WPS7317
Policy Research Working Paper 7317
Effects of Income Inequality on Aggregate Output
Markus Brueckner
Daniel Lederman
Latin America and the Caribbean Region
Office of the Chief Economist
June 2015
Policy Research Working Paper 7317
Abstract
This paper estimates the effect of income inequality on real inequality has a significant negative effect on transitional
gross domestic product per capita using a panel of 104 gross domestic product per capita growth and the long-run
countries during the period 1970–2010. The empirical level of gross domestic product per capita. However, the
analysis addresses endogeneity issues by using instrumental impact varies by the level of economic development, so
variables estimation and controlling for country and time much so that in poor countries income inequality has a sig-
fixed effects. The analysis finds that, on average, income nificant positive effect on gross domestic product per capita.
This paper is a product of the Office of the Chief Economit, Latin America and the Caribbean Region. It is part of a larger
effort by the World Bank to provide open access to its research and make a contribution to development policy discussions
around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors
may be contacted at m.brueckner@uq.edu.au or dlederman@worldbank.org.
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
Produced by the Research Support Team
Effects of Income Inequality on Aggregate Output
by
Markus Brueckner and Daniel Lederman*
Key words: Income Inequality, Economic Growth
JEL codes: O1
* University of Queensland (Brueckner), and World Bank (Lederman). We gratefully acknowledge insightful comments
from Antonia Díaz, Marcelo Olarreaga and other participants in the inequality and growth workshop held at the
Carlos III University in Madrid, Spain, June 10, 2015.
1. Introduction
The relationship between aggregate output and the distribution of income is an important topic in
macroeconomics (see Galor, 2011). The role that income inequality plays for economic growth has
recently received also quite a bit of attention in policy circles and the press. For instance, the World
Bank Group has made extreme-poverty eradication and boosting the incomes of the bottom 40
percent of developing countries’ distribution of income across households its key global objective
for development. The International Monetary Fund has weighed in with a discussion on the role of
income distribution as a cause and consequence of economic growth; see, for example, Ostry et al.
(2014).
This paper provides estimates of the within-country effect that income inequality has on
aggregate output. Our empirical analysis starts from the premise that the effect of changes in
income inequality on GDP per capita may differ between rich and poor countries. This premise is
grounded in economic theory. In a seminal contribution, Galor and Zeira (1993) proposed a model
with credit market imperfections and indivisibilities in investment to show that inequality affects
GDP per capita in the short run as well as in the long run. The Galor and Zeira model predicts that
the effect of rising inequality on GDP per capita is negative in relatively rich countries but positive
in poor countries. We test this prediction by introducing in the panel model an interaction term
between income inequality and countries' initial (i.e. beginning of sample) GDP per capita.
Our empirical analysis shows that, for the average country in the sample during 1970-2010,
increases in income inequality reduce GDP per capita. Specifically, we find that on average a one
percentage point increase in the Gini coefficient reduces GDP per capita by around 1.1 percent over
a five-year period; the long-run (cumulative) effect is larger and amounts to about -4.5 percent. To
be clear: this finding implies that, on average, increases in the level of income inequality lead to
lower transitional GDP per capita growth; increases in the level of income inequality have a
negative long-run effect on the level of GDP per capita. We document the robustness of this result
2
to alternative measures of income inequality; alternative income inequality data sources; splitting
the sample between the pre- and post-1990 periods (end of the Cold War); and restricting the
sample to countries located in Latin America and the Caribbean or Asia.
While the average effect of income inequality on GDP per capita is negative and
significantly different from zero, it varies with countries' initial income level. In an econometric
model that includes an interaction term between initial GDP per capita and income inequality, the
coefficient on the interaction term is negative and significantly different from zero at the 1 percent
level. Quantitatively, the size of the coefficient on the interaction term implies that differences in
initial income induce a substantial effect on the impact that changes in income inequality have on
GDP per capita. For example, at the 25th percentile of initial income, the predicted effect of a one
percentage point increase in the Gini coefficient on GDP per capita is 2.3 percent (with a
corresponding standard error of 0.6 percent); at the 75th percentile of initial income, the effect is -
5.3 percent (the corresponding standard error is 0.8 percent). The estimates from the interaction
model thus suggest that in poor countries increases in income inequality increase GDP per capita
while the opposite is the case in high and middle income countries.
Additional evidence that our empirical results are in line with the Galor and Zeira (1993)
model comes from the response of investment and human capital.1 Our panel estimates show that
within-country increases in income inequality significantly increase the investment-to-GDP ratio in
poor countries but decrease it in high and medium income countries. Furthermore, within-country
increases in income inequality significantly increase the stock of human capital (measured by the
average years of schooling and share of the population with secondary and tertiary education) in
poor countries; on the other hand, in high and medium income countries increases in income
inequality reduce human capital.
1
Ideally, in the cross-country time series context, we would like to use data on the distribution of wealth rather than
income since wealth inequality is the relevant measure in theoretical models with credit market imperfections.
Unfortunately, data on wealth inequality are not available to generate a long time-series for a large number of
countries. As noted in previous empirical research (e.g. Perotti, 1996), income inequality and wealth inequality are
highly positively correlated.
