How economists explain the relationship between inequalities and growth
In the development economics field, the discussion about the relationship between inequalities and growth goes back in time, and it is a widely difficult issue. How does one affect the other?
I recently reviewed, for academic purposes, some of the literature covering this topic. The picture emerging is quite complicated: there are a number of theories that explain what links income inequalities to economic growth. Some of them state a positive relationship, some of them negative.
Until 1998’s paper by Deininger and Squire “New ways of looking at old issues: Inequality and Growth”, the relationship was thought to be positive.
It is worth noticing that in the past few years the number of theories stating that inequalities, instead, hinder growth, are more numerous, and they come with increased empirical evidence. Also OECD’s working papers on the issue strongly argues for a negative relationship.
But what are the mechanisms that explain this relationship? The picture below is a simple scheme I made to make some order in this jungle of theories, with a focus on human capital as an explanatory mechanism.
- (A) Endogenous fiscal policy theory
- (B) Human capital accumulation
- (C) Demand channel issues
- (D) Incentives to invest
- (E) Propensity to consume and savings
- (F) Political economy
Below you will find a brief description of all these theories, where each one is a stream of literature itself.
If you’re interested in the left-hand side vicious circle that connects education, inequality and social mobility, feel free to write me and we can discuss it (I decided not to publish my full essay here, a bit too technical and basically just a critical review).
After going through the econometric approaches, to my in-training-economist’s mind, the human capital explanation sounds very convincing.
In a nutshell, for non-economists: start from an unequal society, where also education is not equally distributed. This means that the rich will access more and better education (yielding a higher return from it), whereas the poor will suffer a lockout effect from all the positive effects that education gives (resulting in a lower level of human capital, lower future wages and opportunities).
This creates dynasties of rich-educated and poor-uneducated households, as the effect is transmitted throughout generations, as the educational system is undemocratic.
This, from an economic and social point of view may have two contrasting effects: one (theory D) is that getting educated translates in a higher wage, therefore I will have a greater incentive to invest in my education, causing economic growth. Inequality is simply a necessary condition in society that sparks the incentives for investments that in turn lead to growth.
On the other hand (theory B), the view is that if inequalities are too high, the lockout-effect for the bottom layer of the population is so strong that there will be a large portion of society under-investing in their human capital, therefore hampering economic growth (obviously simplifying the story, if one doesn’t consider that a low level of education in a large part of the society creates all sorts of negative social returns).
The empirical evidence and the trends in inequality show more proof pointing towards the negative effect of inequality on growth. OECD and IMF have strongly emphasized this view, that opens up space for a number of policy recommendations in the direction of accessible, democratic education that promotes equality of opportunities.
For a more detailed description of all these theories in the framework, you’ll find more information below.
(A) Endogenous fiscal policy theory
Inequality, at some level, might become socially unacceptable and cause distrust in enterprises and business activity. This distrust might lead to a higher popular pressure for regulations and taxation of economic activities, resulting eventually in a reduction of investments for businesses. As shown by Alesina and Rodrick (1994), in societies with a great portion of citizens excluded from productive resources, the push for redistribution will be higher. This conflict generally harms growth by favoring redistribution processes.
(B) Human Capital Accumulation
The most important contribution for this channel is the model developed by Galor and Zeira (1993). The study is based on two assumptions:
- Credit market imperfection (the cost for the borrower is lower than that of the lender): if there are segregated dynasties that invest differently in human capital, financial market imperfections imply that those who do not need to borrow in order to invest in human capital, are advantaged in a twofold way.
- Human capital is indivisible (technology is non-convex). This assumption makes it possible to link the distribution of wealth to the long-run economic performance
The main finding is that the initial distribution of income will affect output in the short and long term. An economy that presents a more equal distribution of wealth in the beginning will tend to grow wealthier in the long-run.
The bottom-line argument is quite simple: the economic background created by inequality generates a lockout effect for the poorest households, that will find it hard to invest in human capital accumulation of their children. The under-investments of this segment of society harms economic growth and gives birth to a vicious circle that blocks social mobility.
(C ) Demand Side Issues
If the adoption of new technologies depends on a minimum amount of domestic demand, inequality might drive this demand down. The insight would be an economy of two agents, one with high-income level (and the possibility to save, invest and produce), the other with a low-income level (representing the demand side for consumption and mid-range goods). If the demand for mid-range products is below a critical threshold, because of the inequality level getting too extreme, the incentives to invest in the production of such goods for the first agent would drop. In recent papers (Bernstein, 2013), the debate on these demand channel issues has seen new light.
(D) Incentives to invest
A positive effect that income inequality has on growth is that of creating differential returns on investments. According to this theory, a higher level of inequality helps in the creation of the incentives to invest.
From the perspective of returns to education (increase in real wage due to an increase in the individual educational level), it means that the individual has a higher incentive to pursue higher education in order to achieve the skills premiums on the job market.
In addition, the argument for growth relies on the higher productivity of skilled workers: from one side by encouraging individuals to achieve in the educational process, and from the other by stimulating firms to hire high-productivity workers.
This theory is founded on the “Tournament Theory”, (Lazear and Rosen, 1981).
(E) Propensity to consume
This theory goes back to the work of Kaldor (1956), and it is based on the idea that higher inequality increases the level of savings for the rich, whose propensity to consume is lower than that of the poorest segments of the population. This phenomenon increases capital accumulation and has a positive net effect on economic growth.
(F) Political Economy
Several political economy arguments hold the case for a negative effect of inequality on growth. The first scenario is that of a society with extreme levels of inequality, a society that risks social unrest, revolutions and threats to institutions and private property. Instability might, among the rest, drive down the investments in the country and shift long-term planning to short-term planning, therefore harming growth (Knack and Keefer, 2000).
Another political economy explanation on why inequality might slow down growth is that of waste of resources for lobbying reasons by èlite: if the status quo must be preserved in favor of the mean voter instead of the median, the élite must invest wealth in influencing economic policy against redistributions. This resources, spent on lobbying are taken from investments that can help economic growth.
Taking solely the effect of education itself on growth, there are other two effects on the job market that are worth mentioning. In a society that is shifting to a knowledge economy, education represents the key for innovation and efficiency: skill biased technological change has made education a staple part of a sustainable development process: the job market is more connected to knowledge than it ever was. Moreover, as Barry McGaw (2001) argues, a higher education level tends to give workers steadier and more regular jobs, compared to low-skilled workers.