an essay on the effects of income inequality on...

Title An Essay on the Effects of Income Inequality on EconomicGrowth

Author(s) FUJISAWA, Nobuhiro

Citation 沖縄大学法経学部紀要 = Okinawa University　JOURNALOF LAW & ECONOMICS(13): 1-12

Issue Date 2009-11-30

URL http://hdl.handle.net/20.500.12001/5997

Rights 沖縄大学法経学部

[Articles]

An Essay on the Effects of Income Inequality on Economic Growth

Department ofLawand Economics, Okinawa University, Kokuba 555, Naha, Okinawa 902-8521, Japan

Nobuhiro FUJISAWAr

Abstract

Income inequality has been a hot topic in economic circles for many years. Some

authors have viewed the issue from how income inequality affects the economy, while

others have looked at how the economy might influence unequal distribution of resources,

such as income. Income inequality has also been shown to have unequal benefits in

different stages of development. Income inequality influences politics in a big way as well.

The term "income gap" that many are familiar with has much to do with a country's

economic growth, with some of the determinants being poverty, the accumulation of

human capital, redistribution, social conflict, economic mobility and trade liberalization.

This short paper will look at income inequality in all these areas and suggest future

research on the relationship of income distribution and economic growth.

Keywords: Income Inequality, Economic Growth, Preferential Trade Agreements

JEL classification: F15; 011; 015; 040

t E-mail: [email protected]; tel.: +81-98-832-2988; fax: +81-98-832-2988.

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1. Introduction

Since Kuznets (1955) showed the relationship between economic growth and income

inequality, many studies have explored the influences of economic growth on income

distribution. The Kuznets curve - whereby inequality first increases and later decreases

during the process of economic development - emerges as a clear empirical regularity. This

implies that once a country develops enough, problems caused by income inequality could

vanish. However, this doesn't mean that countries around the world eventually pass

through the same process of development. In fact, incomes per capita in countries around

the world are diversified, and have no tendency toward convergence. As Pen (1973)

indicated, inequality among countries is imaged as a "parade of dwarfs and a few giants."

One reason why we should pay attention to income inequality is its relationship to

poverty. For any given average level of income, if income is not distributed relatively

evenly, there will be a group of people who feel poor. In many instances, poverty can be an

outcome of perception from making comparisons. If a large enough percentage of the

population perceives themselves as poor, and the government has relatively weak controls

in place, widespread unrest can be an outcome. For this reason, poverty can be a serious

problem that a government must tackle one way or another. In addition to social unrest,

overall economic growth can be affected by unequal income distribution.

In the 1990's, Galor and Zeira (1993) and Banerjee and Newman (1993) looked at the

cause and effect relationship from the opposite view with their research into how income

inequality influences economic growth. They argued that income distribution plays an

important role in the determination of aggregate economic activity and economic growth.

They showed that when credit constraints are present, reducing wealth inequality can

actually have a stimulating effect on growth. Pioneered by them, many studies on the

effect of income inequality on economic growth have been explored.

For instance, Fishman and Simhon (2002) presented a model that links the division of

labor and economic growth with the division of wealth in society. They showed that

income equality increases investment in specialization and leads to a division of labor and

high long-run development. Nakajima and Nakamura (2008) constructed a model that links

income with the price of education. They showed that the educational expenditures of the

rich could prevent the poor from escaping poverty, thus causing persistent inequality.

2. Overview 1

There are a number of channels through which income inequality affects economic

growth. This paper shows what determines the possibility that a high level of inequality is

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good for growth at some stages of development and bad for growth at others.

Section 3 reviews the relationship between poverty and economic growth. It shows

that economic growth in a country as a whole is effective in escaping from poverty. Section

4 explains the effects of income inequality on the accumulation of human capital. It is noted

that human capital is one of the key factors of economic growth in recent new growth

theories and that it is affected by income inequality in a different way than that of physical

capital. Section 5 reviews how income inequality affects efficiency in the economy through

income redistributions through taxes. Section 6 reviews social conflict in respOnse to

income inequality. It indicates how lower wealth can lead to lower growth and even to

stagnation when the incentives to domestic accumulation are weakened by redistributive

considerations. Section 7 reviews economic mobility as the means of change for income

inequality. Section 8 reviews how trade liberalization affects income inequality. Section 9

discusses the direction of future research.

