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# **1. Introduction**

Although the question of whether inequality may have a detrimental effect on subsequent economic growth has been asked many times, there is no consensus answer in the literature. Theory provides ambiguous predictions: whereas higher inequality may lead to faster growth through some channels (such as higher aggregate savings when a greater share of income accrues to the rich), it may have negative effects through other channels (such as lower aggregate rates of investment in human capital if credit constraints prevent the poor from financing an optimal amount of education).

The empirical evidence has been correspondingly mixed. The earliest crop of papers including measures of income inequality in growth regressions, in the 1990s, tended to find a negative and statistically significant coefficient, which was widely interpreted to suggest that the theoretical channels through which inequality was bad for growth dominated those through which there might be positive effects. But all of these studies relied on OLS or IV regressions on a single cross-section of countries. Using the “high-quality” subset of the Deininger and Squire (1996) dataset, which permitted panel specifications, Forbes (2000) and Li and Zou (1998) found positive effects of lagged inequality on growth, and suggested that omitted (time-invariant) variables may have biased the OLS coefficients. Banerjee and Duflo (2003) raised further questions about the credibility of the earlier results – whether drawing on single cross-sections or on panel data – by showing that if the true underlying relationship between inequality (or its changes) and growth was non-linear, this would suffice to explain why the previous estimates were so unstable. The prevailing conclusion from these disparate results, as summarized by Voitchovsky (2009), was that “recent empirical efforts to capture the overall effect of inequality on growth using cross-country data have generally proven inconclusive”. (p. 549) And yet, the question continues to motivate researchers and policymakers alike. Asking what might explain the absence of poverty convergence in the developing world, Ravallion (2012) revisits the effects of the initial distribution on subsequent growth, and claims that a higher initial level of poverty – not inequality – is robustly associated with lower economic growth. In remarks delivered at the Center for American Progress in 2012, Alan Krueger, Chairman of the Council of Economic Advisers to the US president, claimed that “the rise in inequality in the United States over the last three decades has reached the point that inequality in incomes is causing an unhealthy division in opportunities, and is a threat to our economic growth” (Krueger, 2012).<sup>2</sup> The conjecture that an “unhealthy division of opportunities” might be bad for growth is consistent with some of the theory: if production sets are non-convex and credit markets fail, the poor may be prevented from choosing privately optimal levels of investment – in human or physical capital (Galor and Zeira, 1993). Others have suggested that low levels of wealth are associated with reduced returns to entrepreneurial effort as a result of the need to repay creditors. This moral hazard is anticipated by lenders, leading to credit market failures and differences in the entrepreneurial opportunities available to rich and poor agents (Aghion and Bolton, 1997).

> 2 Voitchovsky (2009) also suggests that the link between income and wealth inequality and growth might operate through the distribution of opportunities: “... income or asset inequality is considered to reflect inequities of opportunity.”(p.550)