Income Inequality, Democracy, and Public Sector Size

Abstract

This study synthesizes and tests explanations of how public sector size and democracy affect income inequality. The results, based on unbalanced panel data for 64 developing and developed countries and a total of 341 observations from 1970 to 1994, show that a strong interaction between democracy and public sector development explains withincountry income inequality. Public sector expansion translates into worse distributional outcomes in nondemocracies or limited democracies because the state is more inclined to support the development of particular core industries or client populations in urban formal sectors through targeted taxation or transfer systems. On the other hand, the larger public sector size leads to better distributional outcomes in fully institutionalized democracies because the democratic political mechanisms enable the state institutions to be more responsive to the demands of lower classes and more committed to achieving better distributional outcomes. This study demonstrates that democracy is associated with inequality as an institutional background that converts the effects of public sector size on inequality from positive to negative by strengthening the hegemony of equity orientation within state institutions.