Income Inequality, Government Expenditure, and Economic Growth: Theory and Empirics

Abstract

To explain the relationship between income inequality and economic growth, we develop a computational model of endogenous growth by taking the effects of fixed government expenditure into account. With such a model, a non-linear relationship between level of income inequality and economic growth rate is identified and shown to be consistent with empirical findings reported in the literature. This relationship can be either positive or negative, depending on per capita GDP. In fact, there exists a threshold level for per capita GDP. If the per capita GDP is above this threshold, income inequality facilitates economic growth; otherwise, it hurts economic growth. The threshold point is jointly determined by income inequality level and per capita GDP. Furthermore, our model indicates that there exists a positive relation between income inequality level and per capita GDP on these threshold points. Using cross-country data, we empirically verify this relationship from the computational model. Sensitivity analysis is performed to show the robustness of our results.

Keywords: Income inequality, economic growth, government expenditure, majority voting, basic tax rate

JEL Classification: E40, O42, D60