How are economic inequality and growth connected?
In the mid-20th century, economists began witnessing inequality’s decline in the developed world. Prior to the two World Wars and Great Depression, rising inequality was characteristic of most of the developed world, but in the aftermath of the upheavals, the trend reversed. At the time, many reasoned that declining inequality was a natural outgrowth of the development process: As countries become more economically mature, inequality would fall. This trend led Nobel Laureate economist Simon Kuznets to write:
“One might thus assume a long swing in the inequality characterizing the secular income structure: widening in the early phases of economic growth when the transition from the pre-industrial to the industrial civilization was most rapid; becoming stabilized for a while; and then narrowing in the later phases.”
Given the narrowing of inequality in the more economically developed nations, Kuznets’ analysis suggested that the inequality in poorer countries was a transitional phase that would reverse itself once these nations became more economically developed. Thus, similar to how the level of inequality was decreasing in wealthy nations, inequality would eventually decline in poorer countries as they became richer. In fact, some economists theorized that inequality in the less developed world was actually good for growth because it meant that the economy was generating select individuals wealthy enough to provide the savings necessary for investment-led growth.
Today, the world looks very different than it did in 1955 when Kuznets made his famous assertion. In the past several decades, economic inequality in the United States and other wealthy nations has risen sharply, spurring renewed interest in the question of whether and how changes in income distributions affect economic wellbeing. Over the same time period, economic inequality has persisted and even grown in many poorer economies.
These trends have sparked economists to conduct empirical studies, analyzing data across states and countries, to see if there is a direct relationship between economic inequality, and economic growth and stability. Early empirical work on this question generally found inequality is harmful for economic growth. Improved data and techniques added to this body of research, but the newer literature was generally inconclusive, with some finding a negative relationship between economic growth and inequality while others finding the opposite.
The latest research, however, provides nuance that can explain many of the conflicting trends within the earlier body of research. There is growing evidence that inequality is bad for growth in the long run. Specifically, a number of studies show that higher inequality is associated with slower income gains among those not at the top of the income and wealth spectrum.
Economists and policymakers today should not be surprised that empirical studies were inconclusive given the broad theoretical (and sometimes contradictory) reasons that hypothesized inequality would both promote growth and inhibit growth. On the one hand, hundreds of years of economic theory has been built on the hypothesis that inequality in outcomes creates incentives for individuals to work hard or be more productive than others in order to receive greater incomes—activity that spurs growth. In addition, many theorized that inequality would help individuals become rich enough to save some of their earnings and fund investments necessary to produce economic growth.
On the other hand, economic theory also suggests the opposite—that inequality may inhibit the ability of some talented but less fortunate individuals to access opportunities or credit, dampen demand, create instabilities, and undermine incentives to work hard, all of which may reduce economic growth. Growing inequality could also generate a relatively larger group of low-income individuals who are less able to invest in their health, education, and training, thereby retarding economic growth.
In this paper, we review the recent empirical economic literature that specifically examines the effect inequality has on economic growth, wellbeing, or stability. This newly available research looks across developing and advanced countries and within the United States. Most research shows that, in the long term, inequality is negatively related to economic growth and that countries with less disparity and a larger middle class boast stronger and more stable growth. Some studies do suggest that in the short run, inequality may spur growth before hindering it over the longer term, but overall there is growing evidence that, in the long run, more equitable societies are associated with higher rates of growth.
In looking at studies that directly estimate the effect of inequality on growth, there are concerns about data quality and statistical methodology. The purpose of these studies is to establish whether economic inequality has some effect on economic growth or stability. For researchers, there are important two questions: is there a causal relationship between inequality and growth? If so, can researchers actually identify this factor, or are they actually measuring the effect of some other factor. Establishing causality is exceptionally difficult in the social sciences and the standard approach employed for studying relationships between inequality and growth has been to look at the level of inequality preceding the growth period being measured. This does not firmly establish causality but can be indicative of it. On the other hand, the approaches for detecting the relationship vary widely by the statistical design, the data, controls included. Given enough time and flexibility in their specifications, economists have demonstrated an ability to draw a variety of conclusions. The best practices in this area are evolving and so it is important to look at the breadth of the literature, rather than focus on a single paper or approach.
Important as well for the purposes of this paper is this—the latest economic research we reviewed only examines the outcome of whether there are results for regressions that demonstrate positive or negative relationships between inequality and economic growth and stability. This means the paper cannot provide clear guidance for policymakers on exactly how to address inequality or mitigate its effects on growth. In other words, the research examined in this paper generally does not identify the channels or mechanisms by which inequality affects growth.
An additional issue (above and beyond the challenges of how to specify a model) is the paucity of data to evaluate questions about inequality and growth. Ideally, economists would want a variety of measures for inequality, including earnings, income, and wealth, that can be compared across a large number of countries over a long period of time. Sadly, such a perfect data set does not exist. Therefore, econ- omists are left to do the best estimates with the data at hand. Over time, though, the data sets that have been used to perform these analyses have been improving.
Other scholars who have examined this literature have also come to the conclu- sion that to inform policymaking, we need to do more than search for a mechanis- tic relationship between inequality and growth. Dani Rodrik, the former Harvard University professor now at the Institute of Advanced Studies, underscores the limitations of this kind of research, arguing that methods for analyzing data that span across places and time are ill-suited to address the fundamental questions about the relationship of government policy and inequality with growth outcomes. This conclusion is echoed by University of Melbourne economist Sarah Voitchovsky in her recent review of the literature in the “Oxford Handbook on Economic Inequality,” where she says:
“While data constraints continue to limit the type of empirical analyses that can be undertaken, investigations that focus on specific channels generally provide more robust conclusions than evidence from reduced form analyses.”
This paper does not contain policy advice. Instead, it contains analysis that largely demonstrates there are direct, and possibly causal, relationships between economic inequality and growth—places that begin with a lower level of inequality subsequently tend to grow faster and have longer periods of growth than those with a higher level of inequality. In future research, we will focus on the channels through which inequality could or does affect economic growth.