THE INFLUENCE OF INCOME INEQUALITY ON ECONOMIC GROWTH IN LESS

DEVELOPED AND DEVELOPED COUNTRIES

QAISER MUNIR

PERPUST rtýr; ýa UNNERSITI MALAYSIA SABAH

THESIS SUBMITTED IN FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE

OF DOCTOR OF PHILOSOPHY

SCHOOL OF BUSINESS AND ECONOMICS UNIVERSITI MALAYSIA SABAH

2007

UNIVERSITI MALAYSIA SABAH

BORANG PENGESAHAN STATUS TESISO

JUDUL : THE INFLUENCE OF INCOME INEQUALITY ON ECONOMIC GROWTH IN LESS DEVELOPED AND DEVELOPED COUNTRIES

IJAZAH : SARJANA DOKTOR FALSAFAH, EKONOMI (EKONOMI PEMBANGUNAN)

SESI PENGAJIAN : 2003-2007

Saya, QAISER MUNIR mengaku membenarkan tesis Sarjana ini disimpan di perpustakaan Universiti Malaysia Sabah dengan syarat-syarat kegunaan seperti berikut:

1. Tesis adalah hakmilik Universiti Malaysia Sabah 2. Perpustakaan Universiti Malaysia Sabah dibenarkan membuat salinan untuk

Tujuan pengajian saya. 3. Perpustakaan dibenarkan membuat salinan tesis ini sebagai bahan pertukaran

Antara institusi pengajian tinggi 4. TIDAK TERHAD

Disahkan oleh

(Penulis: QAISER MUNIR)

Alamat: C22-21, Lorong 20, Taman Indah permai, 88899, Kota Kinabalu. Sabah, MALAYSIA.

Tarik: 27 July 2007

PROF MADYA pit. %ASIM Rl. MD. MANSUR

Universiti !N Sekolah Pcrn4lÄan & Ekon Dekan

(Penyelia: , Prof. Madya Dr. Kasim Hj. Md. Mansur)

CATATAN :@ Tesis dimaksudkan sebagai tesis Ijaza Doktor Falsafah dan Sarjana secara penyelidikan atau disertassi bagi pengajian secara kerja kursus dan penyelidikan, atau Laporan Projek Sarjana Muda (LPSM)

DECLARATION

The material used in this thesis are original except for quotation, excerpts, summaries and references, which have been duly acknowledged.

QAISER MUNIR PS03-002-068(A) [DATE : 25"JULY 2007]

i

ACKNOWLEDGEMENTS

All praise and thanks to Almighty Allah, for given me strength to carry on. Now that I am

close to the final stage, I wish to thank the people who took me through these years.

First and foremost, I am grateful to my supervisor, Dr. Kasim Hj. Md. Mansur. Without

his continuous support, encouragement, and valuable comments, this research project

would be impossible.

I really acknowledge the Universiti Malaysia Sabah (UMS), which granted me the

scholarship to pursue my studies at this level. Without this support I may not be able to

overcome my financial expenses and continue my research project.

Shazia, my life-partner and best friend, whom I love and cherish more than

anything. She always supported and encouraged me so that I was able to overcome

many challenges. Without her support, I cannot say where I would be now. Shazia thank

you for being there for me always, you have made this and every other issue in my life

worth fighting for it.

Last but most deserved, I thank my parents, in-Laws, bothers, sister, and friends

although, they are not here to observe my accomplishments, and I wish to recognize the

impact they have had on my life. They always taught me the importance of obtaining a

good education. They supported my education to the highest level despite difficult

circumstances back at home; I sincerely appreciate and hope that this degree will make

them proud.

Finally, I would like to thank the staff at the School of Business and Economics

(SBE), Universiti Malaysia Sabah, for their help and cooperation throughout my stay in

the doctoral program.

