Middle income trap and income inequality: Empirical evidence on the distributional effect of economic liberalization and political regime

In this paper I empirically examine the income-equalizing role of economic liberalization policies and political regime in a sample of 117 countries over the period of 1970-2014. With a specific focus on the middle income countries (MICs) shown to have been “trapped” at that level long after their transition from low income status, I propose that income inequality could be the underlying factor exacerbating growth slowdowns and suppressing development strategies aiming to escape from the trap and graduate to high income level. Using the Standardized World Income Inequality dataset, and via panel fixed effects and system GMM estimations that are able to handle unobserved heterogeneity, omitted variable bias and potential endogeneity, I examine the interrelationship between income inequality, five dimensions of Economic Freedom in the World, and democracy measures. The findings yield robust empirical evidence that freedom to trade internationally, unpredictable inflation and money supply, and small government size have significant relationship with inequality. Nevertheless, the impact of these variables on income inequality depends on the types of political regime in the country under study. The results suggest that these liberalization policies may yield the intended positive effect on income distribution in the presence of sufficiently democratic political regime.