Inequality and Economic Growth

Income Redistribution and Tax Rate

Long-run growth rates among many countries diverge. Growth rates among developing countries particularly diverge. We do not see any evidence that many countries would converge with the same growth rate in the long run. The endogenous growth model may explain why the long-run growth rate may differ among countries. In this section, we investigate this issue from the viewpoint of fiscal aspects.

An interesting fact is that the larger the inequality, the smaller the growth rate. If we trace the growth rate of a country over the long run, a country with a large degree of inequality experiences a low growth rate, while a country with a small degree of inequality experiences a large growth rate. We may explain this outcome using the endogenous growth model in the political economy.

Suppose that the actual tax rate in each country is determined by the majority rule of democracy, as explained in Chap. 12. In a country with a small degree of inequality, voters are not greatly concerned about redistribution. Thus, the tax rate is set to maximize the growth rate. However, in a country with a high degree of inequality, people want significant redistribution. In order to attain a fair outcome for income redistribution, the tax rate is set higher than the growth-maximizing rate. As a result, the economic growth rate is less in a country with higher inequality.

However, in the early stage of growth, income inequality may enhance growth, while aggressive redistribution may depress growth. This is because in the early stage of growth, it is necessary for some elite groups to learn the experiences of economic growth in developed countries. By doing so, developing countries may start to grow. If an aggressive redistribution policy is conducted in the early stage of growth, it may damage the elite. In this regard, even elite groups cannot try to learn

Fig. 5.6 Kuznets hypothesis

from developed countries. Then, all people may be equally poor and the country does not grow a great deal. The non-linear relationship between economic growth (or per capita income) and income inequality, namely the idea that growth initially enhances inequality but later reduces inequality, is called the Kuznets hypothesis (see Kuznets 1955). Figure 5.6 explains this hypothesis.

 
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