Heterogeneity in Ability and Inheritance, Disparities, and Development

Abstract

This paper investigates the impact of income inequality on economic growth. A two-period overlapping generations model is developed where agents are heterogeneous in innate abilities and inheritance. In the first period, they receive their inheritance and their abilities are revealed. There are only two types of abilities: high and low. Individuals decide on their education level, and divide their inheritance between spending on education and saving. In the second period, individuals supply their labor and allocate the labor income and the return to their saving between consumption and bequests to their offsprings. Initial capital stock is owned entirely by the capitalists. In this context, a more equal distribution of income enhances economic growth if the economy is lower than a threshold capital-labor ratio, while income inequality has an insignificant effect above this threshold. The predictions of the model are tested empirically using the Hansen (1999) threshold estimation. The results, using a panel of 70 countries for the period 1971-1999, suggest that there is a statistically significant threshold income per capita, below which the coefficient on the relationship between inequality and economic growth is significantly negative and above which the estimate is not significant.

Keywords:

• Income inequality
• economic growth

JEL Classifications:

• D9
• D31

Acknowledgements

I thank Christopher Carroll, an anonymous referee, and participants in the Southern Economic Association Annual Meeting 2007, and California State University, Fullerton, Seminar Series. Any remaining errors are my own.

Notes

¹The introduction of technological progress that is fueled by human capital accumulation would not affect the qualitative results. If human capital accumulation is conducive for economic growth, the optimal evolution of the economy would require the fastest physical capital accumulation in early stages of development so as to raise the incentive to invest in human capital. Inequality in early stages would therefore stimulate the process of development.

²This formulation is common in the literature and suggests that individuals are ex-ante identical in their intertemporal preferences, although due to differences in income their marginal propensity to save may differ. This form is supported empirically by Altonji et al. (1997).

³300 bootstrap replications are used for each of the three bootstrap tests.

⁴300 bootstrap replications are used for each of the three bootstrap tests.