Oded Galor (2011). NBER Working Paper 17058, May.

This paper reviews a recently popular thesis in development economics that income distribution has an important impact on human capital formation and the development process.

Classical economists traditionally argued that inequality promotes economic development.  Neoclassical economists advanced the hypothesis that inequality has no impact on growth.  Contemporary economists have found that inequality does indeed affect the growth process, and significantly.  Inequality may be quite detrimental to growth and affects growth through several channels, including human capital, entrepreneurial activity, aggregate income, and economic development. 

Galor explains how historical changes have undergird economists' views on the role of inequality.  He writes: “The replacement of physical capital accumulation by human capital accumulation as the prime engine of economic growth has changed the qualitative impact of inequality on the process of development.  In early stages of industrialization, as physical capital accumulation was a prime source of economic growth, inequality enhanced the process of development by channeling resources towards individuals whose marginal propensity to save is higher.  In later stages of development, however, as human capital has become the main engine of economic growth, a more equal distribution of income, in the presence of credit constraints, has stimulated investment in human capital and economic growth” (1).

This has had a particularly strong effect in the area of land ownership.  After industrialization, public education increased the productivity of labor in industrial production more so than labor in agricultural production, leading to migration to urban area and falling profits for landowners.  Therefore, agricultural landowners had an incentive to lobby against public education.  In countries where they held political power, it was not uncommon for oppressive institutions that preserved inequality to arise.

After the process of industrialization has completed, human capital becomes more important than physical capital.  The aggregate return to investment in human capital is maximized when that investment is widely distributed among individuals in society.  This creates a role for public education and equality.  Specifically, equality reduces the adverse effects of credit constraints and therefore promotes overall human capital accumulation and growth. 

Overall, Galor's unified theory of inequality and growth is helpful because it shows how inequality has different impacts at different stages of development, and predicts some social and political configurations that may be expected to arise at each stage.  In theory, “In economies in which the return to human capital is relatively lower, inequality is beneficial for economic growth, whereas in economies in which the return to human capital is relatively higher and credit constraints are largely binding, equality is beneficial for the development process” (27).

Galor's theory is also useful in that it shows how “Inequality in the ownership of factors of production [particularly land] has generated an incentive for some better-endowed agents to block the implementation of institutional changes and policies that promote human capital formation, resulting in a suboptimal level of investment in human capital from a growth perspective” (28).  He demonstrates the validity of his theory with case studies of England, Continental Europe, the United States, Japan, Russia before the Bolshevik Revolution, South Korea, and Taiwan.