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Impact of Income Distribution on Economic Growth
Impact of Income Distribution on Economic Growth
  • Table of Contents

    Chapter 1. Introduction

    Chapter 2. Review of Relationship between Income Distribution and Economic Growth

    Chapter 3. The Model

    Chapter 4. Analysis of the Impact of Income Distribution on Economic Growth  

    Chapter 5. Conclusions and Policy Implications



    Since Kuznets' work on economic growth and income inequality in 1955, there is more or less an academic consensus on how income distribution changes at different stages of economic growth. However, debate still continues on how income inequality affects economic growth. It is because of a dual causality between economic growth and income distribution; as an economy grows, its income inequality changes, which in turn affects economic growth. This study takes into account the dual causality as it analyzes the impact of income distribution on growth of an economy.


    This study adopts the endogenous growth model that includes capital, technology, and human capital. It also uses the framework of an overlapping generation model, but expands the time periods allowed to an agent from two in the general version to three with the addition of the time for education to accumulate human capital. Agents sell their labor and human capital to earn wages in the second period. In the last period, each agent chooses its occupation between an entrepreneur and a lender, and spend profits or interests for consumption and investment in children’s education. This study is to propose a growth model of the dual causality to investigate how initial income distribution, tax systems, and redistribution policies affect economic growth. We assume that the marginal return for both capital and education (or human capital) is diminishing.


    Agents save all their wage income in the second period. Each agent in the third period chooses its occupation between an entrepreneur and a lender. An entrepreneurs borrows savings from lenders and initiates an investment, and a lender receives interests from entrepreneurs. The basic premise of economic development theories is that large investments and big firms employ more productive technologies, so in the model, the productivity allowed to an entrepreneur depends on the amount of capital that the agent can invest. For simplicity, it is assumed that there are only two types of investment, a less productive investment and a productive one. The size of investment required to run the productive investment is called the threshold capital.


    The wage is an increasing function of human capital and (physical) capital, so an agent with high level of human capital receives more than one with low level of human capital. At an optimum, the marginal product of each worker should be the same across all agents with different levels of human capital. Given capital level, high human capital produces more marginal product of capital, thus more capital is assigned to agents with high human capital to equalize the capital’s marginal product. Since wages are increasing in capital, the wage gap among workers gets widened due to the capital reallocation among heterogeneous workers. The income gap affects the available investment types, the amount of profit and interest income, and the amount of human capital investment to their children in the third period. It is highly unlikely for an income gap to be reduced in the model without government interventions.


    In low-income countries, most agents initiate small-size and low-productivity investment due to low level of income. In these economies, if unequal income distribution allows a few agents to run the large-size and high-productivity investment, it promotes economic growth. It is different in high-income countries where most agents have enough capital to run a productive investment. If income is unequally distributed in those countries, some agents cannot initiate the productive investment, and overall growth rates decrease. In this case, more equal distribution encourages rapid economic growth. It thus reveals a dual causality between income inequality and economic growth. Kuznets' theory shows how income inequality changes as an economy develops; economic growth first increases and later decreases economic inequality. This study shows the same relation between the two in a reverse way; high inequalities can stimulate economic growth in the early stage of development, and low inequalities help an economy maintain growth when the economy’s average income is high.


    There are two types of tax, an income tax and a corporate tax, in the model. Taxation on wages income reduces savings and lowers capital accumulation, and it can cause a productivity switch from a productive investment to an unproductive one in case there are agents whose pre-tax wages are greater than the threshold capital but fall below it after paying taxes. If the tax burden is not too excessive as to cause the productivity switch, the tax policy will not affect economic growth. Income tax in the model, therefore, has conditional growth effects. In contrast, taxation on capital gain, both profits for entrepreneurs and interests for lenders, has a direct impact on consumption and human capital investment, but not on savings and capital accumulation. A decrease in human capital investment pulls down long-run growth rates, so taxation on capital income has unconditional growth effects. Since consumption is a key measure of welfare, taxation on capital income shrinks the level of welfare by lowering consumption.


    It is assumed that tax income is redistributed to agents as a form of income transfer, and a government does not spend tax revenue on public production or investment. If tax revenue is transferred to agents in periods 1 and 3, the human capital investment is augmented. A transfer to workers in period 2, it works like the government do public savings to promote capital accumulation. Without government expenditure, any redistribution policies increase at least one of the three parameters; physical capital accumulation, human capital investment, or welfare, and spur growth.


    The aforementioned dual causality between growth and distribution implies that some low-income countries might fall into poverty traps arising from the initial income distribution. Previous studies pointed to human capital, corruption and the production function as a source of income disparity among countries, and this study finds the initial income distribution state can also explain income disparities and poverty traps. 

Hyeongjun Bang's other publications : 3
{Research Series} posts
No Title Author Date Attach
3 Impact of Income Distribution on Economic Growth Hyeongjun Bang December 28, 2018 Impact of Income Distribution on Economic Growth
2 Innovative SMEs and Youth Job Creation Yoon-Gyu Yoon, Hyeongjun Bang, Yongjin Nho December 28, 2018 Innovative SMEs and Youth Job Creation
1 Gender Wage Gap by Lifecycle: with Focus on Marriage and Childbirth Selim Choi, Hyeongjun Bang December 28, 2018 Gender Wage Gap by Lifecycle: with Focus on Marriage and Childbirth