Income Inequality,Taxation, and Growth

Much recent theoretical and empirical research has focused on the relationship between income distribution and economic growth. The fiscal policy approach argues that inequality is linked to pressure for redistributionary taxation, leading to low capital investment and, therefore, growth. Empirical analyses are consonant with this view in that the long-run relationship between inequality and growth is negative. However, several empirical inconsistencies with the fiscal policy approach do emerge: (a) there exists a short-run, positive relationship between income inequality and growth and (b) the relationship between inequality and taxation is mixed, at best. This paper presents a simple theoretical model that reconciles the intuitively appealing fiscal policy approach with the empirical findings.