Editing Economic growth (section)

== Inequality and growth ==

=== Theories ===
{{Further|Economic inequality|Effects of economic inequality}}

The prevailing views about the [[Social inequality and economic growth|role of inequality]] in the growth process has radically shifted in the past century.<ref>Galor, Oded (2011). "Inequality, Human Capital Formation, and the Process of Development". ''Handbook of the Economics of Education.'' Elsevier.</ref>

The classical perspective, as expressed by Adam Smith, and others, suggests that inequality fosters the growth process.<ref name="BergOstryEE">{{Cite journal|last1=Berg|first1=Andrew G.|last2=Ostry |first2=Jonathan D.|year=2011 |title=Equality and Efficiency|journal=Finance and Development|volume=48 |issue=3 |url=http://www.imf.org/external/pubs/ft/fandd/2011/09/berg.htm|access-date=July 13, 2014 |publisher=International Monetary Fund}}</ref><ref name="BergOstrySD">{{cite journal|last1=Berg |first1=Andrew|last2=Ostry|first2=Jonathan|year=2017|title=Inequality and Unsustainable Growth: Two Sides of the Same Coin|journal=IMF Economic Review|volume=65|issue=4|pages=792–815 |doi=10.1057/s41308-017-0030-8 |s2cid=13027248|url=http://www.imf.org/external/pubs/cat/longres.aspx?sk=24686}}</ref> Specifically, since the aggregate saving increases with inequality due to higher property to save among the wealthy, the classical viewpoint suggests that inequality stimulates capital accumulation and therefore economic growth.<ref>{{cite journal|last=Kaldor|first=Nicoals|year=1955|title=Alternative Theories of Distribution |journal=Review of Economic Studies|volume=23|issue=2|pages=83–100|doi=10.2307/2296292|jstor=2296292}}</ref>

The [[Neoclassical economics|Neoclassical perspective]] that is based on [[representative agent]] approach denies the role of inequality in the growth process. It suggests that while the growth process may affect inequality, income distribution has no impact on the growth process.

The modern perspective which has emerged in the late 1980s suggests, in contrast, that [[income distribution]] has a significant impact on the growth process. The modern perspective, originated by [[Galor-Zeira model|Galor and Zeira]],<ref name=":4">{{Cite journal|last1=Galor|first1=Oded|last2=Zeira|first2=Joseph|date=1993|title=Income Distribution and Macroeconomics|journal=The Review of Economic Studies|volume=60|issue=1|pages=35–52 |doi=10.2307/2297811|jstor=2297811|citeseerx=10.1.1.636.8225}}</ref><ref name=":5">{{Cite journal|last1=Galor|first1=Oded|last2=Zeira|first2=Joseph|date=1988|title=Income Distribution and Investment in Human Capital: Macroeconomics Implications|journal=Working Paper No. 197 |publisher=Department of Economics, Hebrew University}}</ref> highlights the important role of [[Homogeneity and heterogeneity|heterogeneity]] in the determination of aggregate economic activity, and economic growth. In particular, Galor and Zeira argue that since credit markets are imperfect, inequality has an enduring impact on [[human capital]] formation, [[Aggregate income|the level of income]] per capita, and the growth process.<ref>{{Cite web|url=https://www.brown.edu/Departments/Economics/Faculty/Oded_Galor/pdf/WB.pdf |title=The Effect of Distribution on Growth|last=The World Bank Group|date=1999}}</ref> In contrast to the classical paradigm, which underlined the positive implications of inequality for capital formation and economic growth, Galor and Zeira argue that [[Economic inequality|inequality]] has an adverse effect on [[human capital]] formation and the development process, in all but the very poor economies.

Later theoretical developments have reinforced the view that inequality has an adverse effect on the growth process. Specifically, Alesina and Rodrik and Persson and Tabellini advance a political economy mechanism and argue that inequality has a negative impact on economic development since it creates a pressure for distortionary redistributive policies that have an adverse effect on investment and economic growth.<ref name=":6">{{cite journal |last1=Alesina|first1=Alberto|last2=Rodrik|first2=Dani|year=1994 |title=Distributive Politics and Economic Growth|journal=Quarterly Journal of Economics|volume=109|issue=2 |pages=65–90|doi=10.2307/2118470|jstor=2118470 |url=http://dash.harvard.edu/bitstream/handle/1/4551798/alesina_distributive.pdf}}</ref><ref name=":7">{{cite journal|last1=Persson|first1=Torsten|last2=Tabellini|first2=Guido|year=1994|title=Is Inequality Harmful for Growth?|journal=American Economic Review|volume=84|issue=3|pages=600–21|jstor=2118070}}</ref>

