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Persson and Tabellini (1994) argue that increased inequality leads to greater demand for redistribution and thus less growth. However, empirical work has challenged this relationship. This paper develops a model that distinguishes between income inequality induced by differences in labor productivity and income inequality induced by differences in capital income. Whilst the standard argument applies to productivity-induced income inequality, greater capital income inequality leads to smaller government if, as often observed, capital income is difficult to tax, and thus higher growth since such policies cause less distortionary taxes and less impact on accumulation. Using OECD data, government size and capital income inequality (proxied by the top 1% income share) are found to be negatively related in both fixed effects and instrumental variable regressions. Results also suggest that an increase in capital income inequality has a significant positive relationship with subsequent economic growth in fixed effects with period dummies. Moreover, controlling for capital income inequality yields a negative relationship between labor income inequality and growth, as originally conjectured.
