Does Income Inequality Reduce Growth?

Abstract

This paper examines the effects of inequality on the rate of growth of an economy. We assume that it is easier for an individual to achieve a given level of human capital the higher society's average level of human capital. Agents with above average human capital find it relatively more costly to acquire additional human capital, while agents with below average human capital find it relatively cheaper to acquire additional human capital. The existence of such an externality implies that even when there is no income inequality agents will behave inefficiently. In order to achieve the optimal growth rate, a lump sum tax must be combined with a subsidy to investment in education. When incomes are heterogenous, we show that income convergence is attained in the long run. We also show that the effect of inequality on the growth rate of an economy depends on the functional form of the externality. When the externality function is concave, income dispersion reduces the rate of growth. On the other hand, when the externality function is convex, the effect is ambiguous.