In accordance with the credit market imperfection approach, a study by Roberto Perotti showed that inequality is associated with lower level of human capital formation (education, experience, apprenticeship) and higher level of fertility, while lower level of human capital is associated with lower growth and lower levels of economic growth. In contrast, his examination of the political economy channel found no support for the political economy mechanism.<ref name=":8">{{cite journal|last=Perotti |first=Roberto|year=1996|title=Growth, Income Distribution, and Democracy: What the Data Say |journal=Journal of Economic Growth|volume=1|issue=2|pages=149–87|doi=10.1007/BF00138861 |s2cid=54670343}}</ref> Consequently, the political economy perspective on the relationship between inequality and growth have been revised and later studies have established that inequality may provide an incentive for the elite to block redistributive policies and institutional changes. In particular, inequality in the distribution of land ownership provides the landed elite with an incentive to limit the mobility of rural workers by depriving them from education and by blocking the development of the industrial sector.<ref>{{Cite journal|last1=Galor|first1=Oded|last2=Moav|first2=Omer|last3=Vollrath|first3=Dietrich|date=2009 |title=Inequality in Landownership, the Emergence of Human-Capital Promoting Institutions, and the Great Divergence|journal=Review of Economic Studies|volume=76|issue=1|pages=143–179|doi=10.1111/j.1467-937X.2008.00506.x|pmid=23946551|pmc=3740999}}</ref>

A unified theory of inequality and growth that captures that changing role of inequality in the growth process offers a reconciliation between the conflicting predictions of classical viewpoint that maintained that inequality is beneficial for growth and the modern viewpoint that suggests that in the presence of credit market imperfections, inequality predominantly results in underinvestment in human capital and lower economic growth. This unified theory of inequality and growth, developed by Oded Galor and Omer Moav,<ref>{{Cite journal|last1=Galor|first1=Oded|last2=Moav|first2=Omer|date=2004|title=From Physical to Human Capital Accumulation: Inequality and the Process of Development|journal=Review of Economic Studies |volume=71|issue=4|pages=1001–1026|doi=10.1111/0034-6527.00312|citeseerx=10.1.1.561.4168}}</ref> suggests that the effect of inequality on the growth process has been reversed as human capital has replaced physical capital as the main engine of economic growth. In the initial phases of industrialization, when physical capital accumulation was the dominating source of economic growth, inequality boosted the development process by directing resources toward individuals with higher propensity to save. However, in later phases, as human capital become the main engine of economic growth, more equal distribution of income, in the presence of credit constraints, stimulated investment in human capital and economic growth.

In 2013, French economist [[Thomas Piketty]] postulated that in periods when the average annual rate on return on investment in capital (''r'') exceeds the average annual growth in economic output (''g''), the rate of inequality will increase.<ref>{{cite book|title=Capital in the Twenty-first Century.|last1=Piketty|first1=Thomas|date=2014|publisher=Brilliance Audio|isbn=978-1491534656}}</ref> According to Piketty, this is the case because wealth that is already held or inherited, which is expected to grow at the rate ''r'', will grow at a rate faster than wealth accumulated through labor, which is more closely tied to ''g''. An advocate of reducing inequality levels, Piketty suggests levying a global [[wealth tax]] in order to reduce the divergence in wealth caused by inequality.

=== Evidence: reduced form ===
The reduced form empirical relationship between inequality and growth was studied by Alberto Alesina and Dani Rodrik, and Torsten Persson and Guido Tabellini.<ref name=":6" /><ref name=":7" /> They find that inequality is negatively associated with economic growth in a cross-country analysis.

[[Robert Barro]] reexamined the reduced form relationship between inequality on economic growth in a panel of countries.<ref>{{cite journal|last=Barro|first=Robert J.|year=2000|title=Inequality and Growth in a Panel of Countries|journal=Journal of Economic Growth|volume=5|issue=1|pages=5–32|doi=10.1023/A:1009850119329|s2cid=2089406}}</ref> He argues that there is "little overall relation between income inequality and rates of growth and investment". However, his empirical strategy limits its applicability to the understanding of the relationship between inequality and growth for several reasons. First, his regression analysis control for education, fertility, investment, and it therefore excludes, by construction, the important effect of inequality on growth via education, fertility, and investment. His findings simply imply that inequality has no direct effect on growth beyond the important indirect effects through the main channels proposed in the literature. Second, his study analyzes the effect of inequality on the average growth rate in the following 10 years. However, existing theories suggest that the effect of inequality will be observed much later, as is the case in human capital formation, for instance. Third, the empirical analysis does not account for biases that are generated by reverse causality and omitted variables.

