There is a wealth of academic, donor and practitioner literature on the relationships between growth, poverty and inequality, some of which – particularly the two-way relationship between growth and inequality – are highly contested. Knowledge of these relationships is important for practitioners seeking to develop informed policies to foster inclusive growth.
Many studies have demonstrated that economic growth is a prerequisite for poverty reduction if income distribution is held constant (Deininger and Squire, 1997; Dollar and Kraay, 2001; Ravallion, 2005; Bourguignon, 2004). Similarly, there is consensus that the two factors that determine why there are different rates of poverty reduction at a given rate of growth are the initial level of inequality in a country, and how inequality changes over time. The higher the level of initial inequality within a country, the less poor people will gain from economic growth (Bourguignon, 2004; Ravallion, 2004; Balakrishnan, Steinberg, and Syed, 2013).
In light of this, Bourguignon (2004) notes that the relationships between growth and poverty, and inequality and poverty, are ‘essentially arithmetic’. He therefore emphasises that understanding the two-way relationship between growth and inequality is the real challenge for producing a development strategy focused on fostering pro-poor or inclusive growth.
The impact of growth on inequality
Numerous mechanisms which cause economic growth to alter the distribution of income within an economy have been proposed. A key strand in this literature is the theory that economic growth alters the distribution of resources and labour in an economy, which in turn affects the distribution of income. The Kuznets Curve hypothesis (see below) is grounded in this viewpoint.
Institutional change is another key mechanism which may cause economic growth to change the distribution of income in an economy. As average incomes grow there is a greater demand for adequate public services and accountable institutions (Birdsall, 2007), and the transaction costs that constrain institutional change may become more affordable as a consequence of economic growth.
The empirical evidence for the impact of economic growth on inequality is mixed. Many authors have found clear evidence for the presence of the Kuznets Curve, implying that economic growth leads to an initial increase in inequality followed by a subsequent decrease. However, once detailed panels of household data enabled studies to assess changes of distribution of incomes over time within countries, cross-country regressions have revealed a strong one-to-one relationship between the growth of average incomes of the poor, and overall average incomes (Deininger and Squire, 1997; Dollar and Kraay, 2001; Dollar, Kleineberg and Kraay, 2013).
Some of the literature cautions, however, that cross-country regressions should not be relied upon to make meaningful generalisations as the way in which economic growth affects income distribution is country specific (Kakwani and Pernia, 2000; Bourguignon, 2004). Instead, Bourguignon (2004) argues that country-specific case studies demonstrate a strong and complex relationship between growth and inequality which varies on a country by country basis, and that these types of studies will be important in enabling policy makers to develop successful country specific policies targeting both growth and income distribution.
The Kuznets Curve
The hypothesis that inequality first rises and then falls (in an inverted U-curve) as economic growth increases and an economy becomes more developed was first put forward by Kuznets (1955). The proposed cause of the initial increase in inequality is the shift of workers and resources from agriculture to industry during the early period of development, creating a significant urban-rural gap. According to this hypothesis, inequality will only begin to fall later in the development process, once ‘trickle-down development’ leads to workers earning higher wages and a welfare system being established.
Empirically, the presence of a Kuznets Curve is heavily contested. Many studies (Ahluwalia, 1976; Papanek and Kyn, 1986; Barro, 1999) find evidence that supports the Kuznets Curve hypothesis as an empirical regularity, but often find that the curve fails to explain the variations in inequality between countries or over time. Others criticise the hypothesis on the grounds that the inverted U-shape is a consequence of historical differences in inequality between countries, rather than the development of individual countries themselves. Deininger and Squire (1996) control for this historical difference in inequality in their analysis, and find no empirical evidence for the Kuznets curve.
The impact of inequality on growth
The literature on the impact of inequality on economic growth is likewise vast. Credit market imperfections, or an inability of the poor to borrow due to lack of collateral or underdeveloped capital markets, have been put forward by numerous authors as a hindrance to economic growth (Barro, 1999; Bourguignon, 2004; Birdsall, 2007).
