terms of the stylized model introduced in Section II. In the model, poverty affects growth only through its negative impact on investment, and such impact arises because of the absence of well-developed capital markets. This amounts to three testable predictions. First, poverty has a negative impact on investment. Second, this is the relevant mechanism at work – i.e., once we control for investment, poverty has no significant impact on growth. Third, the adverse effect of poverty on investment is driven by financial market imperfections – with perfect capital markets, poverty should have no impact on growth. Below we test these three hypotheses. Throughout we focus on headcount poverty P0; results with the other poverty measures are qualitatively similar and thus not reported to save space.

# _V.I Income, poverty, and investment_

Before proceeding with the formal econometric tests, we document some stylized facts on investment, poverty, and income levels. Little is known about the impact of poverty on investment, and as a first approximation to the issue we follow an approach similar to that of Ben David (1995). We rank 99 countries for which we have income, poverty and investment data according to their per capita income in the mid 1990s<sup>28</sup> . Then we partition those countries into 10 groups of 10 countries each (with the exception of the last group that has 9 countries only). The poorest countries in the sample are in the first group, the next 10 countries are in group 2, and so on; thus the 10 richest countries form group 10.

Figure 1 plots median (log) income for each group (panel A), poverty (US$2 poverty line) in panel B, and gross fixed capital formation relative to GDP (GFCF) in panel C.<sup>29</sup> Inspection of this figure reveals a clear non linear pattern in the relationship between income, poverty and investment. For example, headcount poverty falls dramatically between the first and fourth group – from about 66 percent to less than 8 percent, but after that it declines much more modestly as we move further up along the income group classification. Similarly, investment increases from 14 to about 22 percent of GDP between the first and fourth group, and then remains virtually constant between the fourth and tenth group. Note that these non-linearities are not driven by the underlying income data (panel A), whose association with investment seems to be well described by a linear pattern.

As a result, there seems to be a closer association between poverty and investment than between income levels and investment. In fact, the correlation coefficient between the income series in Figure 1(a) and the investment series in Figure 1(c) is about 0.55 (i.e., investment tends to be higher in richer countries), whereas the correlation coefficient between the investment series and the poverty series in Figure 1(b) is - 0.77.

# _V.II Poverty, investment and growth_

The first issue we explore is whether investment may be the channel of transmission through which poverty affects growth. The empirical growth models estimated in the previous section follow the conventional reduced-form approach in which investment has been “substituted out”. A considerable literature, starting with the classic study by Levine

> 28 We pick the 1990s because it is the period over which more poverty observations are available.

> 29 The results remain virtually unchanged if one uses gross capital formation (GFC) as investment measure.

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