Inequality Overhang: A Heterogeneous Approach

Abstract

The linearity of the relationship between income inequality and economic

development has been long questioned. While theory provides arguments

for which the shape of the relationship may be positive for low levels of

inequality and negative for high ones, most of the empirical literature assumes

a linear specification finding conflicting results. Employing an innovative

empirical approach, robust to endogeneity, we find pervasive evidence of

nonlinearities. In particular, similar to the debt-overhang literature, we

identify an inequality-overhang level, in that the slope of the relationship

between income inequality and economic development switches from positive

to negative at a net Gini coefficient of about 27 per cent. We also find that

in an environment characterized by widespread financial inclusion and high

income concentration, rising income inequality has a larger negative impact

on economic development because banks may curtail credit to customers at

the lower end of the income distribution. On the positive side, a sufficiently

high female labor participation can act as a shock absorber reducing such a

negative impact, possibly through a more efficient allocation of resources.