Others cite redistributive pressures, either in a democratic context or through socio-political unrest, as channels through which inequality can constrain subsequent growth (Rodrik, 1998; Barro, 1999; Bourguignon; 2004). From an institutional perspective, Birdsall (2007) argues that high levels of inequality can discourage the development of institutions which make a market environment conducive to economic growth (e.g. an accountable government).
Empirically, the many authors find no clear relationship between overall inequality and subsequent economic growth. However, there is some consensus that inequality can negatively impact the growth of poor people’s incomes and positively impact the income growth of the rich (Barro, 1999; Birdsall, 2007; van der Weide and Milanovic, 2014).
Most of the literature regarding the impact on inequality of economic growth focuses on income inequality and long-run average growth. However, some studies have found that it is inequality of wealth rather than income that is an impediment to rapid growth (Deininger and Squire, 1997). Other authors have argued that it is the impact of inequality on sustained periods of growth, rather than on the initiation of rapid growth, that should be assessed. By assessing breaks in growth, they find a robust association between lower inequality and sustained growth (Berg and Ostry, 2011; Berg, Ostry and Tsangarides, 2014).
Annotated bibliography
Bourguignon, F. (2004). The Poverty-Growth-Inequality Triangle. Washington DC: World Bank
Should development policy focus on growth, poverty, or inequality? This paper argues that the quick elimination of all forms of absolute poverty is a meaningful goal for development. To achieve this, strong, country-specific combinations of growth and distribution policies will be required. As the relationships between growth and poverty, and inequality and poverty, are essentially arithmetic, the fundamental challenge for designing these policies lies in understanding whether growth rates and changes in income distribution are independent of each other or interrelated. Despite finding that country specificity undermines generalisations, the author states that redistributionary policies undertaken alongside the development process can help to mitigate the potential for growth to initially increase inequality (as per the Kuznets hypothesis). The paper then proposes several hypotheses (e.g. credit market imperfections and social conflict) for why lower inequality can lead to higher growth rates, but finds that cross-country regressions have been unable to prove these relationships.
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Balakrishnan, R. Steinberg, C. and Syed, M. (2013). The Elusive Quest for Inclusive Growth: Growth, Poverty, and Inequality in Asia? Washington DC: IMF
What impact has economic growth in Asia over the past two decades had on poverty reduction? This paper finds that while poverty has fallen across the region over the last two decades, increased inequality has reduced the impact of growth on poverty reduction. Asia’s recent period of growth has been both less inclusive and less pro-poor in relation to other developing regions and compared to Asia’s own past. Furthermore, past increases in inequality in Asia are likely to reduce the future impact of income growth on poverty, even if the level of inequality remains constant in the future. The paper then challenges the assertion made by Dollar and Kraay (and others) that incomes of the bottom quintile rise in line with average income during growth, and finds that once instruments are used for the income variable then the regression results point to the income of the bottom quintile rising less fast than average income. The paper also finds that increased spending on education, labour market reform, and financial inclusiveness are key factors in determining how inclusive or pro-poor growth has been in Asia.
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Barro, R. (1999). Inequality and Growth in a Panel of Countries. Cambridge, Massachusetts: Harvard University
This paper begins with a theoretical explanation of four mechanisms by which inequality can affect growth and investment: credit market imperfections, redistribution under a democratic system, socio-political unrest, and savings rates. After conducting a regression analysis using a broad panel of countries, little overall relationship between income inequality and rates of growth and investment is found. The analysis shows, however, that higher inequality tends to slow down growth in poor countries, and increase growth in rich countries (the threshold used $2000 US in 1985 dollars). This finding may justify the use of redistributionary policies in poor countries as a means of stimulating economic growth.
