Economic Growth and Income Inequality

Last Updated: 10 Aug 2020
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Studies on the relationship between income inequality and Growth initiated from the pioneering research by Simon Kuznets (1955) where deliberated economic growth and income inequality and came up with a hypothesis that is currently called as the Kuznets hypothesis or the inverted U-Curve. The Kuznets hypothesis formed the foundation from which most early studies analyzed the relationship between income inequality and growth. Kuznets (1955) assumed that in the initial stages of economic Growth, both a nation’s economic growth and its inequality increase.

As countries grow and develop, the income gap between the rich and the poor should decrease. Indeed, according to Kuznets, there is a slow change from a low-inequality, low-income, agricultural economy, towards a high-income and medium-inequality economy characterized by industrial production. This shift would lead to the inverted U-shaped relationship between real GDP per capita and inequality.

Kuznets says that in the initial period, agriculture represents the majority of a country’s economy, which is also characterized by low levels of inequality. According to Kuznets, a shift towards the secondary and the third sectors has in nature two effects in the short term. The first effect is that it speeds up economic growth leading to higher levels of GDP per capita. The second and most dramatic effect is that this increases the level of inequality.

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Accordingly, in the initial stages of economic Growth, the level of GDP per capita and inequality are positively correlated. As countries develop they shift more and more resources from agriculture to industry (and later to services), and this will in time decrease the income gap between the industry and agriculture simply because there will be more and more workers working in the industrial sector. So, the long run relationship between inequality and GDP per capita is negative. The Kuznets hypothesis therefore showed connection from Growth to income inequality.

Some researchers shown support to Kuznets Hypothesis e.g. Oswang, (1994); Milanovic, (1994); Fishlow, (1995) as well as Ali, (1998), Banerjee and Duflo (2003), Perotti (1993) and Aghion and Bolton (1997) and examined the relationship between income inequality and output growth with the inverted U-shaped hypothesis. And agreed with Kuzents In the initial stage of development, the rich is getting richer but the poor is getting poorer in the presence of imperfect market.

However, Robinson (1976) mentioned U-curve has been observed in both developed countries and modern developing countries by using cross sectional data. This is because in the study of Robinson (1976), Kuznets process is analyzed with the existence of within-sector inequality. Based on the study of Shahbaz (2010), the Kuznets’ inverted U-curve in Pakistan is existed. In addition, income inequality and economic growth have co-integrated movement in long run (Khattak, Muhammad & Iqbal, 2014).

Though various research have found some support for the Kuznets hypothesis but some studies such as Ahluwalia, (1976); Bruno, Ravallion and Squire, (1995) and UNCTAD, (1997), found no such relationship between growth rates and income inequality. Deininger and Squire (1996) also did not find any evidence for the existence of such (Kuznets Relationship) a relationship between development and inequality. This shows that not all economies follow the inverted U-Curve hypothesis during their development path but Kuznets theory marked an important starting point for many inequality studies that followed.

Delbianco, Dabus & Caraballo, (2014) they studied the linkage between the inequality of income distribution and the economic growth of 20 Latin American and Caribbean countries from 1980 to 2010. The study finding shows that the relationship between inequality and economic growth mainly depends on the different income levels. It means the evidence is “approximately heterogeneous.”

In common, inequality is dangerous to economic growth. But, when we are speaking about richer countries’ income, higher inequality motivates economic growth, and it means at a higher income level the negative effects of inequality are alleviated and the relationship becomes positive. The evidence suggests that progressive redistributive policies in favor of poorer strata of population help economic growth in lower income economies and the stage of development of each country matters for the analysis of the economic growth.

Barro (2000) also uses panel data, but finds both a negative and a positive effect depending on the development of the country. With a low GDP per capita inequality has a negative effect on growth, while the effect is positive when GDP per capita is high in other words Concludes that the effect of income inequality on economic growth is different contingent on the state of economic development. Income inequality in poor countries retards economic growth, but income inequality in rich countries encourages economic growth.
Deininger & Squire (1998) also support Barro (2000) finding, stating that initial inequality reduces income growth for poor, but not for rich countries.

Fields (1989) examined if the saving of the richest people are more than the poorest, the capital accumulation to the poorest will decline and slow down the growth.
Tiwari, Shahbaz and Islam (2013) investigated the impact of financial development on the rural‐urban of Indian data for period 1995-2008 and found that the relationship is positive in the urban areas and negative in the rural areas.

Malinen (2012) Studied the Estimating the long-run relationship between income inequality and economic development by using of unbalanced panel of 53 coun¬tries and determined that there is a long-run balance relationship between growth and inequality, for developed countries this relationship is negative. Likewise, Abida and Sghaier (2012) they look empirical relationship between economic growth and income inequality for four north Africa nations namely (Tunisia, Algeria, Morocco, and Egypt) for the 1970-2007 periods. They indicated that the long-run growth elasticity of income inequal¬ity is negative.

Persson and Tabellini\'s (1994) study presents that in unequal economies the governments would favor more redistributive policies. This in turn would affect incentives, and thus decrease growth. Inequality would thus hamper growth. Both Persson and Tabellini (1994), Alesina and Rodrik (1994) test this type of model and find support that inequality has a negative effect on economic growth correlation for democracies only.

Whereas Clarke (1995) obtains a negative correlation for both democracies and non-democracies. Keefer and Knack (2000) find evidence of a negative correlation between income inequality and growth, but this correlation becomes insignificant once a measure of property rights is included as a control variable. More recently,
Sirine (2015) stated that the relationship between income inequality and economic growth are negative in developing countries.

