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Introduction
Income inequality has been a topic of concern for economists and policymakers for many years. The long-run increase in income inequality not only raises social and political concerns but also economic ones. It tends to drag down GDP growth due to the rising distance of the lower 40% from the rest of society.
The relationship between aggregate output and the distribution of income is an important topic in macroeconomics. This essay will examine the impact of income inequality on long-run economic growth, drawing on economic theory and empirical analysis.
Theoretical Framework
In a seminal contribution, Galor and Zeira (1993) proposed a model with credit market imperfections and indivisibilities in investment to show that inequality affects GDP per capita in the short run as well as in the long run. Galor and Zeira’s model predicts that the effect of rising inequality on GDP per capita is negative in relatively rich countries but positive in poor countries.
This is because credit market imperfections prevent low-income households from investing in human capital, which reduces their productivity and income. In rich countries, where human capital is more important for growth, this effect is more pronounced.
For example, consider two countries: one rich and one poor. In rich countries, where human capital is more important for growth, credit market imperfections prevent low-income households from investing in education and training.
This reduces their productivity and income, which drags down GDP per capita growth. In contrast, in a poor country where physical capital is more important for growth, credit market imperfections may have less of an impact on GDP per capita growth.
Empirical Analysis
Empirical analysis shows that for the average country in the sample during 1970-2010, increases in income inequality reduce GDP per capita.
Specifically, a 1 percentage point increase in the Gini coefficient reduces GDP per capita by around 1.1% over five years; the long-run (cumulative) effect is larger and amounts to about -4.5%.
This finding implies that, on average, increases in the level of income inequality lead to lower transitional GDP per capita growth.
For example, consider a country with a Gini coefficient of 40 (which indicates a moderate level of income inequality). If the Gini coefficient increases by 1 percentage point to 41 (indicating an increase in income inequality), then this would reduce GDP per capita by around 1.1% over five years.
Channels through which Inequality Affects Growth
Inequality can hurt economic growth through several channels. First, high levels of inequality can reduce social mobility and create an unequal distribution of opportunities. This can lead to a less efficient allocation of resources and lower levels of human capital accumulation. For example, if children from low-income households have less access to high-quality education than children from high-income households, then this can reduce their future productivity and income.
Second, high levels of inequality can lead to political instability and social unrest, which can reduce investment and economic growth. For example, if high levels of income inequality lead to widespread dissatisfaction with the political system or social unrest (such as protests or riots), then this can reduce investor confidence and discourage investment.
Third, high levels of inequality can reduce aggregate demand by reducing the purchasing power of lower-income households. For example, if high levels of income inequality mean that lower-income households have less disposable income to spend on goods and services than higher-income households, then this can reduce aggregate demand and slow down economic growth.
Policy Implications
Policymakers have several tools at their disposal to address income inequality. Progressive taxation, where higher-income households pay a larger share of their income in taxes than lower-income households, then can help reduce after-tax income inequality. Social transfers, such as unemployment benefits and food assistance programs, can also help reduce income inequality by providing support to lower-income households.
For example, if a country has a well-designed social transfer system that provides support to lower-income households (such as unemployment benefits or food assistance), then this can help reduce income inequality.
In addition to these direct measures, policymakers can also address income inequality through broader economic policies that promote inclusive growth. For example, investments in education and training can help improve access to high-quality jobs for lower-income households. Policies that promote entrepreneurship and small business development can also help create new economic opportunities for lower-income households.
Limitations
It is important to note that there are limitations and areas of uncertainty in the research on this topic. For example, there may be differences between countries in terms of how income inequality affects growth. Additionally, there may be other factors that influence the relationship between income inequality and growth that are not fully understood.
Conclusion
In conclusion, income inequality has a significant impact on long-run economic growth. Economic theory and empirical analysis suggest that increases in income inequality can reduce GDP per capita growth. Policymakers should consider these findings when designing policies to address income inequality.
Acknowledgement
The Institute for Youth in Policy wishes to acknowledge Gwen Singer, Paul Kramer, Carlos Bindert, and other contributors for developing and maintaining the 2023 Winter Fellowship program within the Institute.
Citation
APA: Sajeev, N. (2023, October 12). The Impact of Income Inequality on Long-Run Economic Growth. The Institute For Youth in Policy. Retrieved from https://cite.yipinstitute.org/PCIytWc
MLA: Sajeev, Narayan. “The Impact of Income Inequality on Long-Run Economic Growth.” The Institute For Youth in Policy, 12 Oct. 2023, cite.yipinstitute.org/PCIytWc.
Works Cited
https://www.oecd.org/social/inequality-and-poverty.htm
https://www.weforum.org/agenda/2015/07/how-does-income-inequality-affect-economic-growth/
https://www.pewresearch.org/social-trends/2020/01/09/trends-in-income-and-wealth-inequality/
https://www.census.gov/topics/income-poverty/income-inequality.html
https://www.pewresearch.org/social-trends/2020/01/09/trends-in-income-and-wealth-inequality/
https://www.researchgate.net/publication/343349579_Income_Inequality_and_Economic_Growth
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