Income distribution and economic growth; empirical results for Slovakia

The relationship between income inequality and economic growth is an ambiguous one but most mainstream economists view real wage increases as a drag on economic growth as they lead to higher labor costs, lower competitiveness and reduction of employment. In this study we provide an alternative view and show that a labor income increase may also have a positive effect on growth. Which of these two effects dominates in a particular country depends on the institutional and legal environment of that country, its macroeconomic conditions and also its economic policies. We apply a general Keynesian growth model that combines demand and productivity regimes to test empirically two distinct economies – the small, very open economy of Slovakia and the large, relatively closed economy of the euro area. We find that an income rise increases domestic demand and reduces external trade in both economies. But the total effect of income inequality on economic activity is opposite in both economies in the short run. In the Slovak case the positive effect of lower income inequality on domestic demand is surpassed by its negative effect on net exports. Hence higher income inequality is associated with higher economic growth; the Slovak economy is profit-led. In the case of the euro area the positive effect of income rises on domestic demand is larger than the negative effect on net exports. Hence higher income inequality is associated with lower economic growth; the euro area is wage-led. In the long run, however, both economies are wage-led. The regime switch in the Slovak economy is caused by the inclusion of the positive impact of a wage increase on productivity. We also partially analyze the economies of the Slovak trading partners and doing so we get results for new EU member economies that are compared and contrasted with the old EU members.