I thank Almighty Allah for letting me meet these wonderful people and for

making this research a success.

ii

ABSTRAK

Dalam memblcarakan hal-hal berhubung dengan ekonomi, sosial, politik dan moral perkara yang sering diberi perhatian o%h sesebuah negara is/ah ketidaksamaan pengagihan pendapatan. Pengag/han pendapatan yang adil merupakan isu yang semakin mendapat perhatian sepanjang masa. Meskipun terdapat banyak penulisan dibuat tentang ketidakseimbangan pertumbuhan, terdapat masih banyak perbezaan pendapat tentang impak terhadap pertumbuhan yang tidak seimbang. Kajian ini mel/hat dan menilai semula empirik hubungan antara ketidakseimbangan pendapatan dan pertumbuhan ekonomi dengan menggunakan pendekatan data panel yang merangkumi 56 buah negara dar/ tahun 1960 - 2000. Tidak seperti pendekatan-pendekatan yang lepas, kajian /ni menggunakan pendekatan yang terbaik setakat /ni iaitu Generalized Method of Moments (GMM) ke atas data penal dinamik, seperti differenced-GMM estimator yang diperkenalkan o%h Arellano dan Bond (1991) dan akhir-akhir ini diperkembangkan lagi oleh Blundell dan Bond (1998). Penggunaan GMM da/am membuat penganggaran mempunyai banyak faedah da/am menangani berlaku kemungkinan ke atas Country-Specific Fixed effects sepert/ geographical dan c/ri-c/ri Institusi time ivanant. Di samping itu, penganggaran /ni sesuai untuk menangani Omitted Variable bias disebabkan kesan daripada perbezaan waktu antara negara- negara tertentu dan juga menangani isu-isu luaran (endogeneity) dan kesilapan pengukuran da/am regresi. Kajian ini menunjukkan bahawa pengaruh ketidaksamaan pendapatan atas kadar pertumbuhan per kapita benar GDP secara signifikan negatif. Keputusan /n/ adalah berkesan untuk sees/fikasi perbezaan dan kaedah penganggaran yang memberikan keputusan konfl/k da/am kaj/an yang berbeza, dengan tidak mengambilk/ra sumber data yang yang sama. Impak negatif ketidaksamaan atas pertumbuhan ada/ah /ebih /emah dan positif, dan tidak signifikan secara statistik untuk negara maju; walaubagaimanapun, /a tetap dan negatif serta berkesan untuk negara sedang maju. Kajian /n/ juga mengenalpasti kesamaan pendapatan adalah berkolerasl dengan pertumbuhan secara pos/t/f. Kajian-kajian terdahu/u tentang ekonomi pollt/k mempostulatkan dua saluran utama yang menyambungkan ketidaksamaan kepada pertumbuhan yang lebih rendah. Kaj/an in/ memeriksa semula pendekatan pendekatan /nl dan mendapat/ bahawa ketidaksamaan pendapatan membangkitkan tegangan sos/al dan politik da/am masyarakat dan membawa kepada ketidaktentuan sosial polit/k dan ekonomi yang me%set. Has/l penemuan menyokong kepada pendekatan pertama, /a/tu ketidakstabilan sos/al-politik. Akh/mya, dalam rangka kerja, pendekatan yang kedua, keputusan kajian /ni tidak menyokong hipotesis pengund/ median' (hypothesis med/an voter). Keputusan ramalan pendekatan ini dengan kuatnya mencadangkan impak positif pencukaian ke atas pertumbuhan berlainan dengan seperti mana yang dirama/kan o%h teorl, iaitu negatif. Teon pengundi median' (median voter) da/am kelakuan politikal menandakan jika pengundi median' (median voter) kurang daripada pengundi mean' (mean voter) (taburan pendapatan ada/ah secara pencong kepada positif dan lebih kepada ketidaksamaan), dengan ini, pengundi median' (median voter) akan cenderung kepada pencukaiamn yang progresif atas per/aburan yang direka untuk ditaburkan semula pendapatan melalui pembayaran pindah m/lik, yang membawa kepada pertumbuhan ekonomi per kapita GDP yang /ebih lambat. Dengan in/, disertas/ in/ memberi keputusan tidak menyokong idea bahawa kebanyakan masyarakat yang sama bertumbuh dengan cepat disebabkan mereka menghasilkan permintaan yang kurang untuk taburan semu/a dan dengan itu, keherotan akan kurang.

