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For the most part, mainstream economists have not been concerned with the apparent trend of rising inequality. The assumption of textbook economics is that inequality is likely to enhance growth by concentrating income among the rich, who save and invest more, and by creating a necessary incentive for individuals to work hard.

Moreover, as Kuznets suggests, increasing inequality may be a natural outcome of the early stages of development, as people begin the shift from low productivity subsistence agriculture to high-productivity sectors. For economists, inequality has typically been at worst a necessary evil and at best a reasonable price to pay for growth. For development economists, inequality has not been the central policy issue, but rather the reduction of absolute poverty. Even Kuznets’ analysis is not an exception; he treats inequality as an immutable (and thus not policy sensitive) outcome of the early stages of growth, which in any event would be eventually self-correcting as growth proceeded (Kuznets 1955; Chenery and Syrquin 1975).

Only beginning in the 1990s, once the fall of the Berlin Wall had liberated the mainstream from the taboo of Marxian thought, did inequality begin to be viewed as a possible cause of low growth, and thus as a phenomenon that mattered, at least for understanding growth itself. In the past 15 years there has finally been more theoretical and empirical work on inequality and development, much of it ably reviewed in major reports from the United Nations Development Programme (UNDP), Inter-American Development Bank (IDB), and recently by the World Bank. Still there is no agreement among economists, and no particular attention among development practitioners, to the likelihood that inequality matters—for growth itself or for poverty reduction, or for any larger definition of development or of individual well-being.

Yet if people care about their relative income status then ipso facto inequality matters. That they do, to some extent, has long been remarked; consider Adam Smith (1776), who noted that for a man to retain his dignity, he may in one society need enough income to buy a linen shirt, to Thorstein Veblen (1970) who noted that the absolutely well-off worry about their status relative to the more absolutely well-off. Hirshman (1973) observed that drivers stuck in the slow lane in a tunnel become deeply frustrated if their lane never moves—quite independent of their type of car. Because it is relative and not absolute income that matters (and expectations about future relative income as Hirshman’s tunnel metaphor illustrates), economic growth and subsequent increases in a country’s average income do not seem to increase the average level of happiness in a country (Easterlin 1995). What matters for people is their relative not their absolute income.6 Graham and Felton (2005) report that based on happiness surveys, people in Nigeria are as happy as people in France despite the huge discrepancy in per capita income.

In short, inequality of absolute income seems to matter: more obviously to people at the low end, who may resent the better-off, but probably to some at the high end too, who may enjoy their own affluence less if others are visibly worse off. Inequality is probably most bothersome (to the rich as well as the poor) when low income is persistent for identifiable groups of people and thus most obviously unjust—rooted in racial or other discrimination, for example, or in inadequate access to education for low-income children. Reducing inequality may therefore be an end in itself for some people and in some societies.

There are also, however, instrumental reasons why inequality matters—reasons that should be of interest to development economists concerned primarily with growth and absolute poverty. Money inequality in developing countries matters for at least three (instrumental) reasons:

(i) Where markets are underdeveloped, inequality inhibits growth through economic mechanisms; (ii) Where the institutions of government are weak, inequality exacerbates the problem of creating and maintaining accountable government, increasing the probability of economic and social policies that inhibit growth and poverty reduction; (iii) Where social institutions are fragile, inequality further discourages the civic and social life that undergirds the effective collective decision making that is necessary to the functioning of healthy societies.

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