3
Identification of the causal effect of income inequality on aggregate output is complicated
by the endogeneity of the former variable. Income inequality may be affected by countries' GDP per
capita as well as other variables related to deep-rooted differences in countries' geography and
history. We address this issue by estimating a panel model with country and time fixed effects. We
instrument income inequality with variation in that variable not driven by GDP per capita.
The remainder of the paper is organized as follows. Section 2 reviews related literature.
Section 3 discusses the data. Section 4 presents the econometric model. Section 5 discusses the
empirical results. Section 6 concludes.
2. Related Literature
The literature on the relationship between income inequality and aggregate output is well
established in economics and we refer the reader to Galor (2011) for an exhaustive survey. In this
section we only discuss empirical papers that make an attempt to use plausibly exogenous variation
in income inequality.
Galor et al. (2008) examine the impact that land inequality had on human capital for the
United States at the beginning of the 20th century using state level data. Instrumenting land
inequality with the interaction between nationwide changes in the relative prices of agricultural
crops and variation in climatic characteristics across states, the authors find that inequality had on
average a significant negative effect on human capital. According to Maddison (2013), the real GDP
per capita of the United States at the beginning of the 20th century was around 5,000USD. Using a
value of (the natural logarithmn) 5,000USD and plugging it into our estimates, we find that the
effect of inequality on education and GDP per capita is negative (see Section 5). Our panel
estimates, which are based on a sample of 104 countries during 1970-2010, are therefore consistent
with the results in Galor et al. (2008).
Easterly (2007) uses the abundance of land suitable for growing wheat relative to that
4
suitable for growing sugarcane as an instrument for income inequality in a cross-section of 104
countries. He finds that inequality has a significant negative average effect on GDP per capita, as
we do. Easterly does not explore how the impact of income inequality on GDP per capita varies
depending on countries' initial level of development. In contrast to our panel analysis, the results in
Easterly are driven exclusively by cross-country variation.
There exist a number of empirical studies using panel data which instrument inequality
using internal instruments (i.e. lagged values of inequality). Examples are Forbes (2000), Panizza
(2002), Banerjee and Duflo (2003), Voitchovsky (2005), and Halter et al. (2014). Unfortunately,
none of these papers address the important issue of whether the instruments for inequality are
relevant. As noted in Bound et al. (1995), IV regressions based on weak instruments lead to
inconsistent estimates. It should, furthermore, be pointed out that none of the papers that use an IV
approach in a panel context explores how the impact of income inequality on GDP per capita
depends on countries' initial level of economic development.
3. Data
Income Inequality. The main indicators of income inequality -- the Gini coefficient and the share
of income held by the 1st, 2nd, 3rd, 4th and 5th quintiles -- are taken from Brueckner et al. (2015).
Brueckner et al.'s (2015) primary data source is the UN-WIDER World Income Inequality Database,
supplemented with data from the World Bank’s POVCALNET database for developing countries.
According to Brueckner et al. (2015), comparability between the two data sources is ensured by
making adjustments to the data sets for individual countries so that the income (or consumption)
shares consistently correspond to those of a consumption (or income) survey. The authors drop
duplicates as well as survey-years with inferior data quality from the WIID, survey-years for which
no extra information (consumption/income) is available; and survey-years for which the income
shares add up to less than 99 or more than 101. As robustness checks on our main source of income
5
inequality data, we will present estimates based on the Gini income inequality coefficient and
income shares of the 1st, 2nd, 3rd, 4th, and 5th quintiles provided by WDI (2014).
Other Data. Data on real GDP per capita and investment are from the Penn World Tables (Heston
et al., 2012). Data on the average years of schooling and the share of population with secondary and
tertiary education are from Barro and Lee (2010). Descriptive statistics for the above variables are
provided in Appendix Table 1. For a list of the countries in the sample, see Appendix Table 2.
4. Estimation Framework
Following the empirical literature on the impact of income inequality on economic growth (e.g.
Forbes, 2000), the baseline econometric model is:
(1) ln(y)it - ln(y)it-1 = ai + bt + θ1Inequalityit + θ2Inequalityit*ln(yi1970) + φ ln(y)it-1 + uit
where ln(y)it stands for the natural logarithmn of real GDP per capita in country i and period t;
ln(yi1970) is the natural logarithmn of country i's GDP per capita at the beginning of the sample, i.e.
in 19702; ai are country fixed effects; bt are time fixed effects; uit is an error term. We note that this
equation can be re-written as:
(1') ln(y)it = ai + bt + θ1Inequalityit + θ2Inequalityit*ln(yi1970) +(1+φ)ln(y)it-1 + uit
We estimate equation (1') with 5-year non-overlapping panel data. The panel comprises 104
countries during the period 1970-2010. This is the largest possible 5-year non-overlapping sample
given the availability of data on GDP per capita and income inequality. Our measures of income
inequality are the Gini coefficient and the income shares accruing to the 1st, 2nd, 3rd, 4th, and 5th
quintiles.
The parameter φ captures the convergence rate over a 5-year period. The contemporaneous
effect of a within-country change in inequality on the natural logarithmn of GDP per capita is
captured by θ1+θ2*ln(yi1970). If φ is significantly negative, so that 1+φ is below unity in absolute
2
The term, ln(yi1970), does not appear in the econometric model because it is implicitly contained in the country fixed
effects, ai.
