The Debate over the Relationship between Income Inequality and Economic Growth: Does Inequality Matter for Growth?

Article excerpt

Abstract

The last twenty years have seen an increasing interest by economist for understanding the effects that income distribution has on economic performance, and even though economic theory has focused traditionally in issues such as productivity and efficiency, scholars now recognize the potential causal relationship between income inequality and the way economies can grow. This paper contributes to the debate over the relationship between income inequality and inclusive economic growth by developing a comprehensive description and analysis of the most influential views that take part in this important topic. A description of the way this debate has been developing over the last decades is present, as well as a detailed review of the three main positions (negative, positive and non linear relationship) proposed in the literature. The main policy implication is that recent literature supports the statement that inequality does matter for economic growth and that inclusive distributional policies can impact growth rates in the long run.

Keywords: income inequality; economic growth

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1. Introduction

Although economic theory has focused traditionally in issues such as productivity and efficiency, the role that income inequality plays in economic dynamics has been present but not manifest in economic literature since a long time. For some, inequality is simply an element of the generally accepted view of a necessary trade-off between efficiency and equality(Note 1), in which both cannot coexist and are mutually exclusive. Others implicitly perceive inequality as a condition that is automatically addressed by the markets and the efficient use of the available resources, in an extremely confident trickle down view. Even modern welfare economics see the process of income distribution as a secondary issue(Note 2) and are more focused on competitive equilibrium and reaching a Pareto optimality, thus abstracting from any judgment over distribution(Note 3).

While most of the debate over the inequality-growth relationship during the largest part of the XX century was focused on the effects of growth and development over inequality levels, the last twenty years have seen the development of a new debate: this time with the purpose to understand the other side of the relationship, namely the effects that income inequality might have over economic growth. Perhaps a contemporary phenomenon such as globalization, the enormous disparities between countries, or the inconsistencies found with the expected inequality among countries and their development level, have motivated this new approach, in an effort to better understand this phenomenon.

This paper develops a comprehensive description of the contemporary views that have tried to explain the effects that inequality exerts over growth, as well as the different positions that have shaped the new debate and the way it has developed over the last decades.

1.1 The effects of income inequality over economic growth

The increasing interest in understanding the way inequality influences economic performance has motivated the development of research on this topic over the last two decades. The results have not yet come to converge into one generalized position over the sign of the relationship. Moreover, the remarkable disparities in the results, both in theoretical and empirical studies, have derived into a complex debate, with four main positions: the studies which affirm a negative relationship (Alesina and Rodrik, 1994; Clarke, 1995; Perotti, 1993; Alesina and Perotti, 1996; Persson and Tabellini, 1994; De la Croix and Doepke, 2003; Josten, 2003; Ahituv and Moav, 2003; Viaene and Zilcha, 2003; Josten, 2004; Castelló-Climent, 2004; Knowles, 2005; Davis, 2007; Pede et al., 2009). The ones who found a positive one (Partridge, 1997; Forbes, 2000; Li and Zou, 1998; Nahum, 2005) the studies who propose a sign changing nonlinear relationship (Barro, 2000; Banerjee and Duflo, 2003; Pagano, 2004; Voitchovsky, 2005; Bengoa and Sanchez-Robles, 2005; Barro, 2008; Castelló-Climent, 2010). …

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