There are clashing views on the relationship between income inequality and growth. Some have pointed to at least some measure of inequality as a necessary outcome of the rewards to innovation and risk-taking. Others have argued that excessive income inequality depresses investment in both human and physical capital, two key sources of long-term growth.
In recent research we argue that the crucial missing link in the inequality-growth relationship is inequality of opportunity.
Opportunity acts as an umpire in the relationship between income inequality and long-term growth.
In societies where opportunities are unequal, including across generations, an increase in income inequality tends to become entrenched, which limits the potential and prospects of low-income earners, and stymies long-term growth.
Our chart of the week shows how inequality of opportunity acts as an umpire in the relationship between income inequality and long-term growth.
We use data on inequality of opportunity from the World Bank’s Global Database on Intergenerational Mobility, which computes the correlation between fathers’ and sons’ incomes for a large sample of countries. The higher the correlation, the less likely that someone will be better off than their parents, which signals a less equal distribution of opportunity. So, the correlation is a measure of what is called intergenerational mobility in economic parlance.
In the figure, we split the sample of countries into those with high intergenerational mobility and low intergenerational mobility.
For countries with high mobility, we find little discernible relationship between real GDP per capita growth and income inequality, as measured by the widely-used Gini coefficient. However, for countries with low mobility, the relationship is strongly negative. So, inequality of opportunity is central to explaining the relationship between inequality and growth.
As shown by a growing body of literature, higher inequality of opportunity tends to persist in the presence of unequal access to education, labor markets segregated into insiders and outsiders, and financial markets that favor the better-off.
Governments need policies to widen access to high quality early education, reduce labor market duality and structural unemployment, and broaden the sources of finance available to new entrepreneurs.
The evidence in our paper suggests that leveling the playing field in this way would not only promote social justice, but also enhance growth.