Inequality & Growth

Conventional wisdom about the relationship between income distribution and economic development has been subjected to dramatic transformations in the past century. While Classical economists advanced the hypothesis that inequality is beneficial for economic development, the Neoclassical paradigm, which had subsequently dominated the field of macroeconomics, dismissed the Classical hypothesis and promoted the viewpoint that the study of income distribution has no importance for the understanding of macroeconomic activity and the growth process. A metamorphosis in these perspectives has taken place in the past two decades. Theory and subsequent empirical evidence have demonstrated that income distribution has a significant impact on the growth process.

This modern approach was pioneered by Galor and Zeira (RES, 1993).  This research (recently selected among the 11 most path breaking papers in the Review of Economic Studies 80 years history) has marked the onset of the modern approach for the study of the effect of inequality and economic growth. "In the 1990s, the classical view that distribution (one aspect of which is measured by inequality indices) is not only a final outcome, but in fact plays a central role in determining other aspects of economic performance, has come back into fashion. While many economists often start working on a topic at the same time, much of the credit for pioneering this line of enquiry must go to Oded Galor and Joseph Zeira."  The World Bank

In contrast to the representative agent approach that has dominated the field of macroeconomics for several decades, Galor and Zeira analyze the role of heterogeneity in the determination of macroeconomic behavior. The research demonstrated that in the presence of capital markets imperfections and local non-convexities in the production of human capital, income distribution affects aggregate output in the long run, as well as in the short-run. The research developed the hypothesis that equality in sufficiently wealthy economies stimulates investment in human capital and in individual specific projects, and enhances economic growth – whereas inequality promotes growth in sufficiently poor economies, a prediction that was confirmed by initial empirical studies.

The modern approach has demonstrated that in the presence of credit market imperfections, income distribution has a long-lasting effect on investment in human capital, entrepreneurial activity, aggregate income, and economic development. Moreover, in contrast to the Classical viewpoint, which underscored beneficial effects of inequality for the growth process, the modern perspective advanced the hypothesis that inequality may be detrimental for human capital formation and economic development.

The replacement of physical capital accumulation by human capital accumulation as the prime engine of economic growth has changed the qualitative impact of inequality on the process of development. In early stages of industrialization, as physical capital accumulation was a prime source of economic growth, inequality enhanced the process of development by channeling resources toward individuals whose marginal propensity to save is higher. However, in later stages of development, as human capital has become the main engine of economic growth, a more equal distribution of income, in the presence of credit constraints, has stimulated investment in human capital and economic growth (Galor and Moav, RES, 2004)

While the process of industrialization raised the importance of human capital in the production process, reflecting its complementarity with physical capital and technology, human capital accumulation has not benefited all sectors of the economy. Inequality in the ownership of factors of production has generated an incentive for some better-endowed agents to block the implementation of institutional changes and policies that promote human capital formation, resulting in a suboptimal level of investment in human capital from a growth perspective. The transition from an agricultural to an industrial economy changed the nature of the main economic conflict in society. Unlike the agrarian economy, which was characterized by a conflict of interests between the landed aristocracy and the masses, the process of industrialization has brought about an additional conflict between the entrenched landed elite and the emerging capitalist elite. In light of a lower degree of complementarity between human capital and the agricultural sector, education has increased the productivity of labor in industrial production more than in agricultural and primary good production, inducing rural-to-urban migration and a decline in the return to landowners. Thus, while industrialists have had a direct economic incentive to support education policies that would foster human capital formation, landowners, whose interests lay in the reduction of the mobility of their labor force, have favored policies that deprived the masses of education (Galor and Moav, RES 2006; Galor, Moav and Vollrath, RES 2009).

The adverse effect of the implementation of public education on landowners’ income from agricultural production has been magnified by the concentration of land ownership. As long as landowners affected the political process and thereby the implementation of growth-enhancing education policies, inequality in the distribution of land ownership has been a hurdle for human capital accumulation, slowing the process of industrialization, and the transition to modern growth. Variation in the distribution of ownership over land and other natural resources across countries has contributed to disparity in human capital formation and the industrial composition of the economy, and thus to divergent development patterns across the globe (Galor, Moav and Vollrath, RES 2009). Moreover, in some societies, geographical conditions that led to income inequality brought about oppressive institutions designed to maintain the political power of the elite and to preserve the existing inequality.