Income inequality and economic growth in Australia

The relationship between income inequality and economic growth is theoretically ambiguous. You could argue that income inequality should increase economic growth, because: (1) inequality means that there are more people with high incomes, higher income people save more, and more savings increases funds available for investment spending, which increases productivity and economic growth; or (2) inequality increases the incentives for people to work harder and get ahead, increasing productivity and economic growth. On the other hand, income inequality could decrease economic growth, because: (1) inequality creates incentives for people to engage in rent-seeking behaviour, such as buying political favours, which is wasteful of resources; (2) people dislike inequality, so when inequality is high, they pressure the government to engage in redistribution, which reduces work incentives, productivity, and economic growth. So, given the theoretical ambiguity, the only way to establish this relationship is empirically, using data.

That is what this 2017 article by Tom Kennedy (University of New England), Russell Smyth (Monash University), Abbas Valadkhani (Swinburne University of Technology), and George Chen (University of New England), published in the journal Economic Modelling (ungated earlier version here), attempts to do, using Australian data. Specifically, Kennedy et al. construct time series of inequality and economic growth at the state (and territory) level for Australia over the period from 1986 to 2013. They then apply a fairly straightforward panel regression analysis, controlling for state-level investments in physical and human capital, and find that (in their Model 1):

...the effect of inequality on growth is negative and highly significant at the 1% level, suggesting that falling income inequality can substantially boost economic growth. On average, an additional 10% rise in the growth of inequality can bring about a 2.55% fall in real output growth...

A second model, employing a somewhat different specification, results in substantially similar results. However, they look at both contemporaneous and lagged effects of each variable on economic growth. On the lagged effects, Kennedy et al. conclude that:

While policies aimed at increasing physical capital can immediately boost economic growth, the impact of a rise in human capital, or a fall in inequality, on the Australian economy appear to be statistically significant, but with one and two years delay, respectively...

These results should suggest to us that, of the competing theoretical mechanisms linking inequality and economic growth, the negative effects on balance appear to outweigh the positive effects. However, Kennedy et al. don't provide any results that might tell us which mechanisms are at play (or indeed whether there are other mechanisms we haven't thought of that drive this observed correlation). Their analysis also falls short of demonstrating a causal relationship from inequality to lower economic growth. For a better understanding of the causal relationship and underlying mechanisms, we are going to need more research in the future.