3. Is growth good for the poor?

One reason economists care about income inequality is because it relates to pOverty.

Holding constant the average level of income per capita in a country, a higher degree of

income inequality will mean that poor people are worse off. This observation implies that if

there is a Kuznets curve - for pOor countries, an increase in income per capita also means

an increase in inequality - then it is theoretically possible that economic growth can be bad

for the poorest people in a country. Specifically, the effect of growth raising the average

level of income may be counteracted by a widening of inequality as the poorest people fall

further below the average. Whether this theoretical possibility corresponds to reality

whether growth may be bad for the pOor - is an empirical Question.

The most important determinant for the incomes of the pOor is a country's average

level of GDP per capita. Dollar and Kraay (2002) showed that average incomes of the

poorest Quintile rose proportionately with average incomes in a sample of 92 countries

spanning the last four decades. This effect was due to pOlicy that targeted over all GDP

growth, and not specifically the pOorer population. This is because the share of income of

the poorest Quintile does not vary systematically with average income. It also does not vary

with many of the policies and institutions that explain growth rates of average incomes, nor

does it vary with measures of policies intended to benefit the poorest in society. This

evidence emphasizes the impOrtance of overall economic growth for pOverty reduction.

The approach of the paper is based on Wei! (2008) and Benabou (1996).

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Deininger and Squire (1996) also found a strong positive relationship between growth and

reduction of poverty based on a new data set on inequality in the distribution of income.

Summarizing the results of these studies, growth - as measured by GDP per capita

is almost always good for the poor, and so are the policies that lead to this growth.

4. Effects of income inequality on the accumulation of human capital

Income inequality is related to the saving rate for the simple reason that saving rates

tend to rise with income. That is, the higher a person's income is. the higher her saving's

rate is likely to be. The total amount of savings in a country is the sum of savings by people

in all different income groups. The more unequal income is - the higher the fraction of total

income earned by the richer people - the higher total savings will be. which leads to the

accumulation of physical capital.

Although a more unequal distribution of income is beneficial for accumulating physical

capital, the situation is the opposite in the case of human capital accumulation. Unlike the

case for physical capital. the opportunities that anyone person has to invest in human

capital are limited to the human capital that he can invest in himself, such as training and

education.

Galor and Zeira (1993) assumed that at lower levels of investment, the marginal

product of human capital was very high. But as the Quantity of human capital that is

invested in anyone person increases, its marginal product goes down. By contrast, the

marginal product of physical capital that anyone investor faces does not depend on the

amount that that person invests in physical capital. because any single person's investment

is minuscule in relation to the national level of capital. If a person has only a little money, he

will invest in human capital rather than in physical capital because it is always better to

invest in the form of capital with the highest marginal product. But people with a lot of

money to invest will invest their marginal money in physical capital.

In this circumstance, if income is redistributed from the rich person to the poor person,

two things tend to happen. First, human capital accumulation will rise. because the poor

person will invest her extra money in human capital, while the rich person will reduce her

investment in physical capital. Second. total output will go uP. because the marginal product

of human capital being invested in by the poor person is higher than the marginal product

of physical capital that the rich person invests in.

The different effects of income inequality on physical and human capital accumulation

- beneficial in the case of physical capital and harmful in the case of human capital

suggest that inequality may have different effects on the pace of economic growth at

different stages of growth. Galor and Moav (2004) indicated that in early stages of

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industrialization. since physical capital accumulation is a prime source of economic growth.

inequality enhances the process of development by channeling resources towards the

owners of capital whose marginal propensity to save is higher. In later stages of

development, however, as the return to human capital increases due to capital-skill

complementarity. human capital becomes the prime engine of economic growth. This

implies that inequality could be detrimental to growth in developed countries. In other

words, this process is evident when looking at stages of development in countries where

industrial economies have moved up to service economies.

