The unequal distribution of income and resources remains a significant challenge in both developed and developing nations. Metrics such as the decile ratio and the Gini coefficient, derived from the Lorenz curve, illustrate the extent of this disparity. High levels of income inequality can exacerbate social discontent and jeopardize social and political stability. Alesina and Perotti assert that elevated income inequality “increases the likelihood of coups, revolutions, mass violence, or more generally, raises policy uncertainty and threatens property rights, thereby negatively impacting investment and ultimately reducing growth.”
Given the current high levels of income inequality and its increasing trend in many countries, as well as the potentially adverse economic consequences, a substantial body of literature has explored the causes and implications of income inequality for economic development. These studies, particularly those examining the inequality-growth nexus, identify several transmission mechanisms linking income inequality to economic growth. These mechanisms include (i) the level of economic development, (ii) the level of technological development, (iii) socio-political instability, (iv) savings rates, (v) imperfections in credit markets, (vi) the political economy, (vii) institutions, and (viii) fertility rates. Based on these models, the relationship between income inequality and growth can be negative, positive, or indeterminate. For example, theories related to economic development suggest that as development progresses, the relationship between inequality and growth shifts from positive to negative. Similarly, technological development theories indicate that this relationship varies with technological advancements. The socio-political instability model reflects indeterminate outcomes, proposing that high income inequality can either hinder or facilitate growth. Theories on credit market imperfections, political economy, institutions, and fertility rates generally indicate a negative correlation between income inequality and growth. Conversely, the savings rate theory is the only one positing a positive relationship between income inequality and growth.
Given this theoretical ambiguity, it is unsurprising that empirical findings on the relationship between income inequality and growth are highly contested. Early empirical studies by Alesina and Rodrik, Persson and Tabellini (1964, cited in Mdingi and Ho, 2021), and Perotti reported that inequality negatively impacts growth. This negative relationship has been confirmed by numerous subsequent studies. However, evidence of a negative relationship has been challenged by studies reporting positive outcomes for the inequality-growth connection. Additionally, several studies have produced indeterminate results, with many indicating a positive relationship in high-income countries and a negative one in low-income countries. Some studies have even found no significant relationship between inequality and growth (Mdingi and Ho, 2021).
Impact of Income Inequality on Economic Growth Through Channels: An Econometric Analysis
Understanding the intricate relationship between income inequality and economic growth is a pivotal area of inquiry in contemporary economic research. As disparities in income distribution continue to widen across both developed and developing countries, it becomes increasingly important to examine how these inequalities influence economic outcomes.
This study seeks to explore the impact of income inequality on economic growth through various channels, utilizing a range of econometric methods, including pooled ordinary least squares (OLS), fixed or random effects models, and two-stage least squares (2SLS). Additionally, the study will employ the dynamic panel data technique, specifically the Two-Step System Generalized Method of Moments (System GMM), to ensure robust and reliable results. By applying these diverse econometric approaches, the research aims to uncover the nuanced mechanisms through which income inequality affects economic growth.
Methodology
The analysis is conducted in two main stages. The first stage tests the impact of income inequality on channel variables, while the second stage examines the effect of these channel variables on economic growth.
First stage: Impact of income inequality on channel variables
In this stage, we test how the Gini coefficient, a proxy for income inequality, influences channel variables using the following model:
Where:
To address potential endogeneity issues, the study employs pooled OLS, fixed or random effects, and 2SLS methods.
Second stage: Impact of channel variables on economic growth
Using the dynamic panel data technique (System GMM), the second stage evaluates how channel variables influenced by income inequality affect economic growth:
Where:
Control variables
The study includes several control variables commonly used in economic growth literature:
- Human capital: Human capital encompasses the skills, knowledge, and experience of individuals that enhance their productivity and economic value. It is often measured by school enrollment rates, which reflect the proportion of people engaged in formal education and training.
- Investment rate: The investment rate represents the share of a country’s economic output allocated to acquiring capital goods, such as machinery and infrastructure. This metric indicates how much of the economy’s resources are dedicated to expanding future productive capacity.
