Direct and Indirect Effects of Income Inequality On Economic Growth Through Political Economy

Abstract

In addition to its direct effects, income inequality may affect economic

growth indirectly through various transmission channels. Negative effects

may arise from a political economy, socio-political instability, and credit

market imperfections. In other words, inequality may have indirect effects

on economic growth through these transmission channels. In this article,

the focus is on testing the impact of income inequality through the political

economy channel, using several types of taxes as the proxy for redistributive

pressure. In order to test the possible effects through these channels, income

inequality, taxation, and related interaction terms are added into the growth

model. The results show that there is a significant negative interaction

between income inequality and tax channels. This interaction is also

justified with the tax index calculated by the PCA. Marginal effects of the

related tax channels are interpreted for different levels of income inequality.