6
value (i.e. there is convergence), then the long-run effect on the level of GDP per capita is given by
(θ1+θ2*ln(yi1970))/-φ.
An important issue in the estimation of equation (1’) is the endogeneity of inequality to
within-country changes in GDP per capita. Brueckner et al. (2015) use an instrumental variables
estimation to identify the effect of GDP per capita on inequality within countries. Their instrumental
variables for GDP per capita are trade-weighted world income and the interaction between the
international oil price and countries' net-export shares of oil in GDP. Specification tests reported by
the authors indicate that these are valid. According to Brueckner et al. within-country variations in
GDP per capita have a significant negative effect on income inequality. That is, in the equation
below α is negative:
(2) Inequalityit = ei + ft + αln(y)it + εit
The negative coefficient on GDP per capita is consistent with theories of the relationship between
income inequality and growth when credit markets are imperfect, see e.g. Galor and Zeira (1993).
Quantitatively, Brueckner et al. (2015) estimate α to be around -0.08 for the Gini coefficient; i.e. a 1
percent increase in real GDP per capita reduces the Gini coefficient by around 0.08 percentage
points. The authors also provide estimates of the response of the income quintiles to within-country
changes in GDP per capita.
If α is negative in equation (2) then the least squares estimate of θ in equation (1’) is
downward biased. That is, least squares estimation is biased towards finding a negative effect of
income inequality on GDP per capita. We note that instrumental variables estimates based on weak
instruments suffer from a similar bias (i.e. Bound et al., 1995). In order to correct for endogeneity
bias of θ in the estimation of equation (1’) we construct an inequality variable that is adjusted for
the impact that GDP per capita has on inequality, i.e. Zit = Inequalityit - αln(y)it. This instrument is,
by construction, uncorrelated with the natural logarithmn of GDP per capita.3 Using Z as an
3
An analogous instrumental variables strategy has been used in the macro literature on fiscal policy, see e.g.
Blanchard and Perotti (2002) or Fatas and Mihov (2003). Brueckner (2013) applies this instrumental variables
7
instrument for inequality thus cleans the estimate of reverse causality bias.
Another issue in the estimation of equation (1) is that the presence of the country fixed
effects implies a bias. Nickel (1981) showed that in the dynamic panel estimation, i.e. where lagged
GDP per capita is included as a regressor on the right-hand side, the coefficients are biased (the bias
is inversely related to T). We address this issue in two ways. First, we present estimates from a
static panel model. In the static panel model inequality is instrumented with Z. In that model, the
presence of the country fixed effects cause no bias. Second, we present estimates from a dynamic
panel model with country fixed effects where we use the system-GMM estimator. In the system-
GMM estimation we instrument the lagged dependent variable with its lag in addition to
instrumenting income inequality with Z.
5. Results
5.1 Baseline Results
We begin by discussing instrumental variables estimates from the static panel model. In the statistic
panel model the natural logarithmn of real GDP per capita is regressed on measures of income
inequality. The control variables are country and time fixed effects (jointly significant at the 1
percent level). Table 1 presents the relevant results. The table shows that the within-country effect
of income inequality on GDP per capita varies depending on countries' initial level of GDP per
capita. This can be seen, for example, in column (1) where the two-stage least squares estimate on
the Gini coefficient is positive and significant at the 1 percent level; the interaction term between
the Gini coefficient and initial GDP per capita is positive and significant at the 1 percent level.
Looking at the income shares, we see that the estimated coefficients on the income shares accruing
to the 1st, 2nd, 3rd, and 4th quintiles are negative while the interaction with initial GDP per capita is
positive; the opposite is the case for the coefficient on the 5th income quintile.
strategy to estimating the effect of foreign aid on economic growth.
8
In terms of instrument relevance, we note that the first-stage Kleibergen Paap F-statistic is
well in excess of 10 (17) so that according to the tabulations provided in Stock and Yogo (2005) we
can reject the hypothesis that the IV size distortion is larger than 15 (10) percent at the 5 percent
significance level. In Figure 1 we plot the relationship between the Gini coefficient (net of country
and time fixed effects) and the instrument -- i.e. the Gini coefficient adjusted for the impact of GDP
per capita (also net of country and time fixed effects). As can be seen the relationship is positive and
highly significant.
In Table 2 we present estimates from a dynamic panel model that includes the one-period lag
of GDP per capita on the right-hand side. Panel A shows two-stage least squares estimates where
inequality is instrumented with the residual variation in inequality that is not due to GDP per capita.
Panel B shows system-GMM estimates where the lagged dependent variable is instrumented with
its second and third lag; inequality continues to be instrumented with the residual variation in
inequality that is not due to GDP per capita.
Several findings emerge that are worthwile pointing out. First, the message from the
dynamic panel estimates is qualitatively the same as from the static panel estimates: income
inequality has a significant positive effect on GDP per capita for low levels of initial GDP per
capita; the effect is significantly negative for intermediate and high levels of initial GDP per capita.
Second, there is evidence of significant within-country convergence in GDP per capita: the AR(1)
coefficient on GDP per capita is in the range of 0.7-0.8; this suggests that in the sample the per
annum convergence rate of GDP per capita is in the range of 4-6 percent. Third, 2SLS regressions
provide estimates that are quantitatively similar to system-GMM regressions. Fourth, the size of the
contemporaneous (five year) and long-run effect of income inequality on GDP per capita is
substantial.
