Inequality Overhang

IMF Working Papers, March 28, 2017

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The relationship between income inequality and economic development is nonlinear rather than strictly linear.
Using an empirical approach robust to endogeneity, the authors identify an "inequality overhang" where the slope of the relationship between income inequality and economic development switches from positive to negative at a net Gini of about 27 percent.
In contexts with widespread financial inclusion and high income concentration, rising income inequality has a larger negative impact on economic development because banks may curtail credit to customers at the lower end of the income distribution.
Higher female labor participation can act as a shock absorber that reduces the negative impact of rising income inequality, possibly through a more efficient allocation of resources.

Nonlinearities are pervasive in the relationship between income inequality and economic development.
There exists an inequality overhang threshold: net Gini of about 27 percent.
When net Gini is below the overhang level, the slope of the relationship between income inequality and economic development can be positive.
When net Gini exceeds the overhang level, the slope becomes negative.
Financial inclusion combined with high income concentration amplifies the negative effects of rising income inequality via credit curtailment to lower-income customers.
Sufficiently high female labor participation mitigates the negative impact of rising income inequality.

Credit channel: Banks may curtail credit to customers at the lower end of the income distribution in environments with high income concentration despite widespread financial inclusion, worsening the negative effect of inequality on development.
Labor participation channel: Higher female labor participation can improve resource allocation and act as a buffer against the adverse development effects of rising inequality.

Monitor and address nonlinear effects of inequality on development rather than assuming a linear relationship.
Target policies to avoid exceeding the identified inequality overhang (net Gini of about 27 percent), recognizing that crossing this threshold shifts the inequality-development relationship from positive to negative.
Strengthen financial sector policies to prevent credit exclusion of lower-income households, especially in economies with high income concentration.
Promote policies that increase female labor participation as a means to absorb shocks from rising inequality and support more efficient resource allocation.

Source: "Inequality Overhang" by Francesco Grigoli and Adrian Robles, IMF Working Paper, March 28, 2017.

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