Income Distribution and Growth: The Kuznets Hypothesis Revisited

Abstract

This study develops a general equilibrium model in which the evolution of income inequality and output conforms with the Kuznets hypothesis. The paper presents a novel endogenous mechanism that generates the inverted-U relation between income inequality and per capita output, and captures the reciprocal influence between the two. Unlike previous attempts for a comprehensive theoretical modelling of this phenomenon, the evolution of the economy is consistent with another important empirical observation: namely, that output growth is accompanied in the early stages of development by a widening wage differential between skilled and unskilled labour, whereas in a later stage this wage differential declines. This study develops a general equilibrium model in which the evolution of income inequality and output conforms with the Kuznets hypothesis. The paper presents a novel endogenous mechanism that generates the inverted-U relation between income inequality and per capita output, and captures the reciprocal influence between the two. Unlike previous attempts for a compre- hensive theoretical modelling of this phenomenon, the economic evolution is consistent with another important empirical observation: namely, that output growth is accompanied in early stages of development by a widening wage differential between skilled and unskilled labour, whereas in a later stage this wage differential declines. The relationship between the distribution of income and economic growth has been a focus of research for several decades. In a seminal contribution, Kuznets (1955) explored the historical evolution of income distribution and per capita output. His study demonstrated that income inequality widens in the early phase of economic growth and narrows in the later stage of development. Kuznets's inverted-U hypothesis has been debated in the last few decades, and has been confirmed by a large number of cross-section empirical studies and refuted by others.' Time-series analysis indicates that the hypothesis is consist- 2 ent with the experience of most of the developed world. Furthermore, these studies suggest that output growth is accompanied in early stages of develop- ment by a widening wage differential between skilled and unskilled labour and that in a later stage this wage differential declines (see e.g. Williamson 1985). Throughout the years, the link between income distribution and economic growth has been interpreted mostly as a causal relation from growth to income distribution. Recently, however, the nature of this link has been re-examined and attention has been paid to the causality in the other direction. Galor and Zeira (1993) have demonstrated that, owing to borrowing constraints, income