Inequality, Human Capital Formation, and the Process of Development

Abstract Conventional wisdom about the relationship between income distribution and economic development has been subjected to dramatic transformations in the past century. While Classical economists advanced the hypothesis that inequality is beneficial for economic development, the Neoclassical paradigm, which had subsequently dominated the field of macroeconomics, dismissed the Classical hypothesis and promoted the viewpoint that the study of income distribution has no importance for the understanding of macroeconomic activity and the growth process. A metamorphosis in these perspectives has taken place in the past two decades. Theory and subsequent empirical evidence have demonstrated that income distribution has a significant impact on the growth process. The modern approach has demonstrated that in the presence of credit market imperfections, income distribution has a long-lasting effect on investment in human capital, entrepreneurial activity, aggregate income, and economic development. Moreover, in contrast to the Classical viewpoint, which underscored beneficial effects of inequality for the growth process, the modern perspective advanced the hypothesis that inequality may be detrimental for human capital formation and economic development. The replacement of physical capital accumulation by human capital accumulation as the prime engine of economic growth has changed the qualitative impact of inequality on the process of development. In early stages of industrialization, as physical capital accumulation was a prime source of economic growth, inequality enhanced the process of development by channeling resources toward individuals whose marginal propensity to save is higher. However, in later stages of development, as human capital has become the main engine of economic growth, a more equal distribution of income, in the presence of credit constraints, has stimulated investment in human capital and economic growth. While the process of industrialization raised the importance of human capital in the production process, reflecting its complementarity with physical capital and technology, human capital accumulation has not benefited all sectors of the economy. Inequality in the ownership of factors of production has generated an incentive for some better-endowed agents to block the implementation of institutional changes and policies that promote human capital formation, resulting in a suboptimal level of investment in human capital from a growth perspective. The transition from an agricultural to an industrial economy changed the nature of the main economic conflict in society. Unlike the agrarian economy, which was characterized by a conflict of interests between the landed aristocracy and the masses, the process of industrialization has brought about an additional conflict between the entrenched landed elite and the emerging capitalist elite. In light of a lower degree of complementarity between human capital and the agricultural sector, education has increased the productivity of labor in industrial production more than in agricultural and primary good production, inducing rural-to-urban migration and a decline in the return to landowners. Thus, while industrialists have had a direct economic incentive to support education policies that would foster human capital formation, landowners, whose interests lay in the reduction of the mobility of their labor force, have favored policies that deprived the masses of education. The adverse effect of the implementation of public education on landowners' income from agricultural production has been magnified by the concentration of land ownership. As long as landowners affected the political process and thereby the implementation of growth-enhancing education policies, inequality in the distribution of land ownership has been a hurdle for human capital accumulation, slowing the process of industrialization, and the transition to modern growth. Variation in the distribution of ownership over land and other natural resources across countries has contributed to disparity in human capital formation and the industrial composition of the economy, and thus to divergent development patterns across the globe. Moreover, in some societies, geographical conditions that led to income inequality brought about oppressive institutions designed to maintain the political power of the elite and to preserve the existing inequality.