5. Income inequality and efficiency

The way in which income inequality can affect the efficiency of production is through

the channel of income redistribution. When incomes are unequal. governments face

pressure to redistribute income through taxation, which can indirectly lower the level of

efficiency. and thus output.

Based on Alesina and Rodrik (994) and Persson and Tabellini (994), let us assume

that income redistribution is the only thing the government does. Assume also that

redistribution takes the following form. First. the government taxes all workers at the same

rate. Second, the government takes the revenue that it collects from this tax and pays it

back to workers in equal amounts (known as a lump-sum transfer). A worker's pretax

income is the income that he earns before any taxes are collected. A worker's disposable

income is his pretax income minus the taxes that he pays and plus the transfer that he

receives from the government.

We can now examine the amount of redistribution different workers would prefer.

Consider first a worker with pretax income above the mean level in the country. This

worker will be worse off by redistribution for two reasons. First, he will receive less back in

the form of a lump-sum transfer than he paid in taxes. Second, the reduction in economic

efficiency resulting from redistributive taxation will also lower the worker's pretax income.

Thus, a worker with pretax income above the mean will favor a tax rate of zero. In the case

of a worker with pretax income exactly equal to the mean, only one of the two effects

described above is operative. That is, the negative effect of redistributive taxes on

efficiency, and thus on pretax income. makes him worse off. Therefore, this worker will

also be against redistribution.

For a worker who earns less than the mean pretax income, the two effects of the tax

work in opposite directions. The lump-sum payment he will receive from the government

will be larger than his taxes. so his disposable income rises. However, the inefficiency

resulting from high taxes lowers his pretax income, making him worse off. though not as

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badly off as the previous two workers. Thus, a worker with income below the mean faces

a trade-off between the benefits that he gets from redistribution and the costs of

inefficiency due to taxation. The farther below the mean his pretax income, the more

important to him redistribution is, and thus the less harmful reduced pretax income

becomes, and the higher the level of taxation he will prefer.

As a result, all workers with pretax income greater than or equal to the mean will want

a tax rate of zero. Workers with pretax income below the mean will want a positive tax rate.

This desired tax rate will be higher for workers with lower pretax income. So how are

actual rates of taxation determined? The answer is that the determination of tax rates is a

political process. According to median voter theorem, the tax rate chosen will be the one

preferred by the person with the median level of pretax income. Notice that the median

level of pretax income is always (at least in all of the countries for which we have data)

below the mean level of pretax income. Thus, the tax rate selected by the median voter will

be above zero.

Finally, analyzing the effect of income distribution on the level of taxes, and thus the

effect on efficiency, we see that the wider the distribution of income, the farther the median

level of pretax income will be below the mean. When median pretax income falls, the rate of

taxation favored by the median voter rises. Therefore, higher inequality leads to more

redistribution and more taxation, and a lower level of efficiency. Through this channel,

income inequality lowers the average level of income.

6. Social conflict in response to income inequality

The pressure for redistribution is expressed in several ways, all of which affect growth

negatively. One expression is through political instability as different groups compete for

pOwer. Tornell and Velasco (1992), Tornell (1993), and Benhabib and Rustichini (1996)

studied how growth is affected by distributional conflict between long-lasting interest

groups or coalitions by using "dynamic commons problem" games. Through these games,

Benhabib and Rustichini (1996) showed how lower wealth can lead to lower growth and

even to stagnation when the incentives for domestic wealth accumulation are weakened by

redistributive considerations.

Therefore, unstable political situations discourage investment, as occurs when, for

example, people who build factories worry that their property might be confiscated

following some potential future revolution or other change in government.

A second expression of pressure for redistribution is crime. Property crime is often the

attempt by poor people to redistribute resources through channels other than political

systems. Grossman and Kim (1996) incorporated the economic theory of predation into the

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theory of economic growth. They focused on the allocation of resources between the

predator dynasty and the prey dynasty. Generations of the prey dynasty that chose to

deter predation. even though their property was perfectly secure, accumulated productive

capital more slowly than the preceding generations that tolerated predation. Even if

deterrence seems to be a better choice for the prey dynasty. deterrence can be costly.

