From Physical to Human Capital Accumulation: Inequality and The

This paper presents a novel approach for the dynamic implications of income inequality on the process of development. The proposed theory provides an in-tertemporal reconciliation for con‡icting viewpoints about the e¤ect of inequality on economic growth. It argues that the replacement of physical capital accumu-lation by human capital accumulation as a 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 is a prime source of economic growth, inequality enhances the process of development by channeling resources towards individuals whose marginal propensity to save is higher. In later stages of development, however, as the return to human capital increases due to capital-skill complementarity, human capital becomes the prime engine of growth and equality, in the presence of credit constraints, stimulates investment in hu-man capital and promotes economic growth. As wages increase, however, credit constraints become less binding, the adverse e¤ect of inequality on human capital accumulation and growth subsides, and the overall e¤ect of inequality may become positive