INEQUALITY AND GROWTH IN THE UNITED STATES: EVIDENCE FROM A NEW STATE‐LEVEL PANEL OF INCOME INEQUALITY MEASURES

I. INTRODUCTION Rising income inequality in the United States over the past quarter century is well documented (see, e.g., Gottschalk 1997; Krueger 2003; Levy and Murnane 1992; Piketty and Saez 2003). Whether and by how much this change in inequality is associated with a change in economic performance is an important question, yet recent empirical work has been largely inconclusive. Positive relationships between income inequality and economic growth have been found by Partridge (1997, 2005) using a panel of states and by Forbes (2000) using a panel of countries. Empirical work by Panizza (2002) and Quah (2001), however, has found little or no stable relationship between inequality and growth; the results appear to be extremely sensitive to the econometric specification. Additionally, Barro (2000) has found evidence that the relationship is nonlinear, with inequality being positively related to growth among wealthier countries like the United States but negatively related to growth among low-income countries. Much of this recent empirical literature was initiated by the important work of Deininger and Squire (1996), who constructed a large cross-national panel of inequality measures containing several time-series observations for each nation spaced over multiple decades. A parallel empirical literature also emerged using U.S. state-level data, with income inequality measures typically spaced at 10-yr intervals (see, e.g., Panizza 2002; Partridge 1997, 2005). Both the state-level and the cross-national empirical literatures benefited by exploiting the more advanced panel data econometrics afforded by the large-N, small-T panel dimensions. In this paper, we offer a new, more comprehensive panel of state-level income inequality measures and use this panel to reevaluate the empirical inequality-growth relationship. (1) This panel has the unique feature of being large in both N and T, with annual observations of the 48 contiguous states for the entirety of the postwar period 1945-2004. For nearly all the states in the panel, the share of income held by the top decile experienced a prolonged period of stability after World War II, followed by a substantial increase during the 1980s and 1990s. These state-level trends appear to closely replicate the overall trends in aggregate U.S. inequality found by Piketty and Saez (2003). Exploiting the large and balanced size of our inequality panel, we explore the long-run relationship between inequality and growth via three alternative dynamic panel error-correction estimators: the fixed effects (FE) estimator, the mean group (MG) estimator of Pesaran and Smith (1995), and the pooled MG estimator of Pesaran, Shin, and Smith (1999). The greater homogeneity of state-level data helps mitigate the difficulty in adequately capturing structural differences across international panels of earlier studies such as Forbes (2000) and Barro (2000). Corruption levels, labor market flexibility, tax neutrality, tradition of entrepreneurship, and many other factors are only poorly measured, if at all (Barro 2000, 1011), and these sources of heterogeneity are much more likely to contribute to omitted variable bias across countries than across states. The results from our analysis indicate that the long-run relationship between the top decile share of income and economic growth is positive in nature. Moreover, an evaluation of several alternative income inequality measures suggests that this positive relationship is driven primarily by the concentration of income in the upper end of the income distribution. The structure of the paper is as follows. Section II presents the new panel of annual state-level inequality measures and includes an important discussion of its key limitations. Section III then offers an empirical investigation on the impact of income inequality on the growth rate of real income per capita. Finally, Section IV offers a brief set of conclusions. …