iii

ABSTRACT

Income inequality has long been the economic, social, political, and moral concern for countries. The issue of attaining a fair income distribution of the fruits of economic growth and development has even grown in importance through time. Despite an extensive literature on inequality and growth, there remains considerable disagreement on the effect of inequality on growth. This study attempts to empirically re-evaluate the relationship between income inequality and economic growth with dynamic panel data approach for panel of 56 countries from 1960-2000. Unlike the previous approaches, this study employ a novel approach, Generalized Method of Moments (GMM) on dynamic panel data, namely differenced-GMM estimator developed by Arellano and Bond (1991) and recently extended by Blundell and Bond (1998). Advantages of using the GMM estimators to handle the possible country -specific fixed effects such as geographical and time invariant institutional characteristics. Furthermore, these estimators appropriately deal with omitted variable bias due to time invariant country specific effect and tackle the issue of endogeneity and measurement error in the regressors. This study shows that the influenced of income inequality on growth rate of real per capita GDP is significantly negative. This result is rather robust to the use of different specifications and estimation methods that yielded conflicting results in different studies, despite having used the same data sources. This negative impact of inequality on growth much weaker and positive, and statistical insignificant, for developed countries; however, it remains and negative and robust for less developed countries. The present study also finds equality of income is positively correlated to growth. Political economic literatures postulate two major channels linking inequality to lower growth. This study re-examined these approaches and find that income inequality stimulates social and political tension in societies and in tum socio-po/i ical uncertainties depress economic growth. This findings support the first approach namely, socio political instability . Finally, in the frame work of endogenous fiscal policy, a second approach, this study's results are not supportive for "median voter hypothesis" Estimated result of this approach strongly suggests the positive impact of taxation on growth rather than negative as theory predict. The "median voter" theory of political behavior implies that if median voter is poor than mean voter (the income distribution is positively skewed and thus more unequal), then the median voter will prefer a progressive taxation on investment designed to redistribute income through higher transfer payment, which may lead to slower per capita GDP economic growth. Thus, this dissertation results do not support the idea that more equal societies grow faster because they generate fewer demands for redistribution and therefore fewer distortion.

Keywords: Income Inequality, Economic Growth, Dynamic Panel Data, Generalized

Method of Moments (GMM), Socio-Political Instability, Endogenous Fiscal Policy.

TABLE OF CONTENTS

TITLE ..........................................................................................................

DECLARATION ....................................................................................................................

ACKNOWLEDGMENT .........................................................................................................

ii

ABSTRAK ........................................................................................................................... iii

ABSTRACT .......................................................................................................................... iv

TABLE OF CONTENTS ............................................................................................. v

LIST OF APPENDICES ..........................................................................................

