By Sahaj Sohi

Abstract:

Nobel Prize-winning economist Robert Shiller once said, “It’s unfortunate that our efforts at policy can’t help everybody.” This reality has become evident over the years, with policymakers striving for inclusive policies, yet facing challenges in achieving this objective. The relationship between income inequality and economic growth has been a focal point for researchers. Shin defines income inequality as the disparities in income distribution, signifying the gap between the affluent and the less affluent in a country. No straightforward relationship has been conclusively established between these two economic indicators. Researchers have explored various transmission channels, which reveal different types of relationships—negative, positive, inconclusive, or even inverted U-shaped. Such diverse findings pose a challenge for policymakers. This paper thoroughly investigates the nuanced relationship between income inequality and economic growth, examining it through various transmission mechanisms. The primary objective of this paper is to offer insightful recommendations to policymakers on how to address the ambiguous relationship between these two indicators. It aims to guide the implementation of policies that are tailored to the specific nature of the existing relationship, ultimately providing a more effective and targeted approach to economic and social policy challenges.

Current Scenario:

Reducing income inequality meanwhile promoting economic growth will forever be the combined efforts of all policymakers from a macroeconomic standpoint. In instances where policymakers fall short of achieving this sustainable goal, a strategy reconsideration on their end then becomes imperative. (World Bank 2023) Since 1990, several countries have witnessed a decline in income inequality, while others have observed an increase. However, the Gini index has consistently decreased from approximately 70 in 1990 to 62 in 2019, indicating significant progress in the global fight against income inequality which can be attributed to how the less affluent nations have exhibited a much faster growth compared to wealthier counterparts, leading to the overall decline in the global Gini index. However, the unforeseen arrival of the pandemic broke the decreasing trend of income inequality that the World Bank had projected would continue, and then came the most substantial surge in income inequality that the world has ever seen since 1990. In light of the ongoing policy debates emphasizing the importance of fostering economic growth and ensuring equitable income distribution, there is a critical need to thoroughly examine and comprehend the theoretical relationships between income inequality and economic growth.

Literature Review:

There exists extensive literature on the relationship between income inequality and economic growth considering it is one of the primary goals of every nation’s policymakers to achieve the dual objective of fostering growth and impeding inequality. Scholars and researchers have produced a wealth of findings, reporting positive, negative, and inconclusive results regarding the interplay between these two critical indicators. In their paper, Shen, C., & Zhao, X. propose breaking down the study of this relationship into three distinct stages.

In the first stage, the initial noteworthy contribution can be traced back to Kuznets whose work was considered pivotal to this field. Kuznets asserted that the relationship between income inequality and economic growth takes the shape of an inverted U. In essence, Kuznets contended that inequality tends to increase during the early stages of economic development and decrease in later stages.

Moving on to the next stage of influential contribution to the field, Alesina, Rodrik, and Perotti contributed significantly to understanding the relationship between income inequality and economic growth. Alesina and Rodrik conducted comprehensive research on the connection between economic growth and distributive politics across 46 nations over a specific timeframe. Meanwhile, Perotti  analyzed the relationship between income distribution, democratic institutions, and growth in 67 countries. Their collective findings indicated a negative relationship between economic growth and inequality. There also are renowned studies that establish a positive relationship between income inequality and economic growth. One such study was conducted by Partridge. Partridge investigated the relation of these indicators in the United States and reported that an uneven distribution of income and resources among the population could stimulate economic activity, subsequently fostering overall economic growth.

Towards the end of the last stage, another meaningful contribution came from Barro. His research revealed that the connection between income inequality and economic growth was contingent on the developmental stage of a country. His findings suggested that income inequality positively affects economic growth in affluent nations while projecting a negative effect in poor countries. In other words, a high income inequality will lead to higher economic growth in a developed nation like the United States, and a high income inequality level will lead to a low economic growth rate in a developing nation like India reflecting a negative relationship. Mdingi & Ho argue that these discoveries suggest that a clear-cut correlation cannot be established between the two indicators, and there exist underlying channels, such as the level of development in a country as suggested by Barro (2000), that connect these indicators. A theoretical examination of the connection between inequality and economic growth has pinpointed several transmission mechanisms through which income inequality is intertwined with the growth process. We consider five transmission channels to capture the relationship between income inequality and economic growth, namely: growth level of a nation, capital markets, investments and savings, socio-political upheaval, and fertility rate. The next section of the paper thoroughly examines these aforementioned transmission channels and analyzes the process through which inequality affects growth from these perspectives. 