Consider, for example, the estimates in column (1) of Panel A in Table 2. When evaluated at
9
the sample mean (median) of the natural logarithmn of GDP per capita in 19704 the marginal effect
of a change in the Gini on the natural logarithmn of GDP per capita is equal to -1.13 (-0.97). Its
standard error is 0.42 (0.41). These numbers should be read as a one percentage point increase in
the Gini coefficient reducing GDP per capita over a five year period by around 1 percent. The long-
run effect is larger and amounts to about 4 percent.
Figure 2 displays graphically how the marginal effect of a change in the Gini coefficient on
the natural logarithmn of GDP per capita varies across countries' initial GDP per capita. The x-axis
displays values of initial GDP per capita that fall in between the sample minimum and maximum.
As can be seen, for low values of initial GDP per capita the effect of income inequality on GDP per
capita is positive, while for high and intermediate values of initial GDP per capita it is negative. The
marginal effect of the GINI becomes zero at around $665 PPP-adjusted U.S. dollars per capita in
1970 (equivalent to log of GDP per capita of 6.5).
5.2. Robustness
Table 3 shows that our baseline estimates are robust to the use of alternative income inequality data.
We use the inequality data discussed in Section 3 for our baseline regressions because these data
provide us with the largest number of country-year observations. In column (1) of Table 3, we
present instrumental variables estimates based on the Gini coefficient provided by WDI (2014); the
remaining columns use the shares of income accruing to the 1st, 2nd, 3rd, 4th, and 5th quintiles. The
estimate on the Gini coefficient is positive and significant at the 1 percent level; the interaction term
between the Gini coefficient and initial GDP per capita is negative and significant at the 1 percent
level. Looking at the income shares, we see that the estimated coefficients on the income shares
accruing to the 1st, 2nd, 3rd, and 4th quintiles are negative while the coefficients on the interaction
terms between the 1st, 2nd, 3rd, and 4th quintiles and initial GDP per capita are positive; the opposite
4
The sample mean (median) of the natural logarithmn of GDP per capita in 1970 is 6.82 (6.78).
10
is the case for the coefficient on the 5th income quintile and its interaction with initial GDP per
capita. Estimates based on the WDI income inequality data thus confirm the message from our
baseline regressions: increases in income inequality increase GDP per capita in poor countries but
decrease it in rich countries.
Table 4 shows that our main finding holds for the sub-sample of countries located in Latin
America and the Caribbean. These economies are notorious for their relatively high levels of
inequality. For example, of the top 10 countries with the highest Ginis, 7 are from Latin America
and the Caribbean in 2000-2010. Table 4 shows that for the sub-sample of countries located in Latin
America and the Caribbean, the coefficient on the interaction between the Gini coefficient and
initial GDP per capita is significantly negative; this is also the case for the 5th income quintile. On
the other hand, the coefficients on the interactions between initial GDP per capita and the income
shares of the 1st, 2nd, 3rd, and 4th quintiles are significantly positive. We note that in terms of
instrument strength the F-statistic continues to be above 10 for the majority of columns in Table 4;
however it is below 10 in columns (4) and (5). The lower F-statistic is expected because the sample
size is smaller.
Table 5 reports estimates for the pre- and post-1990 period. The split between pre- and post-
1990 period is of interest because it allows to examine whether the estimated coefficients are stable
over time. The year 1990 marks the mid-point in the time period over which the model is estimated
so it is a natural point to check for stability of coefficients. The main message of Table 5 is that the
heterogeneous effect of income inequality on GDP per capita between rich and poor countries is
present in both periods.
5.3. Effects on Investment and Human Capital
In the Galor and Zeira (1993) model the mechanism through which income inequality affects
aggregate output is through investment, in particular, investment in human capital. In this section
11
we present estimates from an interaction model where the dependent variables are the investment-
to-GDP ratio and the average years of schooling. The results in this section should be read as
evidence on the channels through which income inequality affects aggregate output.
Table 6 documents the effects of income inequality on the investment-to-GDP ratio. Column
(1) shows that the marginal effect of a within-country change in the Gini coefficient on investment
is significantly declining in countries' initial GDP per capita. For example, at sample mean initial
GDP per capita the effect of a one percentage point increase in the Gini coefficient on the
investment-to-GDP ratio is -0.23 percentage points (s.e. 0.13 percentage points). At the 25th
percentile of initial GDP per capita the effect is 0.75 percentage points (s.e. 0.24 percentage points);
at the 75th percentile of initial GDP per capita it is -1.34 (s.e. 0.36 percentage points). Hence,
increases in income inequality lead to a higher (lower) investment-to-GDP ratio in poor (rich)
countries. Columns (2)-(6) of Table 6 show that the same message arises when using data on the
income quintiles.
