The connection between economic growth and income inequality

The curve describes a U-shaped relationship between inequality and growth: inequality first increases and later decreases in the process of economic development.

kuznets curve

The idea was to test whether the change in income inequality over time has had a significant impact on GDP per capita on average across OECD countries, and if this influence differs according to whether inequality is measured in the lower or upper part of the distribution. Establishing causality is exceptionally difficult in the social sciences and the standard approach employed for studying relationships between inequality and growth has been to look at the level of inequality preceding the growth period being measured.

Theoretical relationship between economic growth income and wealth inequality

A certain degree of income and wealth inequality is a characteristic of market economies, which are based on trust, property rights, enterprise and the rule of law. The purpose of these studies is to establish whether economic inequality has some effect on economic growth or stability. This large dispersion highlights the limited relevance of the average effect typically estimated. If income is not highly concentrated, an increase in inequality can provide incentives for countries to be more productive. New evidence suggests there is a possibility. In fact, some economists theorized that inequality in the less developed world was actually good for growth because it meant that the economy was generating select individuals wealthy enough to provide the savings necessary for investment-led growth. This type of relationship also emerges in Barro's analysis. There is a growing gap between low- and middle-income households which is particularly pronounced in Finland, Israel, Sweden, Spain and the US. This does not firmly establish causality but can be indicative of it. This newly available research looks across developing and advanced countries and within the United States. Instead, it contains analysis that largely demonstrates there are direct, and possibly causal, relationships between economic inequality and growth—places that begin with a lower level of inequality subsequently tend to grow faster and have longer periods of growth than those with a higher level of inequality. But the initial inequality levels also matter to explain why an increase in inequality varies in its impact on economic development across countries. For emerging countries, inequality has risen in most countries — suggesting that many nations have been on the rising part of the curve.

For emerging countries, inequality has risen in most countries — suggesting that many nations have been on the rising part of the curve. Technological innovations including the factory system, electric power, computers, and the internet tend to raise the level of inequality at first when just a few people initially share in the relatively high incomes of the advanced sector.

To explore the question further, our study estimated a relationship for GDP per capita in which a change in income inequality was added to standard growth drivers such as physical and human capital.

income inequality and economic growth in developing countries

The best practices in this area are evolving and so it is important to look at the breadth of the literature, rather than focus on a single paper or approach.

But the initial inequality levels also matter to explain why an increase in inequality varies in its impact on economic development across countries. Trade-offs and win-win policies Improving access of households and business to banking services, as well as promoting participation of women in the labor force can help combat the negative impact of increasing inequality on economic growth.

What we find is that the effect of income inequality on economic growth can be either positive or negative, and that at a particular level of inequality—at a Gini of about 27 percent to be exact—the direction of the relationship changes—that is, where inequality begins to hurt economic development.

The purpose of these studies is to establish whether economic inequality has some effect on economic growth or stability. High increases in pay of people in top-paying jobs Increasing wealth including rising property prices Growing gaps between urban and rural areas High fertility in poorer households Increasing pay of those with higher levels of schooling especially with the growth of jobs and pay in high-knowledge industries such as computer gaming, engineering systems, financial trading Reductions in the percentage of people who are members of a trade union Linked effects of inequality in health and education Much depends on the extent to which a government has a welfare and tax system in place to provide an income safety-net and also a desire to redistribute rising incomes and wealth so that the benefits of growth can be more equitably shared out.

Conflict between economic growth and inequality

Within countries, indicators of inequality, such as the Gini coefficient, say little about who has benefited or lost from these trends. Eventually, however, as more people take advantage of the new technology, inequality falls. Economists and policymakers today should not be surprised that empirical studies were inconclusive given the broad theoretical and sometimes contradictory reasons that hypothesized inequality would both promote growth and inhibit growth. Overall, for poor countries, the escape from poverty is made more difficult because rising per capita income induces more inequality, which retards growth in this range. A closer look at the situation of households provides a more complete picture and shows that in many OECD countries, gains in disposable incomes have fallen short of increases in GDP. High increases in pay of people in top-paying jobs Increasing wealth including rising property prices Growing gaps between urban and rural areas High fertility in poorer households Increasing pay of those with higher levels of schooling especially with the growth of jobs and pay in high-knowledge industries such as computer gaming, engineering systems, financial trading Reductions in the percentage of people who are members of a trade union Linked effects of inequality in health and education Much depends on the extent to which a government has a welfare and tax system in place to provide an income safety-net and also a desire to redistribute rising incomes and wealth so that the benefits of growth can be more equitably shared out. To shed light on this issue, one recent study by Causa et al. Therefore, econ- omists are left to do the best estimates with the data at hand. Inequality has risen in the OECD area.

In two recent papers— Inequality Overhang and Inequality and Growth: A Heterogeneous Approach —we dig deeper into the direction of this relationship, using a sample of 77 countries at different stages of development and representing all geographical regions, with at least 20 years of data, and employing techniques that address some shortcomings in the literature.

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A New Twist in the Link Between Inequality and Economic Development