ix

UST OF FIGURES ................................................................................................... x

UST OF TABLES ..................................................................................................... xi

CHAPTER 1: INTRODUCTION

1.1 Problem Statements of the Study ................................................... 1

1.2 Motivation of The Study ................................................................... 6

1.3 Objectives of the study ..................................................................... 7

1.4 Limitations of the study .................................................................... 9

1.5 Significance of the study .................................................................. 9

1.6 Structure of the Study ..................................................................... 10

CHAPTER 2: LITERATURE REVIEW

2.1 Growth Models .................................................................................. 12

2.1.1 The Neoclassical Growth Models ............................................ 12

2.1.2 Endogenous Growth Models ..................................................... 14

2.2 Income Distribution ............................................................................ 17

2.2.1 Size Distribution or Factor Distribution ................................... 17

2.2.2 Income verses Wealth ............................................................. 18

2.2.3 Inequality Measures ................................................................ 20

2.2.3.1 Positive Measures .................................................... 20

2.2.3.2 The Normative Approach ......................................... 23

2.3 The Relationship between Inequality and Growth ............................ 26

2.3.1 The Influence of Economic Growth on Inequality ................ 27

2.3.2 The Influence of Income Inequality on Economic Growth ... 32

2.3.3 Direct Relationship between Inequality and Growth........... 50

CHAPTER 3: METHODOLOGY AND DATA

3.1 Model Specification ............................................................................. 64

3.1.1 Cross Section Estimation (OLS) .............................................. 66

3.1.2 Panel Data Estimation ............................................................. 67

3.1.3 Dynamic Panel Data Estimation .............................................. 75

3.1.3.1 Arellano and Bond Estimator (DIFF-GMM) ................. 77

3.1.3.2 Blundell and Bond Estimator (SYS-GMM) ................... 82

3.1.3.3 Tests for the Validity of the GMM Estimators ............. 84

3.2 The Data ................................................................................................. 85

3.2.1 Our Measure of Income Inequality ............................................ 89

3.2.1.1 Gini Index ..................................................................... 89

vi

3.2.1.2 Income Share and Kuznets Ratio ................................ 95

3.2.1.3 Theil's T Statistic .......................................................... 96

3.2.2 Income Inequality Data ........................................................... 100

3.2.3 Other Determinants of Growth ................................................ 103

3.3 The Channels through Inequality Effects Growth . 112

3.3.1 Models ....... .. 113

3.3.2 Data .......................................................................................... 117

3.3.2.1 Data of Socio-political Instability Channel ................. 117

3.3.2.2 Data for Endogenous fiscal Policy Approach ............. 118

CHAPTER 4: ESTIMATED RESULTS

4.1 Estimation Results for the Influenced of Inequality on Growth ......... 125

4.1.1 Cross-sectional Regressions.. .. 125

4.1.2 Panel Regressions 128

4.1.2.1 Estimation results with five-year intervals data 130

4.1.2.2 Estimation results with ten-year intervals data......... 138

4.2 Robustness of estimated results ......................................................... 143

4.2.1 Other measures of income inequality ..................................

144

4.2.2 Inclusion of other growth determinants... .... ....... ...................

151

4.2.3 Excluding the outliers.. - .... ....... - ................................. 160

4.3 Parameter Heterogeneity (Less Developed and Developed Countries)164

4.3.1 Non-Linearity ............................................................................... 165

vii

4.3.2 High income verses Low income countries ................................. 162

4.4 The Channels Through which Inequality Effects Growth ................... 171

4.4.1 Estimation results for Socio-political Instability .......................... 172

4.4.2 Estimation results for Endogenous fiscal Policy Approach......... 176

CHAPTER 5: SUMMARY, CONCLUSIONS AND RECOMMENDATIONS FOR FUTURE RESEARCH

5.1 Summary and Conclusions ................................................................... 182

5.2 Recommendation for Future Research ............................................. 184

REFERENCES ................................................................................................................ 194

viii

LIST OF APPENDICES

APPENDIX A VARIABLE NAMES, DEFINITIONS AND SOURCES ........................ 203

APPENDIX B COUNTRIES INCLUDED IN THE STUDY BY REGIONAL AND INCOME CLASSIFICATION BASED ON INCOME Inequality and DATA .................................................................... 210

APPENDIX C Table Cl: DESCRIPTIVE STATISTICS OF VARIABLE USED IN TABLE 4.4 WITH TEN YEAR DATA ................................

211

Table C2: CORRELATION OF VARIABLE USED IN TABLE 4.4 WITH TEN YEAR DATA

................................................ 211

Table C3: DESCRIPTIVE STATISTICS OF VARIABLE USED IN TABLE 4.8 ........................................................................ 212

Table C4: CORRELATION OF VARIABLE USED IN TABLE 4.8........ 212

Table C5: DESCRIPTIVE STATISTICS OF THE VARIABLES USED IN TABLE 4.9 and 4.10 .......................................................

213

Table C6: CORRELATION MATRIX OF THE VARIABLES USED IN TABLE 4.9 and 4.10

.................................................................... 213

Table C7: VARIABLES CLASSIFICATION and INSTRUMENTS SET FOR TABLE 4.9 and 4.10 ........................................................

214

Table C8: DESCRIPTIVE STATISTICS OF SOCIO-POLITICAL INSTABILITY INDEX VARIABLES .................... 215

Table C9: DESCRIPTIVE STATISTICS OF THE VARIABLES USED IN SOCIO-POLITICAL INSTABILITY APPROACH .................. 215

Table C10: CORRELATION MATRIX OF THE VARIABLES USED IN ENDOGENOUS FISCAL POLICY APPROACH ...................... 216

APPENDIX D The Dynamic Panel Data Estimators ................................................ 217

ix

LIST OF FIGURES

Figure 2.1: The Kuznets Inverted-U Curve ........................................................................ 27

Figure 2.2: Endogenous Fiscal Policy Approach through Inequality Affects Growth........ 34

Figure 2.3: Socio-Political Instability Channel through Inequality Affects Growth............ 43

Figure 3.1: Conceptual Framework of the Study ............................................................... 65

Figure 3.2: The Lorenz Curve ............................................................................................. 92

Figure 3.3: Scatter plot of Growth and Income inequality .............................................. 102

Figure 3.4: Scatter plot of Growth and Initial GDP .......................................................... 105

Figure 3.5: Scatter plot of Growth and Human Capital ................................................... 106

Figure 3.6: Scatter plot of Growth and Investment share .............................................. 108

Figure 3.7: Scatter plot of Growth and Inflation (CPI) .................................................... 109

Figure 3.8: Screeplot of Eigenvectors .............................................................................. 122

Figure 4.1: OLS residuals verses fitted (predicted) values .............................................. 131

