Inequality and Economic Growth: A Method-Dependent Relationship Driven by the Measure of Income Inequality?

Abstract

This study re-examines the much studied inequality-growth relationship. An empirical analysis that covers over a hundred countries finds no clear evidence for inequality to boost or dampen the growth of per capita GDP. Furthermore, evidence is found for inequality to promote growth through physical investments and hurt economic development via lower accumulation of human capital. These two mechanisms seem to balance out one another. The conclusions are based on a thorough investigation using the World Income Inequality Database maintained by UNU-WIDER and considering different measures of inequality, various estimation techniques, different specifications of the growth regression, allowing for non-linearities in the relationship and separating the OECD members from the non-OECD countries. The properties of the much-used system GMM estimator are investigated in detail. Even though its use is motivated by disentangling causality from correlation, the technique is found to suffer from weak instrument variables and sensitivity to small changes in the econometric specification. The results from simpler panel techniques follow a predictable pattern, where the use of cross-country (time) variation is associated with negative (positive) estimates. More profoundly, a strong result stemming from a data set that combines information from several countries would be of limited use for policy purposes because the actions to curb or promote income inequality are controlled by national policy-makers.