Table 7 presents estimates of the effect that income inequality has on the average years of
schooling. Column (1) shows that the marginal effect of a within-country change in the Gini
coefficient on schooling is significantly declining in countries' initial GDP per capita. For example,
at sample mean initial GDP per capita, the effect of a one percentage point increase in the Gini
coefficient on the average years of schooling is -0.029 years (s.e. 0.008). At the 25th percentile of
initial GDP per capita the effect is 0.0022 years (s.e. 0.011 percentage points); at the 75th percentile
of initial GDP per capita it is -0.064 (s.e. 0.022). Hence, income inequality is detrimental for human
capital accumulation at relatively high levels of GDP per capita. Columns (2)-(6) of Table 7 show
that the same message arises when using data on the income quintiles.
Table 8 examines robustness of the schooling results to using alternative measures of
education. Columns (1)-(4) report estimates for the share of population with secondary schooling
and tertiary schooling. For both measures we find that the effect of income inequality is
12
significantly decreasing with countries' initial GDP per capita. Quantitatively the estimated effects
are sizable. Consider, for example, the estimates in column (1) of Table 8. At sample mean initial
GDP per capita, the effect of a one percentage point increase in the Gini coefficient on the share of
population with secondary education is -0.23 percentage points (s.e. 0.09 percentage points). At the
25th percentile of initial GDP per capita the effect is 0.20 percentage points (s.e. 0.13 percentage
points); at the 75th percentile of initial GDP per capita it is -0.72 percentage points (s.e. 0.26
percentage points). For tertiary education the effects are somewhat smaller but still statistically
significant. For example, the estimates in column (3) of Table 8 imply that at sample mean initial
GDP per capita the effect of a one percentage point increase in the Gini coefficient on the share of
population with tertiary education is -0.05 percentage points (s.e. 0.05 percentage points); at the 25th
percentile of initial GDP per capita the effect is 0.16 percentage points (s.e. 0.07 percentage points);
and at the 75th percentile of initial GDP per capita it is -0.30 percentage points (s.e. 0.13 percentage
points).
5.4 Extensions
In this section we consider two extensions of our baseline econometric model. The first extension is
to interact initial (i.e. 1970) average years of schooling with income inequality. If schooling is a key
determinant of GDP per capita then we should find similar results to those in Section 5.1. The
second extension is to include in the model an interaction between income inequality and the GDP
share of government expenditures (in addition to an interaction between schooling and income
inequality). This extension allows to examine the question of whether initial cross-country
differences in schooling have an effect on the impact that income inequality has on GDP per capita,
independently of a relationship between schooling and the size of government.
Table 9 presents estimates from an econometric model where initial (i.e. 1970) average years
of schooling in the population are interacted with income inequality. The estimated coefficient
13
(standard error) on the interaction term between average years of schooling and the Gini coefficient
is -0.49 (0.09), see column (1). This suggests that the marginal effect of income inequality on GDP
per capita growth is significantly decreasing in countries' initial level of human capital. The same
message is obtained when considering the income quintiles, see columns (2)-(6).
To illustrate the implied difference in marginal effects, it is useful to consider some specific
values of the average years of schooling in the sample. At the 25th percentile, the average years of
schooling is around 4.2 years. Plugging the value of 4.2 into the estimates shown in column (1) of
Table 9 yields a predicted marginal effect of 0.51 with a standard error of 0.18.; that is, a one
percentage point increase in the Gini coefficient increases GDP per capita by around 0.5 percent.
Consider now the sample median of average years of schooling. The sample median is around 6.4
years. The predicted marginal effect (standard error) at the median value of schooling is -0.56
(0.22). It is also instructive to consider the effect at the 75th percentile. At the 75th percentile the
value for average years of schooling is around 8.6 years. The predicted marginal effect (standard
error) is in that case -1.64 (0.39).
In Table 10 we document the robustness of the interaction between initial years of schooling
and inequality to restricting the sample to: (i) Asia (column (1)); (ii) Latin America and the
Caribbean (column (2)); the pre-1990 period (column (3)); and the post-1990 period (column (4)).
As can be seen from Table 10, the coefficient on the Gini coefficient is significantly positive while
the coefficient on the interaction between the Gini coefficient and schooling is significantly
negative.
Table 11 reports estimates from an econometric model that includes an interaction between
income inequality and schooling as well as an interaction between income inequality and
government size (as measured by the GDP share of government expenditures). The table shows that
there is a negative interaction effect between income inequality and the size of government. Hence,
income inequality is less conducive for GDP per capita growth in countries with a higher share of
14
government expenditures in GDP. Importantly, the table shows that the interaction between income
inequality and schooling remains negative and significant when controlling for an interaction
between income inequality and government size.
6. Conclusion
This paper provided panel estimates of the within-country effect that income inequality has on GDP
per capita. Motivated by the theoretical work of Galor and Zeira (1993), which examined the
relationship between income inequality and aggregate output in the presence of credit market
imperfections and indivisibilities in human capital investment, our econometric model included an
interaction between measures of income inequality and countries' initial level of GDP per capita.
Our instrumental variables estimates showed that income inequality has a significant negative effect
on aggregate output for the average country in the sample. However, for poor countries income
inequality has a significant positive effect. We documented that this heterogeneity is also present
when considering investment, in particular, investment in human capital, as a channel through
which inequality affects aggregate output. Overall, our empirical results provide support for the
hypothesis that income inequality is beneficial for economic growth in poor countries, but that it is
detrimental for economic growth in advanced economies.