Figure 4.2: A Kuznets Inverted-U Curve: Fitted Values ................................................... 168

x

LIST OF TABLES

Table 1.1: Income Inequality: Korea and Philippines............... .......................................... 2

Table 1.2: Income Inequality and Growth: Latin America Vs East Asia .............................. 3

Table 3.1: Gini Coefficient for Italy Using Lorenz Curve With 1995 Income Share Data: ................................................................................ 93

Table 3.2: Gini Coefficient for Italy Using the Brown (1994) Formula with 1995 Income Share Data: ......................................................................... 95

Table 3.3: Sample calculation of Kuznets Ratio for Italy with 1995 income share data

............................................................................................ 96

Table 3.4: Theil Index for Italy with 1995 Income share data ......................................... 98

Table 3.5: Sample calculation of the Theil Index by using Manufacturing Pay data

........................................................................................................ 100

Table 3.6: Descriptive Statistics of the Main Variables Used in Cross-Sectional Data .... 110

Table 3.7: Descriptive Statistics of main Variables Used in Five-year Panel Data set.... 112

Table 3.8: Correlation Matrix of Main Variables Used in 5-year Panel Data set ............. 112

Table 3.9: Statistical Correlation Matrix of Socio-political Variables ................................ 120

Table 3.10: Principal Component analysis .............................................. ......................... 121

Table 3.11: Descriptive statistics of the Variables Used in Endogenous Fiscal Policy Approach

................................................................................... 124

Table 4.1: Estimation Results for Income Inequality and Economic Growth in Cross-Sectional data: 1980-2000 ................................................... 126

Table 4.2: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data without Time Period Dummies .............................................................................................. 133

Table 4.3: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data with Time Period Dummies .............................................................................................. 137

Table 4.4: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Ten-Year Panel Data without Time Period Dummies

..................................................................................... 139

xi

Table 4.5: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Ten-Year Panel Data with Time Period Dummies

.............................................................................................. 142

Table 4.6: Estimation Results for Income Inequality (income share) and Economic Growth in Five-Year Panel Data: Kuznets Ratio (Top Income Quintile to the Sum of Bottom Quintiles) and Top to Bottom income Quintile

....................................................................... 146

Table 4.7: Estimation Results for Income Equality (income share) and Economic Growth in Five-Year Panel Data: Middle class .............................. 148

Table 4.8: Estimation Results for Income Inequality (Manufacturing Pay (wages)) and Economic Growth in Five-Year Panel Data: UTIP-UNIDO (Theil's Statistics)

...................................................................... 150

Table 4.9: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data: Inclusions of Other Growth Determines ........................................................................... 153

Table 4.10: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data: Inclusions of Further Growth Determines

.............................................................................. 157

Table 4.11: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data: Excluding Observations based on Expenditure or Consumption .................................. 162

Table 4.12: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data: Excluding Countries

with Minimum and Maximum Observation for Gini Coefficient ....................... 164

Table 4.13: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data: Non-Linearity .................... 167

Table 4.14: Estimation Results for Income Inequality (Gini Coefficient) and Economic Growth in Five-Year Panel Data: High Income & OECD vs. Low Income & Non-OECD Countries ........................................ 170

Table 4.15: Estimation Results for Income Inequality (Gini Coefficient) and Socio-political Instability in Five-Year Panel Data: 1960-1995 ............... 173

Table 4.16: Estimation Results for Socio-political Instability and Economic Growth in Five-Year Panel Data: 1960-1995 ................................................ 175

Table 4.17: Estimation Results for Inequality and Redistribution in Five-Year Panel Data: Endogenous Fiscal Policy Approach (Political Mechanism)....... 178

xii

Table 4.18: Estimation Results for Growth and Redistribution in Five-Year Panel Data: Endogenous Fiscal Policy Approach (Economic Mechanism) ................................................................................. 180

xiii

CHAPTER 1

INTRODUCTION

1.1. Problem Statements of the Study

The trade-off between equity and economic growth has been the long standing issue of

the theoretical and empirical studies. Every country desires to achieve high economic

growth and fair distribution of income. However, not every country succeeds in achieving

its objectives. In the 1950's and 1960's, one strand of literature has explored the trade-

off between reduced inequality and faster growth. The trade-off between augmented

growth and reducing inequality--unequal distribution of income is necessary condition for

growth, become conventional wisdom. This was mainly based on the influential work of

(Kuznets, 1955) and (Kaldor, 1956). If this is so, however, why do we find in Latin

America relatively low rates of economic growth and high inequality, and in East Asia low

inequality and rapid growth?

