The Incentive Effects of Inequality: An Experimental Investigation

[Author Affiliation]Hyejin Ku, , , , hku@fsu.eduTimothy C Salmon, , , , tsalmon@smu.edu[Acknowledgment]The authors would like to thank the National Science Foundation for research support in funding these experiments. We also thank participants at the Cornell-Edinburgh Conference on Relativity, Inequality and Public Policy; the International ESA Meeting in Washington, D.C.; the European ESA Meeting in Innsbruck; and the Conference on Aspirations and Poverty at the University of Warwick, as well participants in seminars at Virginia Commonwealth University, Carnegie Mellon University, Helmut Schmidt University, and Goethe University in Frankfurt.1. IntroductionEconomists have established many ways in which initial inequality may influence the paths of economic development. In a series of historical studies, Engerman and Sokoloff (1997, 2002, 2005) argue that the initial differences in factor endowments between North and South America contributed to the emergence of different institutions between the two regions, which in turn led to the divergence in the rates of growth. Persson and Tabellini (1994) examine more recent data and argue that there is a significant and large negative relation between inequality and growth, while Banerjee and Duflo (2003) argue that the relationship between growth and inequality is an inverted U-shaped function. Understanding the relationship between inequality and economic growth is important in the design of a broad range of economic development policies, and there is a substantial literature that investigates the mechanics behind the linkages between growth and inequality. Loury (1981), Galor and Zeira (1993), Banerjee and Newman (1993), Durlauf (1996), Benabou (1996, 2000), and Mookherjee and Ray (2003) are well-established studies in the literature, and the typical nature of the proposed linkage between inequality and either growth or persistent inequality in these papers is differential endowment or investment opportunities of agents often in the form of human capital and occupational choice.We propose a new possible linkage between inequality and growth, which may also be useful in explaining the persistence of inequality. The linkage we propose is the incentive effects of inequality from a behavioral perspective. Specifically, we argue that individuals may respond not just to the absolute return on their effort but also to their return relative to that of others. If present, this effect can lead to inequality having a direct impact on the decisions of individuals, unlike in the existing literature wherein it only alters aggregate societal outcomes. To explain the nature of the effect we investigate, suppose that, as a result of identity marks such as gender, caste, or race, an individual receives lesser rewards than others in society for the same amount of effort provided. Then, one can envision this individual eventually becoming discouraged by repeatedly facing disadvantageous inequality, and this could result in the individual exhibiting a variety of responses ranging from decreased on the job work effort to decreased human capital acquisition and decreased contributions to public goods.If such a behavioral response to inequality exists, then there are a number of important consequences associated with it. First, this effect ceteris paribus would generate a negative relationship between inequality and economic growth. There are a number of forces at play in an aggregate economy, so this is not to claim that the overall relationship between inequality and growth must be negative if this effect exists, but the partial effect of inequality on growth due to this behavioral effect would be negative. Second, separately or in addition to the theoretical models cited above, this effect could generate persistent inequality from initial idiosyncratic inequality. The reason is that even if the initial inequality were idiosyncratic, if a worker responds by exerting less effort or investing less in human capital, then this response has the potential to legitimize and then perpetuate the initially low rewards for that individual or group. …