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Dollar, D. and Kraay, A. (2001). Growth is Good for the Poor. Washington DC: World Bank
This paper tests the relationship between the growth of incomes of the poor (defined as the bottom 20 percent) and average income growth. After performing a cross-country regression analysis of 92 countries over four decades, Dollar and Kraay find a one-to-one relationship between growth of income of the poor and growth of mean income. The paper also finds that determinants of growth such as trade openness, financial development, strong property rights and rule of law have benefitted the poor as much as the average household, contrary to the arguments of many critics of globalisation. Similarly a number of ‘pro-poor’ policies, such as public expenditure on health and education and formal democratic institutions, are found to benefit the poor as much as the average household. Dollar and Kraay do not conclude from these findings that growth is all that is needed to improve the lives of the poor, but rather that growth enhancing policies such as trade openness and rule of law should be at the heart of any poverty reduction strategy.
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Dollar, D., Kleineberg, T. and Kraay, A. (2013). Growth Still is Good for the Poor. Washington DC: World Bank
This paper finds a very strong equiproportionate relationship between the average incomes of the bottom 40 percent and overall average incomes, leading the authors to conclude that ‘growth still is good for the poor’. It is also established that there is no global trend towards greater inequality, as the income shares of the bottom 20 and 40 percent show no systematic tendency to decline over time. Finally none of the factors thought to matter for growth (e.g. financial openness and macro-stability) and inequality (e.g. primary school enrolments) are found to robustly correlate with an increased income share for the bottom 40 percent. The authors highlight the difficulty in using cross-national data to identify specific macro policy reforms to boost shared prosperity, as well as the fact that despite zero change in inequality on average there have been significant changes in inequality in certain countries during specific periods. Nonetheless, they conclude that economic growth will lead to shared prosperity on average, and that institutions and policies that promote economic growth in general will promote shared prosperity.
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Deininger, K. and Squire, L. (1997, March). Economic Growth and Income Inequality: Reexamining the Links. Finance and Development
This article finds that the relationship between initial inequality and subsequent growth differs depending on whether initial inequality is measured in terms of income or land, with an uneven distribution of assets found to be more of an impediment to growth than income inequality. The authors argue that lack of access to credit is the key mechanism by which asset inequality results in poor growth. The authors also highlight that the aggregate measures of distribution often used can hide considerable changes in the incomes of different groups. They recommend that welfare analyses of the bottom quintiles should accompany any assessments of aggregate shifts in income. New data is then used to test existing hypotheses regarding growth and inequality. No evidence is found to back up the Kuznets hypothesis, while initial inequality of assets rather than income is found to have a strong negative impact on subsequent economic growth. Despite the strong relationship found between asset inequality and future economic growth, the impact of investment on growth and poverty reduction is found to be even stronger. The authors conclude that policymakers should not pursue a redistributive strategy at the expense of investment, as this could result in lower incomes for the poor.
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Birdsall, N. (2007). Income Distribution: Effects on Growth and Development. Washington DC: Centre for Global Development
How does inequality impact subsequent economic growth? This paper finds that inequality is more likely to constrain economic growth in countries at low levels of income, defined as below about $3200 per capita in 2000 dollars. It is at high levels of inequality (at or above a Gini coefficient of .45) that a negative association emerges between growth and inequality. Birdsall then defines three potential mechanisms through which inequality can negatively impact economic growth. Firstly, inequality can exacerbate the effect of incomplete and underdeveloped markets for capital and information, as creditworthy borrowers with no collateral are denied loans and their lack of wealth or income then stops them from making any investments at all. Secondly, high inequality can discourage the evolution of the economic and political institutions associated with accountable government, as the rich resist tax to fund public services which they can purchase privately. Thirdly, inequality may undermine the civic and social life that sustains effective collective decision-making, leading to impaired economic growth. For example, high inequality has been found to have a significant and positive effect on homicide rates in a cross section of 39 countries.
