The traditional viewpoint about the relationship between income distribution and economic growth suggests that income distribution has no significant effect on macroeconomic activities and economic growth. The observed relationship between inequality and economic growth was interpreted as capturing the effect of the growth process on the distribution of income, rather than the effect of the distribution of income on the growth process. This viewpoint, as exemplified by the representative agent approach to macroeconomics, dominated the field of macroeconomics and economic growth until late 1980s.
This traditional viewpoint had been challenged in the 1990s. Theories and subsequently empirical evidence have demonstrated that income distribution has a significant impact on the growth process. The field has attracted dozens of leading researchers in the 1990s. Hundreds theoretical and empirical papers have been written on the subject, and in 1995 the NBER established a research group on the subject that I have co-directed.
This important research field was pioneered by Galor and Zeira (1993). The World Bank states in the description of the literature on inequality and 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." (Link)
Galor and Zeira (1993) argue that income distribution plays an important role in the determination of aggregate economic activity and economic growth. In contrast to the representative agent approach that has dominated the field of macroeconomics for several decades, this study analyzes 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.
Recently, Galor and Moav (2004) developed a unified theory for the dynamic implications of income inequality on the process of development. The proposed theory, developed argues that the replacement of physical capital accumulation by human capital accumulation as a 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 is a prime source of economic growth, inequality enhances the process of development by channeling resources towards individuals whose marginal propensity to save is higher. In later stages of development, however, as the return to human capital increases due to capital-skill complementarity, human capital becomes the prime engine of growth, and equality, in the presence of credit constraints, stimulates investment in human capital and promotes economic growth. As wages increase, however, credit constraints become less binding, differences in the marginal propensity to save decline, and the aggregate effect of income distribution on the growth process becomes, therefore, less significant.
The proposed theory provides an intertemporal reconciliation between the conflicting viewpoints about the effect of inequality on economic growth. It suggests that the classical viewpoint, regarding the positive effect of inequality on the process of development, reflects the state of the world in early stages of industrialization, when physical capital accumulation was the prime engine of economic growth. In contrast, the credit market imperfection approach regarding the positive effect of equality on economic growth reflects later stages of development when human capital accumulation becomes a prime engine of economic growth, and credit constraints are largely binding. The unified setting, therefore, generates the insight that, for the currently developed economies, the domination of the credit market imperfection channel is an inevitable by-product of the domination of the classical mechanism in early stages of development.
The theory generates a testable implication about the effect of inequality on economic growth, which may provide a greatly needed theoretical guidance in order to resolve the empirical controversy about this relationship. In contrast to the credit markets imperfection approach that suggests that the effect of inequality depends on the country's level of income (i.e., inequality is beneficial for poor economies and harmful for rich ones), the current research suggests that the effect of inequality on growth depends on the relative return to physical and human capital. In economies in which the return to physical capital is relatively larger than the return to human capital, inequality is beneficial for economic growth, whereas in economies in which the return to human capital is relatively higher and credit constraints are largely binding, equality is beneficial for economic growth. Hence, although the replacement of physical capital accumulation by human capital accumulation as a prime engine of economic growth in the currently developed economies is instrumental for the understanding of the role of inequality in their process of development, the main insight of the paper is relevant for the currently less developed economies that have evolved differently. In the currently LDCs, the presence of international capital inflow diminishes the role of inequality in stimulating physical capital accumulation. Moreover, the adoption of skilled-biased technologies increases the return to human capital and, thus, given credit constraints, strengthens the positive effect of equality on human capital accumulation and economic growth.