Recent papers based on superior data, find negative relationship between inequality and growth. Andrew Berg and Jonathan Ostry of the [[International Monetary Fund]], find that "lower net inequality is robustly correlated with faster and more durable growth, controlling for the level of redistribution".<ref name=":9">{{Cite journal|last1=Berg|first1=Andrew|last2=Ostry|first2=Jonathan D.|last3=Tsangarides|first3=Charalambos G.|last4=Yakhshilikov |first4=Yorbol|date=2018|title=Redistribution, inequality, and growth: new evidence|journal=Journal of Economic Growth|volume=23|issue=3|pages=259–305|doi=10.1007/s10887-017-9150-2|s2cid=158898163}}</ref> Likewise, Dierk Herzer and Sebastian Vollmer find that increased income inequality reduces economic growth.<ref>{{cite journal|last1=Herzer|first1=Dierk|last2=Vollmer|first2=Sebastian|year=2013|title=Rising top incomes do not raise the tide|journal=Journal of Policy Modeling|volume=35|issue=4|pages=504–19|doi=10.1016/j.jpolmod.2013.02.011}}</ref>

=== Evidence: mechanisms ===
The [[Galor-Zeira model|Galor and Zeira's model]] predicts that the effect of rising inequality on GDP per capita is negative in relatively rich countries but positive in poor countries.<ref name=":4" /><ref name=":5" /> These testable predictions have been examined and confirmed empirically in recent studies.<ref>{{Cite web|url=https://voxeu.org/article/effects-income-inequality-economic-growth|title=Effects of income inequality on economic growth |last1=Brückner|first1=Markus|last2=Lederman|first2=Daniel|date=2015 |website=VOX CEPR Policy Portal}}</ref><ref>{{Cite journal|last1=Brückner|first1=Markus|last2=Lederman |first2=Daniel|date=2018|title=Inequality and economic growth: the role of initial income|journal=Journal of Economic Growth|volume=23|issue=3|pages=341–366|hdl=10986/29896|hdl-access=free|s2cid=55619830 |url=http://documents.worldbank.org/curated/en/574281528247194319/Inequality-and-economic-growth-the-role-of-initial-income|doi=10.1007/s10887-018-9156-4}}</ref> In particular, Brückner and Lederman test the prediction of the model by in the panel of countries during the period 1970–2010, by considering the impact of the interaction between the level of income inequality and the initial level of GDP per capita. In line with the predictions of the model, they find that at the 25th percentile of initial income in the world sample, a 1 percentage point increase in the Gini coefficient increases income per capita by 2.3%, whereas at the 75th percentile of initial income a 1 percentage point increase in the Gini coefficient decreases income per capita by -5.3%. Moreover, the proposed human capital mechanism that mediates the effect of inequality on growth in the Galor-Zeira model is also confirmed. Increases in income inequality increase human capital in poor countries but reduce it in high and middle-income countries.

This recent support for the predictions of the Galor-Zeira model is in line with earlier findings. Roberto Perotti showed that in accordance with the credit market imperfection approach, developed by Galor and Zeira, inequality is associated with lower level of human capital formation (education, experience, apprenticeship) and higher level of fertility, while lower level of human capital is associated with lower levels of economic growth.<ref name=":8"/> Princeton economist Roland Benabou's finds that the growth process of Korea and the Philippines "are broadly consistent with the credit-constrained human-capital accumulation hypothesis".<ref>{{Cite journal|last=Bénabou |first=Roland|date=1996|title=Inequality and Growth|journal=NBER Macroeconomics Annual|volume=11|pages=11–92|doi=10.1086/654291|s2cid=154145268}}</ref> In addition, Andrew Berg and Jonathan Ostry<ref name=":9" /> suggest that inequality seems to affect growth through human capital accumulation and fertility channels.

In contrast, Perotti argues that the political economy mechanism is not supported empirically. Inequality is associated with lower redistribution, and lower redistribution (under-investment in education and infrastructure) is associated with lower economic growth.<ref name=":8"/>