Distributional Effects of Growth and the Elasticity of Substitution

Reforms that promote economic growth have also an impact on the distribution of capital and income. This paper considers the effect of a rise in the elasticity of substitution between capital and labor. It uses the normalized CES function introduced by Klump and de La Grandville. A reform that raises the elasticity of substitution may have an immediate impact on wages. Dynamic effects are studied in the Ramsey model with heterogenous agents by Caselli and Ventura. Two results on a trade-off between growth and equality are obtained: First, divergence in the capital distribution may occur during growth if a low elasticity of substitution is combined with a high profit share or high risk aversion. Simulations show that a small rise in the elasticity of substitution may reinforce this divergence. Second, a higher elasticity of substitution leads to higher income in the future for the whole population, but sometimes at the cost of an absolute decline in present wages. The existence of a trade-off between growth and equality depends crucially on the choice of the point of normalization.