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.