- Trade openness: Trade openness measures the extent to which a country participates in global trade relative to its economic size. It is assessed by the ratio of a country’s total exports and imports to its gross domestic product (GDP), reflecting its integration into the global market.
- Inflation: Inflation is the rate at which the general price level of goods and services rises over time. It is typically measured by indices such as the Consumer Price Index (CPI), which tracks changes in the cost of a fixed basket of goods and services.
Data
The study analyzes data from 143 countries over the period covering 1980 up to 2017. The Gini coefficient is sourced from the Standardized World Income Inequality Database (SWIID) by Frederick Solt, while other data are obtained from the World Bank Database.
Country grouping
To test for differential impacts based on income levels, countries are categorized into two groups based on the World Bank income classification: low and lower-middle-income countries (LLMC) and upper-middle-income and high-income countries (UHC).
Descriptive statistics
The descriptive statistics for the variables used in the analysis, including mean, standard deviation, minimum, and maximum values, are presented in Table 2.
Conclusion
By employing advanced econometric techniques and a comprehensive dataset, this study aims to provide a nuanced understanding of how income inequality affects economic growth through various channels. The differentiation of countries by income levels allows for a more detailed examination of the mechanisms at play in different economic contexts.
This subtopic delves into the intricate mechanisms through which income inequality influences economic growth, employing robust econometric techniques and detailed data analysis to ensure comprehensive and reliable results. (Topuz, 2022)
Causes and solutions to income inequality
Worsening inequality within countries
While global inequality between countries is decreasing, the gap within countries is widening. According to the World Inequality Database’s 2022 report, the average income gap between the bottom 50% and the top 10% has nearly doubled over the past 20 years. The report explains, “Global inequality today appears to be about as great as it was at the peak of Western imperialism in the early 20th century.”
The setback caused by COVID-19
Organizations like the IMF report that COVID-19 has exacerbated inequality within countries, with poorer individuals suffering more significant impacts than wealthier ones. It has also increased inequality between countries, as richer nations had more resources to address the pandemic and recover more quickly. According to the World Bank, progress in reducing inequality has been set back by about a decade.
Impact on the most disadvantaged
Income inequality disproportionately affects marginalized groups such as women, youth, informal sector workers, the elderly, and people with disabilities. In the UK, rising income inequality has led to a 3.8% reduction in disposable income for the poorest fifth of the population. Additionally, the average income for retired households has decreased from £26,300 to £25,900.
Wealth concentration Among the Top 1%
Over the past decade, the world’s wealthiest 1% have captured 54% of new wealth, becoming increasingly affluent. An Oxfam report indicates that the top 1% gained $42 trillion of the new wealth generated between December 2019 and December 2021, while the bottom 99% received $16 trillion. Although the pandemic hit the poor hardest, the richest individuals increased their wealth. Despite a slight dip in 2022, their wealth has been rising again in 2023.
Income inequality and climate change
Humans emit an average of 6.6 tons of CO2 per person annually, but the top 10% of emitters account for about 50% of total emissions, while the bottom 50% produce only 12%. This disparity is crucial because the wealthiest are the largest contributors to emissions. Poorer countries, which emit relatively little CO2, suffer the worst effects of climate change. Even within wealthy countries, the poorest half of the population has often already met or is close to meeting their nation’s 2030 climate targets. Thus, it is the wealthy who need to make significant changes.
Addressing income inequality
Tackling this complex challenge of inequality requires a multifaceted approach involving policy reforms, social programs, and international cooperation. According to Soken-Huberty (2023), key strategies include ensuring living wages, investing in quality public education, and implementing redistributive tax systems. Each of these measures addresses different aspects of the income gap, from providing a decent standard of living to fostering equal opportunities and redistributing wealth. By adopting comprehensive solutions, societies can work towards a more equitable and just economic landscape, thereby promoting long-term growth and social harmony.
1. Pay living wages.
While many countries have raised wages, these increases are often insufficient to bridge the income gap. According to a World Economic Forum article, the Universal Rights Group’s global director of human rights stresses the importance of living wages, which are calculated based on what is needed for a decent standard of living. Currently, minimum wages in many countries fall short of this standard; for instance, in the US, the minimum wage is not enough to cover the rent for a one-bedroom apartment. Ensuring that workers receive a living wage not only improves their quality of life but also stimulates economic activity by increasing their purchasing power.
