Growth Theory
A case for equality

Economic growth varies substantially across countries and time periods, and it is largely determined by the accumulation of physical and human capital and potentially productive knowledge. Individuals' incentives for productive accumulation depend on their abilities privately to appropriate the fruits of their efforts, so inequality of income distribution is detrimental to growth if distributional conflict gives rise to tax and regulatory policies that reduce the scope for private appropriation. While the recent literature on endogenous growth has emphasized the importance of policy but neglected its linkages with distribution and politics, the corresponding literature on the theory of endogenous policy has emphasized the importance of distribution but neglected its effects on growth.
In Discussion Paper No. 581, Research Fellows Torsten Persson and Guido Tabellini combine insights from both strands in the literature to formulate a two-period, overlapping generations model in which policy is purely redistributive. The older generation accumulates a stock of capital that has a positive externality on the income of the new-born generation. This may be interpreted as physical or human capital that has a `knowledge spillover' on the basic skills of the young or more usefully as a measure of knowledge that promotes technical progress. In this case owners of `capital' earn monopoly rents from their earlier investment in knowledge accumulation, while the policy variable represents regulatory policies: it is an index of individuals' ability privately to appropriate these returns.
Persson and Tabellini define a `politico-economic equilibrium' as a policy that cannot be defeated in a majority vote of all enfranchised citizens and a set of their optimal private economic decisions such that markets can clear. Voters face a trade-off: an increase in the policy variable redistributes income and welfare but diminishes investment and hence the base for redistribution. A median voter who also happens to be an average investor will prefer a non-redistributive policy, while a median voter who is poorer (richer) than average will prefer a tax (subsidy) on investment. For a given country, this theory predicts that a more equal distribution or a higher average level of basic skills will increase growth, as will greater political participation by the rich or reduced political participation by the poor.
Persson and Tabellini then test these predictions empirically on historical data dating back to the midnineteenth century from the US and eight European countries and on post-war data from a broad cross-section of developed and less developed countries. They find a strong negative relation between initial income inequality and subsequent growth; but for the broader sample it is present only for democratic countries as the theory predicts.

Is Inequality Harmful for Growth? Theory and Evidence
Torsten Persson and Guido Tabellini

Discussion Paper No. 581, October 1991 (IM)