Complicated ties between inequality and growth

For many decades economists believed inequality enhanced an economy's growth rate. This conclusion came mainly from comparing capitalist and socialist economies and noting that, on average, capitalist economies appeared to grow much faster.

They attributed the difference in growth rates to the incentives built into capitalism. Under this system, people are allowed to keep the fruits of their own labor rather than having it taken away and distributed to others. That creates incentives for the hard work, innovation, and dynamism needed to realize higher economic growth rates.

Recently, however, researchers have discovered that the relationship between inequality and economic growth is more complicated. In particular, although inequality may enhance economic growth up to a point, beyond some level of inequality, economic growth appears to decline. Thus, if a country has too much inequality, it can be harmful to its growth prospects. Research by the International Monetary Fund, for example, has come to this conclusion.

But the relationship may be even more complicated. A new World Bank working paper from economists Markus Brückner and Daniel Lederman shows that on average across the 104 countries in their study, a negative relationship exists between inequality and economic growth.

However, separating the sample into developed and undeveloped countries tells a different story. In high- and middle-income countries, growth and inequality are negatively related. But in poor countries, the relationship is just the opposite, an increase in inequality tends to increase economic growth.

Why does higher inequality increase growth in poor countries, but lower it in richer countries?

This result appears tied to investment in human capital (as measured by the number of years of schooling and graduation rates). In poor countries, increased inequality is associated with higher investment in human capital, and that translates into higher economic growth. In higher-income countries, the result runs in the other direction. An increase in inequality is associated with lower investment in human capital and lower economic growth.

This isn't the last word on the relationship between inequality and economic growth. Later work may come to different conclusions or extend and qualify these results in various ways. But it does tell us the relationship between inequality and economic growth is more complicated than may have assumed -- and that much more work needs to be done on this important topic.