7. Economic mobility

Economic mobility. which means the movement of people from one part of the income

distribution slide rule to another. especially intergenerational mobility. can explain

intertemporal income inequality. According to Corak and Heisz (1999). a Canadian man

whose father was in the lowest income Quartile has a 17% chance of ending up in the

highest income Quartile. and the son of a man who was in the highest Quartile has a 20%

chance of ending up in the lowest Quartile. About 33 percent of those born to fathers in the

bottom Quartile were also in the bottom as adults. and about 35 percent of sons born to

fathers in the top Quartile also had earnings in the top Quartile. In contrast, those in the

middle of the income distribution spectrum are characterized by close to perfect mobility.

Unfortunately. detailed data on mobility are not available for many countries. so it is not

possible to determine how mobility is related to a country's level of income per capita or its

rate of economic growth.

As to the determinants of mobility. Weil (2008) indicated that the most important

influence can be access to education. Education opens a path to upward movement in the

income distribution scale for children of the poor. In countries with generous public

education systems. such transitions are more likely. He also points out the importance of

public health policies and broad access to medical care.

The literature on the relationship between income distribution and economic

development, which follows the capital market imperfection approach. shows that income

inequality affects long-run economic performance provided that the production technology

of human capital or final output is non-convex.

Moav (2002) demonstrated that the non-convexity of technology can be replaced by an

assumption that savings, which is bequeathed to the next generation. is a convex function

of income. He developed a small. open overlapping-generations economy model in which

the evolution of income within each dynasty in society is governed by a dynamical system

that generates a poverty-trap equilibrium along with a high-income equilibrium. In the

model, the utility function is designed to generate the convex bequest function.

By constructing a simple model that includes the price of education. Nakajima and

Nakamura (2009) showed that the educational expenditure of rich households could

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prevent poor households from escaping poverty. Their framework mainly follows that of

Moav (2002).

Their idea is that the rich household's demand for higher education pushes up the price

of education at a pace faster than the poor household can keep up with. Accordingly, the

poor are gradually excluded from higher education, and consequently income inequality

between the rich and the poor expands in the long run. They indicated that this mechanism

could be an explanation for the rise in income inequality.

8. Trade liberalization and income inequality

In order to argue the relationship between trade liberalization and income inequality,

income heterogeneity within a country must be introduced Fajgelbaum et al. (2009)

constructed a model to study the pattern of trade between countries that differ in size and

income distribution but are otherwise identical. They were able to show that, in many

circumstances, trade liberalization especially benefits the poorer households in wealthy

countries and the richer households in poor countries. They provide a demand-based

explanation for the pattern of trade in goods of different Quality. Those non-homotheticities

in demand forge a link between the shape of a country's income inequality and the pattern

of trade.

Dalgin et al. (2008) and Choi et al. (2009) also showed that such links between income

inequality and trade patterns are important in the real world. Dalgin et al. (2008) pursued an

empirical investigation on the effect of inequality on trade with the use of a gravity model.

Choi et al. (2009) investigated how the distribution of income shapes patterns of

consumption and how international trade in Quality differentiated varieties within narrow

product categories. They showed that country pairs that share more similar income

distributions also exhibit a more similar distribution of import prices.

The recent proliferation of preferential trade agreements (PTAs) sheds light on the

effects of income inequality not only on international economies but also on domestic

economies. For instance, Dollar and Kraay (2004) examined the effects of globalization on

the poor. They identified a group of globalizing developing countries and found that those

countries grew at 5.0% per capita. In contrast, rich countries had a per capita growth rate of

2.2% and non-globalizing developing countries saw only a 1.4% rise. This implies that the

globalizing developing countries are catching up with rich countries while the non

globalizing developing countries are falling further behind.