15
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17
Figure 1. Relationship between Gini coefficient and the Gini coefficient net of GDP per capita
Note: Gini, residual refers to the Gini coefficient net of country and year fixed effects. Gini
coefficient not due to GDP per capita residual refers to the gini coefficient net of country and year
fixed effects, and adjusted for the effect that GDP per capita has on the gini coefficient.
18
Figure 2: Marginal effect of inequality on GDP per capita as a function of initial (1970) GDP per
capita
19
Table 1. Effects of Income Inequality on GDP per capita: The Role of Initial Income
(Static Interaction Model)
Dependent Variable is: ln(GDP per capita)
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 64.55*** -194.23*** -201.23*** -243.46*** -263.23** 85.86***
(12.89) (32.58) (38.62) (49.45) (75.47) (18.50)
Inequality * ln(GDP per -9.92*** 28.25*** 30.33*** 37.10*** 39.68*** -13.28***
capita in 1970) (1.94) (4.70) (5.75) (7.43) (11.86) (2.81)
Kleibergen Paap F-Stat 34.28 64.05 43.31 34.34 15.80 27.83
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 494 494 494 494 494 494
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
20
Table 2. Effects of Income Inequality on GDP per capita: The Role of Initial Income
(Dynamic Interaction Model)
Dependent Variable is: ln(GDP per capita)
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Panel A: 2SLS
Inequality 25.80*** -78.28*** -79.55*** -94.61*** -103.32*** 33.91***
(4.23) (11.51) (12.21) (16.27) (25.04) (5.97)
Inequality * ln(GDP per -3.95*** 11.35*** 11.90*** 14.34*** 15.56*** -5.23***
capita in 1970) (0.63) (1.64) (1.80) (2.42) (3.97) (0.90)
Lagged ln(GDP per 0.74*** 0.75*** 0.76*** 0.76*** 0.75*** 0.75***
capita) (0.06) (0.05) (0.05) (0.06) (0.06) (0.06)
Kleibergen Paap F-Stat 76.81 160.78 119.80 76.66 6.12 59.82
Panel B: Sys-GMM
Inequality 22.73*** -75.73*** -71.94*** -79.36*** -79.37*** 28.50***
(3.05) (9.16) (8.46) (10.80) (12.22) (4.08)
Inequality * ln(GDP per -3.49*** 10.97*** 10.79*** 11.95*** 11.74*** -4.39***
capita in 1970) (0.47) (1.33) (1.28) (1.65) (1.81) (0.63)
Lagged ln(GDP per 0.70*** 0.68*** 0.72*** 0.71*** 0.65*** 0.71***
capita) (0.09) (0.08) (0.08) (0.09) (0.11) (0.10)
AR(1), p-value 0.00 0.02 0.00 0.00 0.00 0.00
AR(2), p-value 0.32 0.05 0.13 0.22 0.99 0.48
Sargan, p-value 0.59 0.95 0.53 0.98 0.32 0.50
Controls and Number of Observations in Panels A and B
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 494 494 494 494 494 494
Note: The method of estimation in Panel A is two-stage least squares; Panel B system-GMM. Huber robust standard errors (shown in parentheses) are
clustered at the country level. In Panels A and B the (external) instrument for income inequality is the residual variation in inequality that is not due to
GDP per capita. Panel B uses as (internal) instrument for lagged GDP per capita the second and third lag. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
21
Table 3. Effects of Income Inequality on GDP per capita: The Role of Initial Income
(WDI Inequality Data)
Dependent Variable is: ln(GDP per capita)
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 55.41*** -269.89*** -219.91*** -195.78*** -175.52*** 61.52***
(13.72) (71.25) (55.09) (45.82) (37.20) (14.76)
Inequality * ln(GDP per -9.10*** 44.34*** 44.74*** 53.16*** 27.59*** -9.97***
capita in 1970) (2.26) (11.74) (16.98) (14.58) (5.89) (2.40)
Lagged ln(GDP per 0.45*** 0.33* 0.36*** 0.32*** 0.67*** 0.49***
capita) (0.17) (0.18) (0.09) (0.07) (0.10) (0.06)
Kleibergen Paap F-Stat 18.46 15.78 17.95 21.70 33.20 33.20
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 296 296 296 296 296 296
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
22
Table 4. Effects of Income Inequality on GDP per capita: The Role of Initial Income
(Latin America and the Caribbean)
Dependent Variable is: ln(GDP per capita)
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 117.32*** -387.32*** -279.93*** -534.85*** -519.66*** 157.27***
