The Institutional Foundations of Inequality and Growth

One unresolved question in the empirical growth literature is the impact of income inequality on future economic growth. While a first wave of cross-country regressions concluded that there was a significant and negative impact on future growth, a second wave of regressions using panel data to control for potential omitted variable bias has consistently found the coefficient on inequality to be positive. A third wave of the literature has made methodological contributions, but has done little to offer a clear story regarding the economic relationships between these variables that might explain the evidence. This paper offers one such story, starting from two fairly uncontested claims: 1) growth and inequality statistics each summarize some aspect of the same underlying distribution dynamics, and thus will be determined jointly by those dynamics; and 2) institutions, particularly those which restrict economic participation and those that create investment incentives for that participation, are likely to be an important determinant of those distributional dynamics. We show that a simple empirical model with these features helps to reconcile the apparent “paradox” suggested by the first and second wave regressions. Draft: July 25, 2006