However, Forbes\'s (2000) studied, using panel data on countries, finds in contrast to Persson and Tabellini\'s a positive short term linkage between inequality and growth.
Beside this Partridge (1997) finds in contrast to Persson and Tabellini, that there is a positive effect of inequality on growth in the sense that the Gini-index is positively correlated to economic growth. Moreover, he finds no evidence that the income distribution has any strong effect on government policy. Hence, he concludes that the income distribution of the population affects growth through another mechanism than that of redistribution.

Li and Zou (1998) considered a more general theoretical framework found that income inequality is positively and most of the time significantly associated with economic growth.
Nguyen (2014), Nguyen (2015) or Le and Nguyen (2016) studied the link between economic growth and inequality of Vietnam By using Gini coefficients to represent income inequality, these authors analyzed the positive relationship between economic growth and inequality in Vietnam in recent periods

Panizza (2002) criticizes Partridge’s Finding. Using a similar data on U.S. states, with unlike conditions, but finds no evidence of a positive result of inequality on growth. Instead, he finds weak evidence of a negative result. In addition to Panizza, Stewart and Moslares (2012) studied the Indian states for the period of 1980-2010, and demonstrated that income inequality affects growth negatively, and achieve that regional Gini coefficients affects the growth rate negatively, by means of the literacy rate and the coefficient of variation of the growth rate as control variables.

Similarly, Abida and Sghaier (2012) they look empirical relationship between economic growth and income inequality for 4 countries in North Africa (Tunisia, Algeria, Morocco, and Egypt) for the 1970-2007 periods. They indicated that the long-run growth elasticity of income inequal¬ity is negative and significant more income inequality reduces economic growth.

Nahum (2005) in order to test how inequality affects economic growth. She makes a study of data within Swedish provinces. She tests the result in 1, 3, 5, and 10-year growth periods, from 1960-2000, using both fixed effects regressions and 2SLS regressions. She finds a strong, positive, and significant effect of inequality on economic growth in the short run of 1 to 5-year growth periods but by using long run of 10-year growth periods the effect is less significant and steady.

Surprisingly, Banerjee and Duflo (2003) found that higher inequality increases growth in more democratic society on the other hand growth decreases in less democratic cultures. Similarly Bjornskov (2008) considered the relationship between income inequalities and economic growth and found that it can certainly depend on the political ideology of the government which positive sign holds under conservative governments and the negative sign under liberal governments.

While Herzer and Vollmer (2012) analyzed the long-run effect of income inequality on income per capita by using heteroge¬neous panel co-integration techniques and used data from 46 developed and developing countries from 1970-1995. Consequently, they found a negative effect of inequality on income, both for the sample as a whole and for groups within the sample.

In regard to previous research, Voitchovsky (2005) focused on the effect of different parts of income distribution on income inequality. She also focused on using more measures for inequality than just the general measures, such as the Gini index. She tests her hypothesis, by studying 5-year growth periods for 21 OECD countries. She finds that inequality in the lower part of the income distribution affects growth negatively, while inequality in the upper part of the income distribution affects growth positively. Her approach is used in this thesis to validate the inadequacy of the Gini index in explaining the link to growth.

Fields (1989) stated that if the saving of the richest more than the poorest, the capital accumulation to the poorest will decrease and slow down the growth.
Barro (2000) theory’s suggested a positive effect and claims that inequality rises savings. This theory anticipated that the marginal tendency to save increases with income and that savings are equal or similar to investment. Thus under these assumptions a more unequal economy consists of more rich people and will grow faster, Because an unequal economy enhance higher savings and higher investments so, higher investments increase economic growth.

According to Helpman (2004), Tachibanaki (2005), Weil (2005) studies shown that the positive relationship between income inequality and economic growth might be explained as follows. In developed countries, the saving rate of rich people is higher than that of the poor. Income redistribution from rich people to poor people reduces the saving rate of the economy as a whole and thus could lead to a decline in economic growth. Another reason is that the income redistribution could lower the incentive for the rich to work hard, and that could also lead to an economic growth decline. As a result, we can infer that income equality makes economic growth lower, and income inequality makes it higher.

Meanwhile, the negative relationship between income inequalities and economic growth might be explained as follows. In developing countries, poor people are under credit constraint. They do not have the opportunity of investing, and extremely poor people in income inequality cannot even participate in product activity. Income inequality might lead to political and social instability, and consequently to economic growth decline. As a result, we can conclude that income inequality makes economic growth lower and income equality makes it higher.

Furthermore, Galor and Moav (2004) describe a unified theory that combines two contradictory approaches at different stages of the development process. Galor and Moav suggest that the classical channel dominates in the early stages of development, at which time physical capital accumulation is the main engine of growth.

However, the credit market imperfection mechanism starts to dominate in the next stages of the process, at which time human capital is the main source of growth. Finally, Galor and Moav suggest that both mechanisms dim with development. There are also other arguments that associate higher inequality with lower future growth. As an example, inequality may reflect polarization of power.

The wealthy may have incentives to lobby against redistribution, thus preventing efficient policies (Bénabou, 2000). Further, Galor et al. (2009) suggest that inequality may bring out incentives for the wealthy to hamper institutional policies and changes that facilitate human capital formation and economic growth. In a more general perspective, Bénabou (1996) argues that high overall inequality may give rise to sociopolitical instability, which in turn reduces growth.

However, Perotti (1993) said the economy’s income level affects this conclusion and illustrates that in very poor economies only the rich may be able to attain education, and inequality may correlate positively with investment in human capital.

Eventually, some researchers said that there is the chance of sociopolitical disorder in an unequal society. Nilsson (2004) stated that Income and wealth inequality can give incentives for the poor to participate in disruptive activities such as crime. These actions can even threaten the country’s political system, which may make a more insecurity in the country’s governmental institutions. Barro (1990) Contribution in such activities leads to a direct misused of resources that harmful to economic growth.

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