Inequality and investment: The role of institutions

Income inequality and its economic effects have become a matter of generalized concern. A consensus has recently emerged in the literature that inequality has a detrimental effect on economic performance but little is known about the exact mechanisms driving this effect. Using panel data from 113 countries over the 1980–2010 period as well as different indexes of property rights, this study examines how income inequality affects investment in different institutional contexts. It documents that inequality substantially decreases investment only for poor property rights but the negative effect vanishes as property rights improve. Analysing the different dimensions of property rights reveals two mechanisms at work. First, when the rule of law is not secured, inequality may increase rent-seeking activities by the wealthy elite at the expense of investment. Second, when the access to the credit market is imperfect, higher inequality excludes the poor from the market, which reduces investment.