Inequality and Growth

Summary of working paper 7038
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High levels of inequality reduce growth in relatively poor countries but encourage growth in richer countries.

High levels of inequality reduce growth in relatively poor countries but encourage growth in richer countries, according to a recent paper by NBER Research Associate Robert Barro. In Inequality, Growth and Investment (NBER Working Paper No.7038), Barro studies a broad panel of countries between 1960 and1995 and finds that growth tends to fall with greater inequality when income per capita is less than $2,000 (in 1985 dollars) and to rise with inequality when income per capita is more than $2,000.

He therefore concludes that income-equalizing policies might be justified on the grounds of promoting growth in poor countries. For richer countries, however, active income redistribution appears to involve a trade-off between the benefits of greater inequality and a reduction in overall economic growth. Barro further shows that the overall relationship between income inequality and growth and investment is weak.

Barro also investigates the effect of economic development on inequality. The traditional relationship here is the "Kuznets curve," named after the Nobel laureate and former NBER affiliate Simon Kuznets. The curve describes a U-shaped relationship between inequality and growth: inequality first increases and later decreases in the process of economic development. Kuznets explained this in terms of a shift from the rural/agricultural sector of the economy to an urban/industrial sector.

This type of relationship also emerges in Barro's analysis. However, the curve likely reflects not only the influence of the level of income per capita, but also an effect of the adoption of new technologies. The poor sector tends to use old technologies, whereas the rich sector uses more advanced techniques. Technological innovations (including the factory system, electric power, computers, and the internet) tend to raise the level of inequality at first when just a few people initially share in the relatively high incomes of the advanced sector. Eventually, however, as more people take advantage of the new technology, inequality falls.

Overall, for poor countries, the escape from poverty is made more difficult because rising per capita income induces more inequality, which retards growth in this range. For rich countries, rising per capita income tends to reduce inequality, which lowers growth in this range.

-- Andrew Balls