Growth level of a nation:

The growth level of a nation or in other words the level of economic development serves as an essential transmission channel, determining the nature of the relationship between income inequality and economic growth. In less economically developed countries, a negative correlation typically exists between income inequality and economic growth. Such countries, still in the early stages of development, experience lower economic growth when confronted with higher income inequality. To illustrate, during the initial phases of development, if the workforce shifts from the manufacturing sector to the service sector, their incomes may rise due to increased demand for their skill set in the service sector, resulting in a hike in the income disparity. However, as this shift continues to go on, a labor shortage in the manufacturing sector may lead to higher incomes for the remaining workers employed in this sector, ultimately reducing income inequality. This essentially demonstrates the inverted U relationship between the variables reflected in Kuznets’s research.

Credit Market:

One major constraint within credit markets is the presence of asymmetric information, which, in the context of this paper, highlights a negative correlation between income inequality and economic growth. Asymmetric information essentially means a situation where the lender and the borrower have very limited information about each other. To elaborate, when income inequality is high, the poor encounter difficulties in accessing credit due to the limited availability of information about the lenders and borrowers in the market. This scarcity of information hampers their ability to make well-informed borrowing decisions. Thus the unequal access to credit for the economically disadvantaged, stemming from imperfections in the credit market, manifests a negative correlation between income inequality and economic growth.

Investments and savings:

Investment choices are predominantly influenced by an individual’s financial capacity, essentially their income and assets. In scenarios with high-income inequality, the economically disadvantaged segment tends to allocate their income towards necessities, making it a challenge for them to participate in high-return investment opportunities, whether in human capital or property. Consequently, high income inequality acts as an obstacle to investment opportunities, thereby impeding overall economic growth.

Savings in contrast is a function of a person’s disposable income.  As an individual’s disposable income rises, their savings rate tends to increase as well. In instances of high-income inequality, the more affluent segment of the economy is more likely to have the ability to save more than the less affluent segment, given their higher marginal propensity to save. With increased savings on the wealthier segments’ behalf, there is a corresponding rise in investments and capital accumulation, ultimately leading to a hike in economic growth.

Therefore, while the lack of available investment opportunities highlights a negative correlation between income inequality and economic growth, the savings rate introduces a positive relationship between income inequality and economic growth.

Socio-Political Upheaval:

Elevated levels of income inequality often result in an exacerbated segment within the economy. The political stability of a nation becomes jeopardized with the rise in income disparity. The aggravated population is very likely to revolt, which then leads to an increase in civic disturbances, criminal activities, and unproductive behaviors such as theft and robbery. The occupancy rate of prisons at the end of each fiscal year has been rising from 118% in 2020 to 131.4% in 2022. None of these outcomes contribute positively to economic growth. The government’s resources are diverted as well as wasted towards addressing these issues instead of being utilized for more beneficial purposes, such as constructing schools and hospitals in rural areas. Hence, when viewed through a socio-political lens, a negative correlation is pretty evident between the two variables: income inequality and economic growth.

Fertility rate:

In situations of high-income inequality,  the economically weaker section, facing financial constraints, tends to have more children to facilitate more contributors of household income sources. Essentially, the poor section of the economy opts for larger families as a strategy to secure greater financial stability in the future. In contrast, the rich counterpart segment of the economy, with ample resources, opts for fewer children and directs substantial investments toward their education, contributing significantly to human capital development. Hence, in situations of high-income inequality, the significant fertility rate differential adversely affects human capital, resulting in a reduction in economic growth.