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Ravallion, M. (2005). Inequality is Bad for the Poor. Washington DC: World Bank
This paper identifies two factors as the main proximate causes of the differing impact of growth on poverty: the initial level of inequality and how inequality changes over time. The author then notes that despite the fact that numerous studies have found no aggregate trade-off between mean income and inequality, this does not mean that there are no trade-offs at the level of specific policies. Reducing inequality by adding further distortions to an economy may well have ambiguous effects on growth and poverty reduction. However, there is potential for ‘win-win’ policies as some of the factors that impede growth also stop the poor from accessing the opportunities unleashed by growth. Successful policies can focus on either correcting the underlying market and governmental failure or on directly intervening to redress the asset inequalities, by fostering poor people’s accumulation of physical and human assets.
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Berg, A. and Ostry, J. (2011). Inequality and Unsustainable Growth: Two Sides of the Same Coin? Washington DC: IMF
This paper highlights that while the evidence on the impact of initial inequality on growth has been mixed, the majority of empirical literature to date overlooks the fact that periods of rapid growth are interrupted by collapses and periods of stagnation. The authors argue that it is more relevant to assess the relationship between income distribution and these breaks in growth. The paper finds that while many developing countries have successfully initiated high levels of growth for a few years, the ability to sustain growth is much rarer. Longer periods of growth are found to be robustly associated with a more equal distribution of income, even when other determinants of growth duration (external shocks, initial income, institutional quality, macroeconomic stability, openness to trade) are taken into account. A key implication is that in the long term, policies to reduce inequality could result in sustained growth, or that reduced inequality and sustained growth may be viewed as ‘two sides of the same coin’.
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Berg, A., Ostry, J. and Tsangarides, C. (2014). Redistribution, Inequality and Growth. Washington DC: IMF
This paper builds on the tentative consensus in the literature that inequality reduces the pace and durability of growth, through mechanisms such as political instability and undermining progress in health and education. It uses a cross-country dataset that distinguishes market (before taxes and transfers) inequality from net (after taxes and transfers) inequality in order to test the effects of redistribution on growth. Firstly, the authors find that more unequal societies tend to distribute more. Secondly, the paper confirms that lower net inequality is robustly correlated with faster and more durable growth, for a given level of redistribution. Thirdly, redistribution is found to have little impact on growth, and it is only in the most extreme cases of redistribution that there is some evidence for a negative impact on growth.
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van der Weide, R. and Milanovic, B. (2014). Inequality Is Bad for Growth of the Poor (But Not for That of the Rich)? Washington DC: World Bank
Using US micro-census data from 1960-2010, this paper aims to ‘unpack’ inequality and growth to predict how different types of inequality can impact the subsequent income growth of different segments of the population. The authors find that high levels of overall inequality reduce the income growth of the poor and increase the income growth of the rich – i.e. the kind of growth that inequality stimulates creates further inequality. Total inequality is then split into ‘top inequality’ (inequality amongst the top 40 percent) and ‘bottom inequality’. The study finds that both top and bottom inequality are negatively associated with income growth for the poor, and that bottom inequality is also positively associated with income growth for the rich. This may be because high levels of inequality, particularly among the rich, result in societal fragmentation. The authors argue that societal fragmentation could result in the rich opting out of publicly provided services such as education and healthcare and lobbying for policies that benefit themselves but limit growth opportunities for the poor (e.g. cuts to public health spending).
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Additional resources
Banerjee, A. and Duflo, E. (2003). Inequality and Growth: What can the data say? Cambridge, Massachusetts: Massachusetts Institute of Technology
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Edward, P. and Sumner, A. (2014). The Poor, the Prosperous, and the ‘Inbetweeners’: a fresh perspective on Global Society, Inequality and Growth? Brasilia: International Policy Centre for Inclusive Growth
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Ravallion, M. (2004). Pro-Poor Growth: A Primer. Washington DC: World Bank
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Kakwani, N. and Pernia, E. (2000). What is Pro-poor Growth. Asian Development Review, 18(1), 1-22.
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