2

# **1. Introduction**

The dynamic relationship between economic growth, inequality and poverty has always commanded considerable attention among economists. The nexus between growth and development on the one hand, and the distribution “of the whole produce of the earth” on the other has been central to the discipline at least since David Ricardo’s (1817) _Principles of Political Economy_ .

In the second half of the Twentieth Century, this relationship was approached from a number of different perspectives. Drawing on the seminal work of W. Arthur Lewis (1954) and Simon Kuznets (1955), one strand of the literature has investigated whether income inequality follows a particular dynamic process as economies grow. Lewis saw the process of economic development as largely driven by the transfer of productive resources from backward, low‐productivity sectors (such as subsistence agriculture) to high‐productivity sectors such as modern plantation agriculture or industry. As labor moved from the poor, but relatively egalitarian backward sectors towards the richer, but more unequal modern sector, Kuznets expected inequality first to rise and then to fall, as the share of workers in the original sector declined. The time‐series data on income inequality that was available to Kuznets in the 1950s was extremely restricted. It came from Germany, the United States and the United Kingdom. But in those countries, an “inverted U” pattern for inequality could indeed be identified, thus lending support to the Kuznets hypothesis, which came to dominate a subfield of development economics for many years to come.

In the 1990s, progress in two areas of economic theory – the consequences of asymmetric information and incomplete contracts for how credit and insurance markets function, and endogenous growth theory – combined to generate a fair amount of interest in another approach to the same broad issue. Rather than asking how growth and development affected the distribution of income, a new literature asked whether high initial levels of inequality (or poverty) might be detrimental for future growth. With missing or imperfect credit markets and non‐convex production sets, individuals with low wealth might be trapped in low‐investment equilibria, leading to divergence between the rich and the poor. Societies starting off with a greater proportion of its population in poverty (or greater inequality given a certain mean) might generate less aggregate investment, or a less advanced occupational structure, and thus lower growth rates.<sup>2</sup> Other stories linking initial income distribution to subsequent growth involved political economy channels. In one strand, higher inequality led the “median voter” to support higher rates of distortionary taxation, leading to lower growth (see, e.g. Alesina and Rodrik, 1994; and Persson and Tabellini, 1994). In another, taxation and public spending were seen instead as potentially efficient mechanisms for correcting market failures, but greater inequality in wealth and political power led to too little public investment (see, e.g., Bénabou, 2000, and Ferreira, 2001).

A considerable expansion in the availability of household survey data, particularly among developing countries, took place in tandem with these theoretical developments. Greater data availability enabled researchers to “test” the predictions of their theories on cross‐country data sets that included measures 2 See, e.g. Galor and Zeira (1993) and Banerjee and Newman (1993).