The relationship between income inequality and economic growth is both important and controversial. Knowledge of how these two variables are related is essential if a policymaker is to be able to neutralize any undesired consequences of, say, a growth-enhancing policy on the economy’s distribution of income.
Its controversy derives from the fact that it has been difficult to reconcile the different theories determining the relationship, especially since the empirical evidence has not been able to provide clear support for one or another approach. Despite the controversy, one thing is clear. Both the degree of income inequality and the growth rate are endogenous variables and thus need to be jointly determined as equilibrium outcomes within a consistently formulated macroeconomic growth model.
Empirical evidence suggests that macroeconomic volatility is potentially an important channel through which income inequality and growth may be mutually related. For example, it is well-known that the middle-income Latin American economies are associated with much greater income inequality than are the East-Asian “tigers”. In 1990, the Gini coefficients of the distribution of income in Brazil, Chile, Mexico, and Venezuela ranged between 55-64%, while those of Hong Kong, Korea, Taiwan, and Singapore, were between 30 and 41%. At the same time, the former were subject to much greater fluctuations in their respective growth rates than were the latter: during the 1980s, the standard deviation of the rate of output growth was, on average, 5.9% for the four Latin American economies, and 2.8% for the East Asian countries.
In fact, using a broader set of data, Breen and García-Peñalosa (2002) obtain a positive relationship between a country’s volatility (measured by the standard deviation of the rate of GDP growth) and income inequality. On the other hand, simple growth regressions have suggested that the mean growth rate is related to its volatility, although the results are not uniform with respect to the direction of this relationship.