(31.80) (77.39) (68.27) (178.56) (236.08) (48.93)
Inequality * ln(GDP per -16.69*** 55.09*** 39.40*** 75.40*** 73.54*** -22.37***
capita in 1970) (4.56) (11.04) (9.77) (25.25) (33.58) (7.01)
Lagged ln(GDP per 0.50*** 0.54*** 0.51*** 0.70*** 0.53** 0.52***
capita) (0.14) (0.11) (0.12) (0.22) (0.18) (0.16)
Kleibergen Paap F-Stat 14.98 31.66 21.97 9.74 5.10 10.98
Time FE Yes Yes Yes Yes Yes Yes
Country FE Yes Yes Yes Yes Yes Yes
Observations 153 153 153 153 153 153
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
Table 5. Effects of Income Inequality on GDP per capita: The Role of Initial Income
23
(Pre- vs. Post-1990 Period)
Dependent Variable is: ln(GDP per capita)
Panel A: Post-1990
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 21.39*** -66.45*** -71.98*** -72.52*** -116.97*** 28.95***
(3.80) (11.75) (12.99) (17.04) (28.75) (5.60)
Inequality * ln(GDP per -3.50*** 10.20*** 11.53*** 11.73*** 19.58*** -4.81***
capita in 1970) (0.65) (1.84) (2.14) (2.85) (4.73) (0.91)
Lagged ln(GDP per 0.42*** 0.36*** 0.41*** 0.45*** 0.53*** 0.44***
capita) (0.08) (0.07) (0.07) (0.08) (0.10) (0.08)
Kleibergen Paap F-Stat 67.34 129.80 93.85 49.81 28.94 54.04
Time FE Yes Yes Yes Yes Yes Yes
Country FE Yes Yes Yes Yes Yes Yes
Observations 292 292 292 292 292 292
Panel B: Pre-1990
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 42.00*** -121.10*** -96.34*** -167.50*** -96.89** 52.72*
(19.94) (44.43) (30.91) (81.26) (48.97) (27.78)
Inequality * ln(GDP per -6.09** 17.15*** 13.78*** 24.03** 13.59** -7.67**
capita in 1970) (2.78) (6.05) (4.23) (11.37) (6.81) (3.89)
Lagged ln(GDP per 0.66*** 0.68*** 0.65*** 0.70*** 0.60*** 0.65***
capita) (0.17) (0.12) (0.12) (0.18) (0.17) (0.18)
Kleibergen Paap F-Stat 6.92 17.52 23.06 6.80 7.46 5.30
Time FE Yes Yes Yes Yes Yes Yes
Country FE Yes Yes Yes Yes Yes Yes
Observations 202 202 202 202 202 202
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
24
Table 6. Effects of Income Inequality on Investment: The Role of Initial Income
Dependent Variable is: Investment/GDP
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 6.63*** -18.83*** -20.40*** -25.72*** -28.12*** 8.83***
(1.74) (5.02) (5.44) (6.52) (8.74) (2.36)
Inequality * ln(GDP per -1.01*** 2.76*** 3.06*** 3.87*** 4.17*** -1.35***
capita in 1970) (0.26) (0.73) (0.81) (0.98) (1.34) (0.36)
Kleibergen Paap F-Stat 34.28 64.05 43.31 34.34 15.80 27.83
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 494 494 494 494 494 494
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10 percent significance
level, ** 5 percent significance level, *** 1 percent significance level.
25
Table 7. Effects of Income Inequality on Human Capital: The Role of Initial Income
Dependent Variable is: Average Years of Schooling
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 18.92** -33.20 -63.65** -87.34** -60.48 26.43**
(9.62) (29.58) (30.79) (35.97) (41.11) (12.65)
Inequality * ln(GDP per -3.22** 5.73 10.89** 14.68** 9.55 -4.47**
capita in 1970) (1.49) (4.38) (4.74) (5.54) (6.27) (1.97)
Kleibergen Paap F-Stat 34.28 64.05 43.31 34.33 15.80 27.83
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 494 494 494 494 494 494
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10 percent significance
level, ** 5 percent significance level, *** 1 percent significance level.
26
Table 8. Effects of Income Inequality on Human Capital: The Role of Initial Income
(Robustness Alternative Measures of Human Capital)
(1) (2) (3) (4)
Dependent Variable is Secondary Completed Tertiary Education Completed Tertiary
Share of Population with: Education Secondary Education Education
Gini 2.80** 2.57*** 1.48** 0.81**
(1.12) (0.89) (0.57) (0.31)
Gini * ln(GDP per capita -0.45** -0.41*** -0.22** -0.12**
in 1970) (0.17) (0.14) (0.09) (0.04)
Kleibergen Paap F-Stat 34.28 34.28 34.28 34.28
Country FE Yes Yes Yes Yes
Time FE Yes Yes Yes Yes
Observations 494 494 494 494
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10 percent significance
level, ** 5 percent significance level, *** 1 percent significance level.
