Overview:
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.