Inequality and growth

Working Paper 2019-501

Abstract

A fundamental unsolved question in economics is whether inequality is good or bad for growth. We argue here that this lack of consensus is due to the cholesterol hypothesis. This hypothesis states that the part of inequality generated by factors beyond the individuals’ control, referred to as inequality of opportunity (IO), is growth-deterring, while the type of inequality generated by the difference in the willingness to exert effort, referred to as inequality of pure effort (IE), is growth-enhancing. We first build an overlapping generation model with human capital to derive a reduced-form growth equation consistent with this hypothesis, and the existing interaction between poverty and inequality. Then, given the inherent difficulty to decompose total inequality into IO and IE, we develop a strategy to test the cholesterol hypothesis: by extending the standard inequality-growth equation with a proxy of IO, the estimated coefficient of inequality must increase, while the coefficient of the IO proxy must be negative. Next, we use the best available data at worldwide level and, given the limitations of the existing IO indices, we construct an alternative proxy of IO by considering that the quality of institutions and ethnic and religious tensions are relevant macroeconomic drivers of IO. Using an instrumental variable approach and different samples and IO measures, our results do not reject the cholesterol hypothesis at worldwide level.

Authors: Gustavo A. Marrero, Juan Gabriel Rodríguez.