Inequality, Human Capital Formation and the Process of Development

Conventional wisdom about the relationship between income distribution and economic development has been subjected to dramatic transformations in the past century. While Classical economists advanced the hypothesis that inequality is bene…cial for economic development, the Neoclassical paradigm, which had subsequently dominated the …eld of macroeconomics, dismissed the Classical hypothesis and promoted the viewpoint that the study of income distribution has no importance for the understanding of macroeconomic activity and the growth process. A metamorphosis in these perspectives has taken place in the past two decades. Theory and subsequent empirical evidence have demonstrated that income distribution has a signi…cant impact on the growth process. The modern approach has demonstrated that in the presence of credit market imperfections, income distribution has a long-lasting e¤ect on investment in human capital, entrepreneurial activity, aggregate income, and economic development. Moreover, in contrast to the Classical viewpoint, which underscored bene…cial e¤ects of inequality for the growth process, the modern perspective advanced the hypothesis that inequality may be detrimental for human capital formation and economic development. 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. While the process of industrialization raised the importance of human capital in the production process, re‡ecting its complementarity with physical capital and technology, human capital accumulation has not bene…ted all sectors of the economy. Inequality in the ownership of factors of production 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. The transition from an agricultural to an industrial economy changed the nature of the main economic con‡ict in society. Unlike the agrarian economy, which was characterized by a con‡ict of interests between the landed aristocracy and the masses, the process of industrialization has brought about an additional con‡ict between the entrenched landed elite and the emerging capitalist elite. In light of a lower degree of complementarity between human capital and the agricultural sector, education has increased the productivity of labor Prepared for the Handbook of the Economics of Education, North-Holland.