Before, further elaborating on the topic, (Benabou, 1996) discussed a very

famous case study of South Korea and the Philippines. Benabou (1996) pointed out that

in early 1960s, these two countries were quite similar with regards to all major economic

indicators (GDP per capita, population, average saving rates, primary and secondary

school enrollments, investment per capita, etc. ), although they differed in the

distribution of income, as we can see table 1.

I

Table 1.1: Income Inequality: Korea and Philippines

Gini Q1 Q2 Q3 Q4 Q5 II

Q3+Q4 ; Q5/Q1 Q5/Q1+Q2

1965 Korea 34.34 5.80 13.54 15.53 23.32 41.81 38.85 i 7.21 2.16 Philippines ! 51.32 3.50 12.50 8.00 20.00 56.000.50 16.00 E 3.50

1988 Korea 33.64 7.39 12.29 16.27 21.81 42.24 38.08 5.72 ] 2.15 Philippines i 45.73 5.20 9.10 13.30 119.90

1 52.50 f 33.20 110.10 13.67 Note: Q= quintile; Source: Benabou (1996)

As compared to Korea, the income distribution in Philippines was more unequal.

The Gini index of Korea was lower as compare to Philippines over next quarter of

century. Also we can see in table 1.1 the income share of the highest 20% of the

population in Philippines still higher in quarter of century which reflects higher inequality

maintained in Philippines. In Philippines the ratio of the income shares of the highest

20% to the lowest 20% or even 40% of the population was nearly twice as large as in

Korea. Over the whole period, fast growth in Korea resulted in a five-fold increase of the

out put level, while that of the Philippines barely doubled. These evidences, clearly

contradicting the prevailing argument, the countries with more unequal distribution of

incomes grew more slowly.

Table 1.2 shows the trends in income distribution and the rate of growth of per

capita income in the two regions. The clear difference between both groups of countries

is evident that on average Gini coefficient (measure of income inequality) for Latin

American countries remains high from 1960-2000. During this period of time the Gini

coefficient for East Asian countries is well below the Latin American countries. East Asian

1)

countries not only maintain low income inequality but their average annual per capita

GDP far higher than their counter parts.

Table 1.2: Income Inequality and Growth: Latin America Vs East Asia

Countries

i Bolivia Brazil Chile

Colombia Cost Rica Dom. Rep 1

Honduras

Gini Coefficient

1960- 1970- 1980- 1970 1980 1990 N/A 53.00 N/A

53.00 57.61 57.78 N/A 1 45.64 53.21

62.00 52.02 54.50

1990- 2000 48.64 59.60 57.88 51.20 46.07 50.46 54.00 48.39 54.98 49.36 N/A

53.84 52.22 39.69 33.64 48.35 45.73 39.00 30.11 48.80 42.00 40.91

1980- 1990- 1990 2000

-2.22 1.08

-0.26 1.46 1.28

_4.79 1.35 }

0.87

-0.94 1.75 {

0.80 5.12

Average Annual Per Capita GDP Growth

1960- 1970 0.60 4.23 2.19 2.23 1.85 1.75 0.91 3.43 3.28 3.73 4.10 2.95 2.60 1.50 5.97 3.08

1 1.73 8.93 6.68

_5.13 7.45 5.05

1970- 1980 2.01

1

1 ý ý

50.00 50.00 _50.00 N/A ' N/A

ý 45.00

N/A ý 61.88 i N/A Jamaica 54.31 1 51.12 N/A Mexico 55.10 i 57.60 50.00 Peru 1 61.00 55.00 49.33 TOT 1 46.02 1 51.00 1 46.09 t-4t

Venezuela 42.00 47.65 39.42 Average 52.92 52.95 49.48 Indonesia 39.90 1_37.30 42.21

