The Unassuming Economist

From a VoxEU post by Shekhar Aiyar and Christian Ebeke:

“There are contrasting theories on the relationship between income inequality and growth, and the empirical evidence is similarly mixed. This column highlights the neglected role of equality of opportunity in mediating this relationship.  Using the World Bank’s new Global Database on Intergenerational Mobility, it shows that in societies where opportunities are unequally distributed, income inequality exerts a greater drag on growth. 

Despite the firm consensus that income inequality is intrinsically undesirable, its impact on economic growth is much disputed. Simon Kuznets famously argued that inequality is beneficial for economic growth at an early stage of development, since a moneyed capitalist class can undertake more investment, but is harmful at a later stage. Others have pointed to inequality as a necessary, even desirable outcome of rewards to innovation and risk-taking. But there are also numerous theories about how income inequality can reduce investment and hinder the full realisation of human potential. As a canonical example, Galor and Zeira (1993) show that if poor families are constrained to under-invest in education, aggregate growth falls.

The empirical evidence is similarly mixed. Barro (2000) finds that for developed economies income inequality raises growth. On the other hand, Berg et al. (2012, 2018) find that income inequality tends to reduce the duration of growth spells. Forbes (2000) and Panizza (2002) find no systematic effect.

The missing link: Inequality of opportunity

In recent work (Aiyar and Ebeke 2018), we point to the neglected role of equality of opportunity in mediating this relationship. Our hypothesis is simple. In societies where opportunities are unequally distributed – where the material circumstances of parents act as binding constraints on the opportunities available to their children – income inequality exerts a greater drag on growth. Any increase in income inequality tends to become entrenched, limiting the investment opportunities – broadly defined to include investment in children – available to low-income earners, thereby retarding long-term aggregate growth. On the other hand, in societies with a more equal distribution of opportunities, an increase in income inequality can be more easily reversed and need not constrain investment opportunities and growth. To the extent that inequality of opportunity matters in this way, its omission from standard regressions of growth on income inequality leads to misspecification, which can help explain the inconclusive nature of the empirical literature to date.

We measure a society’s distribution of opportunity by the economic mobility of its people across generations. The World Bank’s new Global Database on Intergenerational Mobility (GDIM) compiles cross-country estimates of the elasticity of a son’s income (or education level) with respect to the income (or education level) of their father (Narayan et al. 2018). The higher this elasticity, the lower the degree of intergenerational mobility, which we take to signal a less equal distribution of opportunity. Because each observation requires a comparison of life-cycle income over two generations, this is a slow-moving variable whose latest value says something about societal conditions over a period of several decades. For the purpose of our study and due to data availability constraints, we take this variable to be time-invariant.”

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