27
Table 9. Effects of Income Inequality on GDP per capita: The Role of Initial Human Capital
Dependent Variable is: ln(GDP per capita)
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 2.57*** -9.27*** -9.36*** -9.25*** -10.36*** 3.13***
(0.48) (1.84) (1.56) (1.84) (2.08) (0.61)
Inequality interacted with -0.49*** 1.55*** 1.68*** 1.74*** 2.00*** -0.62***
Years of Schooling in 1970 (0.09) (0.31) (0.30) (0.38) (0.45) (0.13)
Lagged ln(GDP per capita) 0.75*** 0.76*** 0.75*** 0.74*** 0.73*** 0.75***
(0.04) (0.04) (0.04) (0.04) (0.04) (0.04)
Kleibergen Paap F-Stat 870.24 1785.57 1708.59 996.34 576.55 662.74
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 494 494 494 494 494 494
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
28
Table 10. Effects of Income Inequality on GDP per capita: The Role of Initial Human Capital
(Robustness Asia, LAC, Pre vs. Post 1990 Period)
Dependent Variable is: ln(GDP per capita)
(1) (2) (3) (4)
Asia LAC Pre 1990 Post 1990
Gini 2.61*** 9.92*** 3.19*** 2.06***
(1.04) (2.26) (1.20) (0.52)
Gini interacted with Years -0.60** -2.07*** -0.71*** -0.43***
of Schooling in 1970 (0.26) (0.48) (0.24) (0.13)
Lagged ln(GDP per capita) 0.83*** 0.48*** 0.60*** 0.39***
(0.07) (0.08) (0.10) (0.07)
Kleibergen Paap F-Stat 165.82 83.86 147.61 690.90
Country FE Yes Yes Yes Yes
Time FE Yes Yes Yes Yes
Observations 87 130 202 292
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
29
Table 11. Effects of Income Inequality on GDP per capita:
(Interaction Model with Initial Human Capital and Government Size)
Dependent Variable: ln(GDP per capita)
(1) (2) (3) (4) (5) (6)
Inequality Variable is: Gini 1st Quintile 2nd Quintile 3rd Quintile 4th Quintile 5th Quintile
Inequality 2.84*** -10.42*** -9.33*** -8.58*** -9.45*** 3.29***
(0.50) (1.83) (1.51) (1.56) (2.15) (0.61)
Inequality interacted with Years -0.22*** 0.82*** 0.69*** 0.66*** 0.83*** -0.25***
of Schooling in 1970 (0.05) (0.18) (0.17) (0.23) (0.38) (0.07)
Inequality interacted with -9.71*** 39.74*** 32.46*** 31.23** 33.59** -11.23***
Government Cons./GDP in 1970 (3.34) (11.01) (11.19) (12.29) (13.07) (4.03)
Lagged ln(GDP per capita) 0.74*** 0.76*** 0.74*** 0.74*** 0.75*** 0.74***
(0.04) (0.04) (0.04) (0.04) (0.04) (0.03)
Kleibergen Paap F-Stat 44.43 105.45 70.32 39.29 17.24 29.86
Country FE Yes Yes Yes Yes Yes Yes
Time FE Yes Yes Yes Yes Yes Yes
Observations 494 494 494 494 494 494
Note: The method of estimation is two-stage least squares. Huber robust standard errors (shown in parentheses) are clustered at the country level. The
instrument for income inequality is the residual variation in inequality that is not due to GDP per capita. *Significantly different from zero at the 10
percent significance level, ** 5 percent significance level, *** 1 percent significance level.
30
Appendix Table 1. Descriptive Statistics
Variable Source Mean Standard deviation
Gini Brueckner et al. (2014) 0.39 0.11
1st Quintile Income Share Brueckner et al. (2014) 0.07 0.02
2nd Quintile Income Share Brueckner et al. (2014) 0.11 0.03
3rd Quintile Income Share Brueckner et al. (2014) 0.15 0.03
4th Quintile Income Share Brueckner et al. (2014) 0.21 0.02
5th Quintile Income Share Brueckner et al. (2014) 0.46 0.10
Gini WDI (2014) 0.41 0.11
1st Quintile Income Share WDI (2014) 0.06 0.02
2nd Quintile Income Share WDI (2014) 0.10 0.03
3rd Quintile Income Share WDI (2014) 0.15 0.02
4th Quintile Income Share WDI (2014) 0.21 0.02
5th Quintile Income Share WDI (2014) 0.48 0.08
Ln GDP per capita Heston et al. (2012) 6.82 1.09
Investment/GDP Heston et al. (2012) 0.23 0.09
Average Years of Schooling Barro and Lee (2010) 6.45 2.67
Share of Pop. Secondary Education Barro and Lee (2010) 0.32 0.17
Share of Pop. Completed Secondary Education Barro and Lee (2010) 0.15 0.11
Share of Pop. Tertiary Education Barro and Lee (2010) 0.08 0.07
Share of Pop. Completed Tertiary Education Barro and Lee (2010) 0.05 0.04
31
Appendix Table 2. List of Countries in Sample
Albania Nicaragua Norway
Algeria Niger Pakistan
Australia Guatemala Panama
Austria Guyana Papua New Guinea
Bangladesh Haiti Paraguay
Barbados Honduras Peru
Belgium Hungary Philippines
Benin India Poland
Bolivia Indonesia Portugal
Botswana Iran Republic of Moldova
Brazil Ireland Rwanda
Bulgaria Israel Senegal
Burundi Italy Sierra Leone
Cambodia Jamaica Singapore
Cameroon Japan South Africa
Canada Jordan Spain
Central African Republic Kenya Sri Lanka
Chile Korea, Rep. Swaziland
Colombia Laos Sweden
Congo, Rep. Lesotho Switzerland
Costa Rica Liberia Tanzania
Cote dIvoire Luxembourg Thailand
Cuba Malawi Togo
Denmark Malaysia Trinidad and Tobago
Dominican Republic Mali Tunisia
Ecuador Mauritania Turkey
Egypt, Arab Rep. Mauritius USA
El Salvador Mexico Uganda
Fiji Mongolia United Kingdom
Finland Morocco Uruguay
France Mozambique Venezuela
Gabon Namibia Vietnam
Gambia Nepal Zambia
Ghana Netherlands Zimbabwe
Greece New Zealand
32