The Heterogeneous Effect of Income on Income Inequality

Income inequality is increasingly becoming a concern and its causes are not yet unambiguously clarified. The view exists that it is an inevitable product of economic progress which will attenuate after the economy has developed. We present contradicting evidence according to which ideology plays a key role. For that, we analyze the within-country effect of income (GDP per capita) on income inequality (Gini index) and apply an instrumental variable (IV) approach to overcome potential endogeneity issues. Our instruments for income are from different fields (weather and economic), in order to reduce estimation biases. Based on annual data for the 1960-2010 period, we present evidence for a heterogeneous pattern: an increase in income (i) leads to an increase in income inequality only in richer countries, but (ii) has no statistically significant effect in poorer countries. In Islamic countries, in turn, an increase in income (iii) leads to a decrease in income inequality. We provide support that these findings are neither driven by our choice of instruments, nor by globalization. We also ensure that this pattern holds true when considering other country-specific characteristics, such as differences in democratic status, savings behavior, labor structure, and technology. In additional tests, we show that the results are also robust to definitions, data sources, model specifications, and to potential outliers. Two conclusions can be drawn from this heterogeneous pattern: first, averaging across a larger set of different countries will lead to biased conclusions. Second, since social order and democracy matter for economic development, these results will have consequences for the stability of both democracy as well as economic growth.