Korea 34.34 33.30 1 38.63 Malaysia N/A 50.00 51.00

_ Philippines 46.14 49.39 46.08 Singapore N/A 41.00 40.69

Taiwan 32.24 29.42 27.96 Thailand 41.28 42.63 43.10

Hong Kong N/A 39.80 37.30 Average i

__M. 78 40.35 j 40.87

i ý 1

i i I 1

_5.67 1.22

_3.11 2.59 3.69 2.03

-1.14 3.27 0.45 3.77

-2.79 1.99 5.56 5.68 5.26 3.17 7.76 7.44 4.05 6.59 5.68

A

-0.25 .! -0.82 1.72 -1.05 -0.43 1.78

-3.13 2.47

-0.90 2.43

-1.36 1

-0.80 i -0.37 ý 1.59 4.08 2.45 7.32 4.67 2.92 4.19

-0.89 1.30 4.48 4.16 6.27 5.36 5.71 3.50 5.04 2.48 4.36 3.15

i

I

Note: Gini coefficients are based on income concept (see chapter 3 on adjustment from

consumption based to income based Gini). Gini Coefficient is taken in beginning of the said period. N/A denotes not available. Sources: Deininger and Squire (1996) and UNDP/World Institute of Development Economics (WIDER, 2005,2a version). Growth rates are calculated based on 1996 international (purchasing power panty adjusted, chain index) constant prices, based on the Penn World Tables 6.1. Sources: Heston, Summers, and Aten (2002).

The experience of the two regions is sufficient to reject the conventional wisdom

of a necessary link between high income inequality and higher growth. Thus, literature

published on income inequality and growth in early and mid nineteen's considers East

Asian countries classic examples. Later on, this fact triggered renewed interest on the

relationship between inequality and growth. The emerging consensus that, inequality

have a positive impact on growth and economy faces a trade-off between equity and

growth, until a 90's has been challenged by the number of cross-sectional empirical and

theoretical studies and provided the evidence that inequality has a negative impact on

growth. The new view is that there is no growth-equity trade-off. Rather, reducing

inequality enhances growth (Clark, 1995; Figini, 1998; Knowles, 2005). Theoretical

literature on the relationship between inequality and growth has identified various

channels through which initial unequal distribution of assets and income may lead to

effect subsequent growth. A vast literature is published on the topic (Perotti, 1996;

Aghion et al, 1999; Barro, 2000; and Deininger and Olinto, 2000).

First, is the endogenous fiscal policy approach, here, if the median voter's income

is less than the arithmetic mean, then the median voter might vote for redistributive

policies, in turn distortionary distributive policies negatively effect on growth (Alesina

and Rodrik, 1994 and Persson and Tabellini, 1994). However, the theoretical prediction

of the model is not supported by the empirical studies (Aghion, 1999).

Second, is socio-political instability, here, higher inequality in the distribution of

assets and income might lead to social unrest which might increase violence and theft, in

turn socio-political instability effect growth (Alesina and Perotti, 1996 and Perotti, 1996).

Though most of the empirical studies find support for this mechanism, however recent

literatures suggest weak relationship between socio-political instability and growth

(Butkiewicz and Yanikkaya, 2005).

4

Third, is the credit market imperfection, which may be caused by higher

inequality in the distribution of wealth and income. In such capital market imperfections

the poor may have limited access to credit and might be prevented from investing in

human capital or other sorts of capital (Aghion and Bolton, 1997). Most of the studies

find support for this channel, for example, Perotti (1996) finds a significant growth-

reducing effect of income inequality that increases in the presence of inefficient financial

markets. Binelli (2001) has tested the relationship between inequality and growth

through credit market imperfections in the context of a gender-sensitive model of human

capital investment, confirming the results obtained by Perotti (1996) of a significant

growth-reducing impact of income inequality in the presence of credit constraints. The

theoretical results of these models acquired great relevance since they were followed by

some empirical support. Evidence from these studies predominantly suggests that

inequality is bad for growth and there is negative and statistically significant correlation

between inequality and economic growth (Perotti, 1996 and Figini, 1998).

More recently, literature was published that questioned the evidence presented in

previous studies conducted in the 90's. This new point of view that inequality can foster

economic growth based on the empirical studies, (Li and Zou, 1998), (Barro, 2000), and

(Forbes, 2000). Their panel data estimation results show that inequality has a positive

impact on economic growth. However, recent studies findings show no overall

relationship between inequality and growth (Banerjee and Duflo, 2003). The findings of

studies recent studies re-open the debate on trade-off between inequality and growth.

The empirical literature is therefore still far from convincing to draw any definitive

conclusion around the sign of the relationship between inequality and economic growth.

5

1.2. Motivation of the study

Summarizing, it is evident that most of the studies on inequality and growth

used cross-sectional data and find negative effect of income inequality on growth in long

period of time. The major shortcomings of these studies are that most of these studies

used unreliable data on income distribution and cross-sectional frame work. The problem

with cross-sectional regression is the problem of parameter heterogeneity as reported by

(Temple, 1999). Cross-countries studies always include a very large number of countries

characterized by relevant differences in their social, political and institutional structure.

