Economic Growth and Income Inequality

Studies on the relationship between income inequality and Growth initiated from the pioneering research by Simon Kuznets (1955) where deliberated economic growth and income inequality and came up with a hypothesis that is currently called as the Kuznets hypothesis or the inverted U-Curve. The Kuznets hypothesis formed the foundation from which most early studies analyzed the relationship between income inequality and growth. Kuznets (1955) assumed that in the initial stages of economic Growth, both a nation’s economic growth and its inequality increase.

As countries grow and develop, the income gap between the rich and the poor should decrease. Indeed, according to Kuznets, there is a slow change from a low-inequality, low-income, agricultural economy, towards a high-income and medium-inequality economy characterized by industrial production. This shift would lead to the inverted U-shaped relationship between real GDP per capita and inequality.

Kuznets says that in the initial period, agriculture represents the majority of a country’s economy, which is also characterized by low levels of inequality. According to Kuznets, a shift towards the secondary and the third sectors has in nature two effects in the short term. The first effect is that it speeds up economic growth leading to higher levels of GDP per capita. The second and most dramatic effect is that this increases the level of inequality.