Income Inequality and Economic Growth in Developing Countries: An Empirical Analysis*

Article excerpt

Abstract

Since the 1950's, income inequality and its impact on the economy has frequently been studied by many authors. Even though numerous studies have considered many aspects of this impacts, there are still many questions that remain. One of the lingering questions involves the nature of the relationship between income inequality and economic growth. Studies indicate conflicting conclusions about this relationship. This paper attempts to use income inequality data from several developing countries and shed new light on it. Based on panel data estimation over the 1966-1991 time period, the empirical evidence shows that developing countries with higher income inequality do not grow at a slower rate than developing countries with a more equal income distribution.

INTRODUCTION

Over the last half century, an intriguing topic among economists and policy makers has been the possible impact of income inequality on the economy, especially on the rate of economic growth. Understanding the relationship between these two very important economic variables is important, because higher income inequality is more often found in less developed countries. If there is a clearer understanding about this relation, specific economic policies could be adopted in less developed countries in the appropriate manner to deal with income inequality and to stimulate economic growth. This paper does not provide definitive or conclusive answer on the relationship between income inequality and economic growth; rather an attempt to provide additional empirical evidence in the search for the answer.

The focus on income inequality and economic growth began in the 1950's when Simon Kuznets (1955) presented his idea of an inverted U relationship between per capita GNP and inequality in the distribution of income. Based upon income distribution data available at that time, Kuznets suggested that as per capita income rose in lesser developed countries, income inequality also rose, reached a maximum, and then declined as income levels rose further. Kuznets developed this theory by studying data estimating income distribution in a few rich and a few poor countries and by studying trends in distribution in a few European countries over time (Perkins et al, 129). His findings were later described as an "inverted-U hypothesis." Following this ground breaking theory, many developing countries tolerated rising income inequality arguing that income would become more equally distributed with advanced development, as Kuznets observed. Thus, developing countries facing high income inequality need not to be concerned with such rising inequality. If, however, income inequality does not reverse itself with advanced development, it is important to understand the possible effects of income inequality on the economy. Whatever may be the theoretical justification of the Kuznets hypothesis, the empirical validity of this phenomenon still remains questionable at best.

A prominent case study displaying a possible relationship between income inequality and economic growth is that of South Korea and the Philippines. As discussed by Benabou (1996), South Korea and the Philippines looked similar in the early 1960's as indicated by many macroeconomic factors, including GDP per capita, populations, urbanization, and primary and secondary school enrollment. They differed, however, in their distribution of income. In 1965, South Korea's Gini coefficient was 34.3 while the Philippines' Gini coefficient was 51.3. During the next thirty years, South Korea averaged 6% growth annually while the Philippines stagnated at 2%. South Korea's output level increased fivefold while the Philippines output level barely doubled (Aghion et al, 1999). This result by no means proved a negative relationship between income inequality and economic growth, but it did invigorate the interest in the relationship.

It is important to understand the relationship between income distribution and economic growth for a number of reasons. …