Policy recommendations:

As previously discussed in this paper, policymakers globally are working towards the dual objective of fostering economic growth while simultaneously reducing income inequality. However, there does not exist a straightforward correlation between income inequality and economic growth as per the analysis we did in this paper. Intuitively one might think that there is a negative relation between the said variables, meaning as income inequality rises, economic growth goes down but our examination has revealed the true complexity of their interplay. The relationship between these variables highly depends on the lens from which we examine their connection. As a result, there is no one universally applicable approach for policymakers to adopt to achieve their dual objective. Instead, effective policies need to be adjusted and altered in consideration of the diverse transmission channels that influence the relationship between these two variables.

In the context of the growth level of a nation, Shen and Zhao (2022) argue that in low-income countries, such as developing nations, the government should enhance the share of labor compensation. This involves reinforcing legislation related to wage protection and instituting a minimum wage system. The aim is to minimize wage disparity, thereby narrowing the gap between the affluent and the economically weaker. Additionally, the government should implement a comprehensive set of tax policies, particularly in the realm of income tax, ensuring that the wealthier segment of the economy fulfills its tax obligations.

In addressing the challenges of unavailability of investment opportunities and asymmetric information within credit markets, where borrowers and lenders lack sufficient knowledge about each other, implementing policies to enhance credit and investment accessibility for the economically disadvantaged becomes imperative. Policies for strengthening the credit reporting systems is a crucial step, this will significantly increase the availability of accurate information both about the lenders and borrowers. Furthermore, the establishment of a regulatory body to oversee the exchange of vital information from the lender’s side to the borrowers, including terms and conditions of loans and associated risks of loans will facilitate in minimizing instances of credit exploitation. Policymakers can further work towards enforcing financial education programs, particularly in rural areas. It will work well towards empowering individuals with the knowledge needed to navigate credit opportunities effectively. By enhancing financial literacy, we enable the economically weaker sections to make much more well-informed and sound decisions about not only their respective credit ventures but also their investment prospects. Policies like these will contribute to a gradual reduction in income disparity. Ultimately, these measures aim to create a more equitable credit environment that supports inclusive economic growth.

In addition to the above-discussed wage legislations, progressive tax policies, and improved access to credit, a diverse array of policies can be employed to address socio-political unrest and increased fertility rates in rural areas, these challenges that more often than not stem from income disparities within a population. Expanding the reach of social safety net programs is crucial. These initiatives mainly revolve around creating provisions like food security, financial aid, and unemployment benefits that aim to support the economically vulnerable. The primary goal here is to prevent their involvement in unproductive activities that could disrupt the overall economic stability. Additionally, implementing policies for effective family planning and healthcare, particularly in rural areas, is essential. Measures like these are mainly designed to address the rising fertility rates in rural communities. This will enable the said community to have a much more thoughtful approach to managing family size and, consequently, the number of income earners within a household.

Conclusion:

It is still a long road to achieving a world free from income inequality and sustainable economic growth. To empower our policymakers and government authorities in formulating laws and regulations catering to the goal of universal economic prosperity, a comprehensive understanding of the theoretical relationship between the two variables is indispensable. Scholars and researchers mastering this field of study have made contributions that presented inconclusive evidence regarding the relationship between a country’s income inequality and its economic growth. Which consequently makes the identification of transmission channels crucial.

By the lens of these transmission channels, policymakers gain a nuanced perspective, enabling the formulation of well-informed policies for the holistic development of society. The existence of these channels demonstrates the complexity of the relationship between income inequality and economic growth. Policymakers thus have to leverage the identified transmission channel and adjust their policies to ultimately eliminate income inequality and foster economic development.

In light of the insights from these channels, this paper provides a set of policy recommendations tailored to each aspect of the intricate relationship between income inequality and economic growth. By adopting a nuanced and targeted approach, policymakers can navigate the challenges posed by income inequality, striving towards a more equitable and prosperous global status.

 About the Author:

Sahaj Sohi, currently in her second year of pursuing a B.A. in Economics (Hons.) at the Jindal School of Government and Public Policy, possesses a profound enthusiasm for the domains of economics, finance, and data sciences. Her specific areas of research interest include Financial Economics, Applied Econometrics, and Data Analysis.