2. Invest in quality public education.
Research indicates that quality public education has numerous positive effects. According to an Oxfam report, good education can reduce poverty, increase opportunities, and promote a more democratic society. Education also plays a crucial role in closing the gender gap, which is essential for addressing income inequality. To effectively tackle this issue, education must be universal, free, and publicly funded. Without these measures, education can exacerbate inequality by segregating students based on race, gender, wealth, and other characteristics. Providing accessible and high-quality education empowers individuals and creates a more skilled and adaptable workforce, benefiting society as a whole.
3. Implement redistributive tax systems.
These systems involve higher taxes for the wealthy and greater subsidies for the poor. In countries like the US, where tax laws favor corporations and the richest individuals, inequality has worsened. For example, the IRS, which has been notoriously underfunded, failed to pursue over 300,000 high-income non-filers between 2014 and 2016. To combat inequality, tax systems should be designed to reduce disparities rather than exacerbate them, including increased spending on social sectors such as education, health, and social protection. Effective tax policies ensure that wealth is more evenly distributed and that all members of society have access to essential services.
By adopting comprehensive solutions such as paying living wages, investing in quality public education, and implementing redistributive tax systems, societies can address the root causes of income inequality. These strategies not only address the symptoms but also tackle the underlying issues, paving the way for sustainable development. Promoting long-term growth and social harmony requires concerted efforts from national governments and the international community, highlighting the importance of collective action in overcoming this pervasive issue.
Conclusion
Income inequality is a significant and enduring global challenge that exists both within and between countries. Although there has been some progress in narrowing disparities between nations, the internal gaps within countries continue to grow, worsened by recent crises like the COVID-19 pandemic. This increasing inequality severely impacts marginalized groups and undermines economic growth and social stability. Effective solutions must address these disparities to foster a more inclusive society.
The causes of income inequality are complex, involving economic, social, and political factors. Unequal access to education and healthcare, regressive tax policies, and wealth concentration among the richest individuals are key contributors. Additionally, income inequality is interconnected with other critical issues, like climate change, highlighting its multifaceted nature. Understanding these root causes is essential for developing effective strategies to reduce inequality.
Addressing income inequality requires comprehensive and sustained efforts. Essential steps include paying living wages, investing in quality public education, and implementing redistributive tax systems. Living wages ensure everyone can afford a decent standard of living; quality education provides necessary skills and opportunities for economic mobility; and redistributive tax systems balance economic scales by ensuring the wealthy contribute fairly to society. These measures are foundational for creating a more equitable economic landscape.
Reducing income inequality can lead to broader social and economic benefits, such as improved health outcomes, greater political stability, and more sustainable economic growth. However, achieving these benefits requires concerted efforts from governments, international organizations, and civil society to implement and support policies promoting equity and inclusivity. Collaboration across all levels is crucial for meaningful progress.
While the challenges posed by income inequality are substantial, they are not insurmountable. By adopting a holistic approach that addresses the root causes and promotes a fair distribution of resources, we can move towards a more equitable and just world. This will not only benefit those currently disadvantaged but also enhance the overall health and prosperity of society. The pursuit of equity is essential for a thriving, stable, and just global community.
References
Mdingi, K. and Ho, S.-Y. 2020. Literature review on income inequality and economic growth. MethodsX, [online] 8(1), p.101402. doi:https://doi.org/10.1016/j.mex.2021.101402 [Accessed 3 August. 2024].
Soken-Huberty, E. 2023. Income Inequality 101: Causes, Facts, Examples, Ways to Take Action. [online] Human Rights Careers. Available at: https://www.humanrightscareers.com/issues/income-inequality-causes-facts-examples/ [Accessed 3 August. 2024].
Topuz, S.G. 2022. The Relationship Between Income Inequality and Economic Growth: Are Transmission Channels Effective? Social Indicators Research, 162. doi:https://doi.org/10.1007/s11205-022-02882-0 [Accessed 3 August. 2024].
