Income inequality and economic progress: an empirical test of the institutionalist approach

American Journal of Economics and Sociology, The,  Jan, 1996  by Kang H. Park

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I

Introduction

In an appraisal of the institutionalist approach to distribution and economic progress, James T. Peach (1987) lamented the lack of empirical studies in this area and suggested (1) more active involvement in the collection and analysis of data, and (2) more careful examination of the relationships between income distribution and economic progress as indicated by available data.(1) This study responds to one of his suggestions, that is, the need for more studies of an empirical nature.

The purpose of this paper is modest: to determine empirically whether there is a strong relationship between income distribution and economic progress. Its first section briefly examines the economic theories on the relationship between income inequality and economic progress within the framework of institutional economics. The second section contains the empirical analysis of the hypothesized relationship which involves construction of a model, description of the variables and data, and interpretation of the estimated results. A cross-national study with a sample of 65 countries is carried out. In the final section, conclusions and suggestions for further study are made.

II

Economic Theories and Institutionalist Perspective

The analysis of income distribution and economic progress (or growth) in the past was largely dominated by the conventional approaches such as neo-classical and neo-Keynesian schools. However, institutionalism offers an alternative explanation, particularly on the relationship between income distribution and economic growth. The institutionalist approach to income distribution is different in several respects from the conventional approaches. First, the conventional theories are theories of the functional distribution of income which focus on how total income is distributed among factors of production. The institutionalist approach, however, is more concerned with the size (or personal) distribution of income, i.e., the distribution of income among family units or households in a nation. According to neo-classical economists, each factor of production tends to receive income according to its marginal contribution to the production of output. Neo-Keynesian theories center around the distribution of total output between labor and capital. Institutionalists claim that the current size distribution of income has been largely determined by discretionary institutional arrangements which include power relationships in the society.

Second, the conventional approaches are more tolerant toward unequal distribution of income as a matter of fact. In some cases, they tend to favor unequal distribution of income as a more or less assumed incentive for higher productivity, or as a stimulant for more saving and investment. Income distribution according to the principle of marginal productivity, however unequal it might be, is regarded as optimal in the sense of Pareto-efficiency by neo-classical economists. In this view, any attempt to redistribute income will reduce the efficiency of the economy by violating the Pareto optimality. Many neo-Keynesians still believe that unequal distribution of income in favor of capitalists is necessary to divert income from consumption to saving and then to investment. To institutionalists there is no ultimately ideal distribution of income. Income distribution arrangements are to be appraised and reappraised through continuous self-corrective life processes which include governmental action; especially, unequal distribution of income resulting from ceremonially invested status and invidious comparisons of occupations is definitely subject to appraisal and change.

Third, the connection between income distribution and economic progress (or growth) is nonexistent, or loose at best, in the conventional approaches. According to these approaches, economic growth mainly depends on the level of investment and the rate of technical progress. The level of investment will also play an important role in distributing total income between wages and profits. If there exists any relationship between these two variables, it is the trade-off relationship according to the conventional views. On the other hand, the institutionalist approach is distinguished from the conventional views by its emphasis on the relationship between income distribution and economic progress.(2) The state of income distribution, an institutional arrangement, may promote or inhibit economic progress. Institutionalists are in general agreement that inequality of income, especially extreme inequality, is detrimental to economic progress. To institutionalists, equity and growth are complements, not substitutes.

Gunnar Myrdal (1968) questioned the conventional view that increasing inequality is symptomatic of economic growth and dynamism.(3) Clarence Ayres (1944) also challenged "the classical supposition that the growth of the national dividend is enhanced by inequality."(4) Marc R. Tool (1979) stated the conventional view and its shortcomings succinctly as follows.