This implies that the parameter estimates obtained from a common regression are

difficult to interpret and possibly inconsistent due to omitted variable biased.

The second shortcoming that weakens the empirical results on the relationship

between income distribution and growth is the poor quality of the data on inequality.

Deininger and Squire (1996,1998) first raised this issue pointing at the inconsistency of

the existing evidence and constructed a new expanded and improved dataset on income

inequality for the period 1950- 1997. However, Deininger and Squire (1996) data

themselves have been criticized because of the heterogeneous methodologies with

which they have been constructed (Atkinson and Brandolini, 2001). Although recent

studies used high quality data on income inequality from (Deininger and Squire, 1996)

but most of the studies remains biased towards selection of countries (Forbes, 2000;

Banerjee and Duflo, 2003). This implies that exclusion of specific regions, like Sub-

Saharan Africa from the studies, show serious shortcomings of these studies.

6

The third methodological criticism to the cross-country empirical literature refers

to the possible problem of endogeneity of inequality and other variables in the growth

regression. This is particularly likely for inequality variable, since Kuznets (1955) suggest

that in early stages of economic development inequality will increase then in later stages

it decline with the process of economic development. It remains difficult, if not

impossible; to adequately address these endogeneity concerns in simple growth

regressions. Moreover, studies based on panel data render the problem of Lagged

Dependent Variable in the model, for example, one of the criticisms on the Li and Zou

(1998) study is to inclusion of lagged dependent variable in the model. Without

correcting the problem caused by lagged dependent variable in the model, estimation

results present from these models would be severely biased and inconsistent (Baltagi,

2005). Thus, (Forbes, 2000, pp, 885) suggests that it is too early, to make any firm

policy conclusions on the basis of this result. Thus,

"the relationship between inequality and growth is far from resolved, and that the further careful reassessment of the sign, direction, and strength of the linkages between these two variables is necessary"

1.3. Objectives of the study:

The empirical analysis presented here takes into account other issues not always

addressed in previous empirical work.

First, the data used in the estimation overcome the problems related to the

questionable quality of the data on income distribution, an important concern for

empirical work in this area. For this, two highly reliable and most consistent databases

7

are used i. e. Deininger and Squire, 1996 and United Nations University's World Institute

for Development Economic Research (UNU/WIDER, 2.0a, Jun 2005. This clearly

increases the number of countries of specific regions. Moreover, the availability of these

data over time allows the estimation of the model using static panel data and dynamic

panel data methods.

Second, unlike, the previous studies, this study employ relatively new estimation

methodology called Generalized Methods of Moments (GMM) in the context of dynamic

panel data. Recently, Arellano and Bond (1991) and Blundell and Bond (1998) developed

the instrumental variable estimation techniques based on GMM, which correct the

problems of endogeneity and lagged dependent variable. Although, few studies

previously used Arellano and Bond (1991) estimation method however, in our limited

knowledge, this is probably the first study in the context of inequality-growth nexus

which use Blundell and Bond (1998) estimator. Simulation studies suggest that in the

presence of highly persistent data and finite sample bias Arellano and Bond (1991)

methodology is less informative.

Using above noted shortcomings of prior studies as a starting point, the specific

questions of the study are:

1. Is influenced of income inequality on economic growth is positively

correlated?

K

2. Is the correlation of income inequality and economic growth is non-

monotonic based on the countries per capita GDP (countries classification

provided in Appendix B)?

3. Is income inequality creates uncertainty in a society, which in turns

affects economic growth negatively of a country?

4. Finally, in the context of endogenous fiscal policy approach, since in the

unequal economies the income of the "median voter" is lower than the

mean income, majority rule would dictate a high level of taxation

distribution, therefore, distortionary taxation in turn depresses economic

growth. Thus, is high income inequality creates distortionary taxation and

which in turn effect growth negatively?

1.4. Limitations of the study

There are a few limitations to the study which could be addressed in future research

once updated data become available on income inequality. First, the selection of

countries was constrained by the availability of data especially in WIDER (2005) and

Deininger and Squire (1996) databases on income distribution and from Barro and Lee

(2000) for human capital data. Second, this study covers period from 1960-2000

because due to the limited up-to-date coverages in most of the international database

related to the topic of this dissertation.

1.5. Significance of the Study

This study tends to provide the clear guidance to the policy maker about the impact of

income inequality on economic growth. more specifically, this study will provides the

9

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