Inequality does Cause Underdevelopment

Abstract

This paper argues that the conflicting results in the voluminous recent literature on inequality and growth are missing the big picture on inequality and long-run economic development. Consistent with the provocative hypothesis of Engerman and Sokoloff 1997 and Sokoloff and Engerman 2000, this paper confirms with cross-country data that commodity endowments predict the middle class share of income and the middle class share predicts development. The use of commodity endowments as instruments for middle class share addresses problems of measurement and endogeneity of inequality. The paper tests the mechanisms – institutions, redistributive policies, and schooling – by which the literature has argued that a higher middle class share raises per capita income. It tests the inequality hypothesis for institutional quality, redistributive policies, and schooling against other recent hypotheses in the literature. I subject the results to testing for over-identifying restrictions, reverse causality, and other checks for robustness. While finding some evidence consistent with other development fundamentals, the paper finds high inequality to independently be a large and statistically significant barrier to developing the mechanisms by which prosperity is achieved.