Income inequality, government expenditures and growth

This paper investigates the relationship between income inequality and growth by utilizing the recently published Deininger-Squire data set. Most of the recent empirical growth literature suggests a negative relationship between inequality and growth on the basis of reduced-form growth equations. This is also found in the author's study. Some effort is made to discuss the argument behind the perceived negative relationship between inequality and growth. According to the fiscal policy approach a high level of income inequality leads to a higher demand for redistribution, which in turn affects growth through resource allocation out of investment or through incentive-distorting taxes needed to fund the redistribution. It is suggested that the last-mentioned relationship between government expenditure and growth is more likely to be non-linear; positive with small amounts and negative with large amounts. Such a relationship, however, is only found for public goods. Thus, government expenditure on 'law and order' may, with higher amounts of expenditure, have negative effects on growth, therefore indirectly supporting the socio-political stability argument.