The impact of income inequality on the growth of an economy

Income inequality is the high degree of disparity among the population with respect to their income. Correlation between the income inequality and growth of an economy is not a nascent issue in economics. Many erudite researchers and economists have tried to answer the causality among these two variables by analyzing empirically. They found a negative relation between the two but studies done by few economists also suggests there exists a positive relation. Renowned economists Simon Kuznets postulated that at the stage of inchoation as economy burgeons, quantum of inequality also surges but after a point inequality starts fading due to large sharing of efficiency and productivity. This relation is known as Kuznets’s inverted “U” curve hypothesis.

Findings suggest that developing economies have a higher degree of inequality as compared to developed nations. For example the ratio of incomes of richest 20% population to bottom 60% population of India is 1.96 and of US is 1.29 (Ray, 2013). Perotti (1993) was among the early proponents to suggest a negative relation between the two variables where he used a theoretical model focusing on the effects of trickle down and argued that poor masses are unable to endeavor human capital because of dearth of redistribution and ponderous inequality thus growth remains sluggish. Alesina and Rodrick (1994) in their pioneer work found a statistically significant negative relation between the income inequality and economic growth. The cogent reason which they explained is a sacrifice between the positive aspects of income redistribution and the deleterious effects of huge taxes on capital engendering incongruous economic growth.

Factors affecting growth of an economy

Growth of a country depends on eclectic factors like savings, investment, trade, employment, human capital, technological advancement and income inequality (Harrod Dommar model, gravity model and endogenous growth model). Chiefly inequality is measured by calculating coefficient of variation, Gini coefficient, Thiel’s index and others. If a small proportion of population has majority of income holdings and large proportion of population has relatively less income, it is known as an economy with high income inequality. To achieve an appreciable growth of GDP it is expected that large portion of the population should participate in economic activities to generate income which will result in lowering the inequality. It is true that growth can be achieved even with less population participating in economic activity and generating ponderous capital to compensate for other masses. But in that situation it will not utilize its optimal capacity of production and labor force. Skills of labor are extremely important in generating income as more skilled the labor, more the income is expected to be generated. These skills further depend on education which in economics referred as human capital. Solow model of growth probates the positive relation between human capital and growth of an economy but to obtain or acquire human capital there is an opportunity cost attached that every individual cannot afford. This clearly indicates; with higher income inequality, lower population will have access to higher education. Many researchers too established a negative relation between income inequality and human capital.

Reducing the gap between the rich and the poor

Ryan (2005) tested the hypothesis that secondary education is negatively related with income inequality and found them statistically significant. Savings also has a significant share in influencing growth as it bolsters the investment of an economy which is channelized by financial institutions. According to permanent income hypothesis, individuals have a tendency not to save at low levels of income because all what they earn is being utilized in meeting their demands. It is lucid that at lower-income levels savings are expected to be nil. Thus higher the income inequality, lower would be savings rate of an economy because at lower-income levels marginal propensity to consume is very close to one. If there are fewer rich people and maximum poor people then savings will certainly hamper. Classical economists argued that egalitarian distribution of wealth will exacerbate savings and thus slower the growth of a country which clearly signals that classical economists seconds income inequality. Study by Partridge (1997) suggests a positive relation between income inequality and growth. He took the state level US data from 1960 to 1990 and found Gini coefficient to increase with increase in the growth of GDP.  As per the reports of Organization for Economic co-operation and Development (OECD); if there is a three percentage point increase in Gini coefficient, the potential GDP declines by almost eight and a half percentage points. A high intensity of inequality might mitigate criminal activities as well because there will be lack of resources for the lower strata of population. So to fulfill their needs unemployed youths might step into crime or might start using drugs. Endogenous growth theory says income inequality will enervate the growth of an economy thus government should try to redistribute the resources via fiscal instruments. Progressive taxation helps the economy in reducing inequality as individuals earning more has to pay marginally more as compare to poor people. Economy with high income inequality is expected to have higher tax rates for rich.

Income inequality and economic growth

Overall the picture is ambiguous as there is literature which suggests a statistically significant negative relation between income inequality and growth and simultaneously there exists literature which establishes a positive relation between the two. Economic theory also has a dichotomous behavior while dealing with income inequality and growth. One side suggests that until and unless there are no capital and resources, growth will be succinct, hence inequality should pertain for a swift growth. Another side explains that growth of a nation will be phlegmatic if there is high income inequality. For development it is indispensable to curb the income inequality by facilitating education which will impart marketable skills in citizens. Income inequality may support micro development but prevents the macro development of any economy. The relationship between the discussed variables depends upon the characteristics of the economy (developed or developing), regional perspective, political structure, and social status, hence drawing a unanimous relation will not be pragmatic.

References

  • Alesina, A. and Rodrick, D. (1994). “Distributive politics and economic growth,” Quarterly Journal of Economics, vol. 109, no. 2, pp. 465–490.
  • Bernstein .J. (2013). “The impact of inequality on growth”, Center for American Progress, pp 1-37.
  • Partridge, M. D. (1997). “Is inequality harmful for growth? Comment”. American Economic Review, 87(5), 1019-1032.
  • Perotti. A. (1993). “Income distribution and investment,” European Economic Review, vol. 38, no. 3-4, pp. 827–835.
  • Ray. D. (2013). Development economics. London: Oxford University Press.
  • Wells. R (2005), “Education’s effects on Income inequality: A further look” CCPR conference cp-05-054.

Priya Chetty

Partner at Project Guru
Priya is a master in business administration with majors in marketing and finance. She is fluent with data modelling, time series analysis, various regression models, forecasting and interpretation of the data. She has assisted data scientists, corporates, scholars in the field of finance, banking, economics and marketing.

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