For the past decade, many studies confirm that PTAs could stimulate economic growth

and flows of international investment, which in turn could lead to welfare improvement for

each county involved in the formation of PTAs. Ariyasajjakorn et al. (2009) examined the

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impact of Free Trade Agreements (FTAs) on income distribution within the Association of

Southeast Asian Nations (ASEAN) and between the members and their trading partners

outside ASEAN. By using a Computable General Equilibrium model, they showed that the

FTAs tend to widen the income gap between capital owners and labor in each ASEAN

member. On the other hand, the income gap between skilled and unskilled labor seems to

decline in each ASEAN member since the unskilled wage improves more than the skilled

wage.

9. Concluding remarks

This paper presented a survey on the effects of income inequality on economic growth

along with various determinants relevant to these effects. Some of these determinants are

poverty, the accumulation of human capital, redistribution, social conflict, economic

mobility, and trade liberalization. The direction of future research that I will perform is

discussed below, especially in relation to PTAs.

As described in section 8, there are a number of studies which confirm that PTAs could

stimulate economic growth. In the future, I plan to investigate the relationships between

heterogeneous income distributions among countries involved in preferential trade

agreements (PTAs) and actual economic growth. Since Kuznets (1955) showed the

relationship between economic growth and income distribution, many studies have

explored the influences of economic growth on income distribution. Several decades later,

Galor and Zeira (1993) looked at the cause and effect relationship from the opposite

perspective with their research into how income distribution influences economic growth.

Also, as Matsuyama (2000) showed, inherently identical countries can be divided into

rich countries and poor countries by forming PTAs, which he called "symmetry-breaking."

Thus PTAs may have some mechanisms that cause inevitable inequalities. In addition, as

Grossman and Helpman (1995) indicated, domestic political environments constrain the

actions that governments can take internationally. Dollar and Kraay (2003) indicated that

not only trade but also domestic institutions have an important role in economic growth.

Helpman (2008) suggested that institutions are more fundamental determinants of

economic prosperity than capital accumulation or R&D investment on the grounds that

they - institutions - frame the environment in which these activities take place and that

institutions are difficult to change. Incorporating those studies to explore how the economic

growth of each country within PTAs is influenced by heterogeneous income distributions

might be crucial to understanding the effects on each country that the recent proliferation

of PTAs may have.

Inequality within a country is correlated to the stage in development of that country,

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which means that income distribution in the country can affect economic growth. The

differences in income per capita around the world are enormous, due in part to

globalization. This situation is sometimes referred to as "a parade of dwarfs and a few

giants." Determining whether income inequality within the country can facilitate or detract

from economic growth reinforced by PTAs is a key issue of future research. In addition, I

propose expanding this research to show how the impact of varying income distributions in

countries involved in PTAs ultimately influences the world economy.

Moreover, different variables should be introduced into the equations to investigate

their influences on economic outcomes. The variables are interest groups, the structure of

industries, political stability. and institutions. These variables were derived from research

by Grossman and Helpman (1995) discussing determinants of the success and failure of

PTAs. By introducing these variables. my project will show why PTAs are characterized

by the diversity of institutions. For instance, the reason why the EU has such a different

institutional structure from that of NAFTA, which in turn differs so much from the

organization for APEC should be studied. My future ambitions are to show whether the

recent proliferation of PTAs serves as "building blocks" or "stumbling blocks" for

multilateral trade liberalization.

The recent proliferation of PTAs involves the whole world, including the United States,

Japan, and many other countries. With PTAs proliferating, one PTA may have a worldwide

crisscrossing of preferences with different rules of origin and different tariff rates on

identical products depending on where a product originates. As a result, the trading system

may become chaotic, much like a "spaghetti bowl" as coined by Bhagwati (1995,2008). My

interest is in the influences that the formation of PTAs among heterogeneous countries has

on economic growth, especially in consideration of income inequality. Of interest is also

exploring how heterogeneous countries affect each other by forming PTAs. For instance. in

the Pacific Rim, there are many countries which differ in income distribution, political

stability, economic fundamentals, and stages of development. Reducing the chaos of the

"spaghetti bowl" through harmonization may help bring about political and economic

stability in the Pacific Rim.

Acknowledgements

I appreciate the comments that Kenneth T. Howells gave and his editing help with my

paper.

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