A New Twist in the Link Between Inequality and Economic Development

IMF Blog, May 11, 2017

Source details

Canonical URL: A New Twist in the Link Between Inequality and Economic Development

Sample: 77 countries at different stages of development and representing all geographical regions, with at least 20 years of data.
Focus: income inequality only (owing to data limitations, wealth inequality is not analyzed).
Approach: techniques that address some shortcomings in the literature and allow heterogeneity in the inequality–growth relationship across countries.

The effect of income inequality on economic growth can be either positive or negative; it is not uniform across countries.
There is a hump-shaped relationship between inequality and economic development, termed an “inequality overhang.”
Turning point: the direction of the relationship changes at a Gini of about 27 percent (net Gini, measured after taxes and transfers).
- For net Gini values below 27 percent, the impact of income inequality on economic development is positive.
- For net Gini values above 27 percent, the impact becomes negative, and as countries become more unequal the negative impact on economic development becomes larger.
Country heterogeneity:
- Median impact of inequality growth on per capita GDP growth is negative and significant, lasting about 2 years.
- Some countries show large negative effects (examples: Ecuador, Jordan, Nigeria, and Panama).
- Some countries show positive effects (example at the 25th percentile: Finland).
Implication: average effects commonly estimated in the literature can be misleading because of large dispersion across countries.

Positive channel at low inequality: increased inequality can endow the rich with means to start businesses and create incentives to increase productivity and investment.
Negative channels at high inequality:
- Reduced aggregate demand by the general population and lower investment in education and health, impairing long-term growth.
- Increased rent-seeking behavior with the top appropriating a larger share of national income.
- Greater risk of reduced social consensus and social unrest, hindering the implementation of pro-growth reforms.

Financial inclusion and female labor participation are examined as tools to mitigate harmful effects of rising inequality.
Financial access:
- Generally desirable, but can exacerbate the negative impact of income inequality on economic development.
- Mechanism: banks may curtail credit to customers at the lower end of the income distribution because of inability to repay, potentially deepening adverse effects.
- Policy implication: consider mechanisms to ensure those who lose access to credit when income becomes more concentrated can continue consuming even when their income falls.
Female labor participation:
- Considered a win-win: enlarges the pool of talent available to work and reduces (or even reverses) the negative impact of inequality on growth.
Caution: policies that expand access to credit or labor supply could also have adverse effects (e.g., over-leveraging poorer households or generating an oversupply of labor) and should be designed to manage these trade-offs.

Source: A New Twist in the Link Between Inequality and Economic Development (May 11, 2017), Francesco Grigoli