Inequality hampers growth, causes political violence, and erodes democracy

Starting from the left- to the right-hand side, the diagram represents different channels of transmission of the effects of higher levels of inequality, their intermediate effects, and the resulting positive or negative impact on our three outcomes of interest: growth,5 human development, and democracy. We broadly divide these channels according to their underlying drivers: the poor, the population at large or the average, and the wealthy. Overall, the diagram suggests that high inequality has predominantly harmful effects on our three outcomes of interest, according to theoretical explanations advanced in the literature. The dominant view then runs contra the expectations of the classical theorists, i.e., that inequality has a positive impact on growth, via savings and investment (shown at the top of figure 1). We highlight six main transmission channels. First, inequality affects incentives for savings and investment and the overall level of institutional quality through its influence on policy making and increased political instability, and consequent effects on property rights and the regulatory framework. This has implications for growth both directly and indirectly via governance. Second, by favoring private over public investment, inequality affects investment in public goods, namely health and education, with implications across the three outcomes. Third, and related, inequality results in underinvestment on human capital resulting from credit constraints, and high fertility, which affects education levels and overall economic growth. Fourth, high taxation will be demanded by a well-endowed median voter and the likelihood of transition to and stability of democracy will also depend on the pressure for redistribution, which is higher with lower levels of equality. Moreover, and fifth, a small middle class will affect the demand not only for democracy but also for manufactures. Finally, high levels of polarization will lead to weak social cohesion via their effects on social capital, as well as low trust and potential high levels in violent crime, which affect health directly and indirectly via investment in public health. Additionally, the concentration of power on the rich leads to increased probability of political violence and affects political engagement. Some of these channels affect all of the outcomes. For instance, the effect through investment in public goods has detrimental effects on human development, and on growth and democracy. Moreover, the resulting polarization and social discontent, which increase the chances of political violence, again negatively impact the three outcomes. However, there is also some indication that, when it comes to growth, the effect might be ambiguous depending on the predominance of the effects of transmission mechanisms. The channel through savings (and investment) points to a potential positive effect, while the different effects through public investment, taxation, the structure of demand, imperfect credit markets, fertility, and social discontent suggest potential negative consequences for growth.