the gross national income contribution of the two extremes of the income distribution, i.e., the richest and the poorest.
• In 2013, Alex Cobham and Andy Summer introduced the Palma method based on Jose Gabriel Palma’s ‘Palma proportion.’
• In societies with lower inequality, this ratio is less than 1, which means that the top 10% of that society does not earn more than the bottom 40%. On the other hand, in communities with high inequality, the ratio can go as high as 7.

Palma Ratio Explained

The Palma ratio measures income equality. Compared to the Gini index, it is less common but more suitable. The income inequality of any country indicates the economic distribution and earnings gap between different sections of society.

A nation with a high-income inequality is often dominated by a handful of people who belong to the richest income brackets—where others remain poor or become poorer. Such economic condition paves the way for crime, exploitation, social unrest, and reduced cost of living.

In 2013, Alex Cobham and Andy Summer found that the Gini index is not a suitable measurement for economic inequality. The Gini index accentuates the middle-income group rather than the rich and poor income brackets. But the middle-income group usually has stable earnings.

In response, they proposed the Palma ratio based on the ‘Palma Proportion’ drafted by Jose Gabriel Palma. Jose is a Chilean economist. Palma highlighted how the rich and the poor income groups contribute 50% of the national income. He emphasized that the difference between those two groups signifies economic inequality. Alex and Andy believed that the Palma ratio was a reliable substitute for the Gini index.

The Palma ratio focuses on the income distribution extremes or tails and provides fair results. However, this ratio did not gain much publicity. Many major organizations like the World Bank still use the Gini index—for gauging a nation's economic inequality.

The United Nations (UN) and the Organisation for Economic Co-operation and Development (OECD) use the Palma method for preparing their database by the United Nations (UN).

Calculation of Palma Ratio

The Palma ratio underlines income distribution extremes, i.e., the wealthiest and the poorest income groups. Since these income brackets are highly sensitive to government policies and other factors, any change in the earnings of these two income groups affects the country's economy.

The following formula used for computation:

Palma Ratio= Gross National Income (GNI) Share of Richest 10% of Population / Gross National Income (GNI) Share of Poorest 40% of population

Thus, 50% of the earners, i.e., the richest 10% and poorest 40%, are considered under this measure. If the Palma ratio is high, the country has considerable income inequality.

Interpretation

According to Alex Cobham and Andy Summer, the Gini index provides a non-intuitive interpretation of economic inequality in a country as it is concerned with the changes in the income of the middle-income group. The Gini coefficient overlooks the rich and the poor income brackets.

Thus, the Palma ratio was brought forward in 2013; it divides the Gross National Income into the following three brackets:

It is interpreted as follows:

When the Palma ratio is high:
A high Palma ratio indicates a greater degree of inequality or unequal income distribution in a nation. In such a country, maximum national income is concentrated in the richer sections of the society. In such countries, the poor don't have sufficient capital to meet their needs; South Africa has the highest Palma ratio of 6.89.

When the Palma ratio is low:
A low Palma ratio is preferable. These countries have better living standards—income distribution between the rich and the poor is fairer. The Slovak Republic has the lowest Palma ratio of 0.71.

According to the Organisation for Economic Co-operation and Development (OECD), the income inequality status of different nations in 2020 is as follows:

The above graph depicts Palma ratios. Countries with the highest income inequality include South Africa: 6.89, Costa Rica: 3.14, Chile: 2.55, Mexico: 2.04, and Bulgaria: 1.89.

On the other end of the spectrum, Norway: 0.9, Iceland: 0.87, Czech Republic: 0.84, Slovenia: 0.83, and the Slovak Republic: 0.71 are nations with the lowest income equality.

Example

Let us take a look at another example. Given below are the inequality ratios pertaining to three nations for the year 2018.

Now, based on the given data, elucidate economic inequality for each nation.

Solution:

The above table shows moderate economic inequality in Australia and Israel (the Palma ratio is slightly above 1.0). On the other hand, economic conditions are relatively worse in Costa Rica, which has a Palma ratio of about 3.0.

Frequently Asked Questions (FAQs)

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This has been a guide to Palma Ratio and its meaning. We discuss the Palma ratio definition, income inequality calculation for countries, & Gini index using examples. You can learn more about it from the following articles - 

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