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Income Inequality and Economic Growth

CAT 2025 Slot 1 · Verbal Ability & Reading Comprehension · Medium · Reading Comprehension

This is a medium Verbal Ability & Reading Comprehension question set from the CAT 2025 Slot 1 paper. It tests Reading Comprehension. The full answer key and a step-by-step explanation are below — try it yourself first, then reveal the solution.

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Passage / data set

Studies showing that income inequality plays a positive role in economic growth are largely based on three arguments. The first argument focuses on investment indivisibilities wherein large sunk costs are required when implementing new fundamental innovations. Without stock markets and financial institutions to mobilize large sums of money, a high concentration of wealth is needed for individuals to undertake new industrial activities accompanied by high sunk costs . . . [One study] shows the relation between economic growth and income inequality for 45 countries during 1966-1995. [It was found] that the increase in income inequality has a significant positive relationship with economic growth in the short and medium term. Using system GMM, [another study estimated] the relation between income inequality and economic growth for 106 countries during 1965– 2005 period. The results show that income inequality has a positive impact on economic growth in the short run, but the two are negatively correlated in the long run. The second argument is related to moral hazard and incentives . . . Because economic performance is determined by the unobservable level of effort that agents make, paying compensations without taking into account the economic performance achieved by individual agents will fail to elicit optimum effort from the agents. Thus, certain income inequalities contribute to growth by enhancing worker motivation . . . and by giving motivation to innovators and entrepreneurs . . . Finally, [another study] point[s] out that the concentration of wealth or stock ownership in relation to corporate governance contributes to growth. If stock ownership is distributed and owned by a large number of shareholders, it is not easy to make quick decisions due to the conflicting interests among shareholders, and this may also cause a free-rider problem in terms of monitoring and supervising managers and workers. . . .

Various studies have examined the relationships between income inequality and economic growth, and most of these assert that a negative correlation exists between the two. . . . Analyzing 159 countries for 1980–2012, they conclude that there exists a negative relation between income inequality and economic growth; when the income share of the richest 20% of population increases by 1%, the GDP decreases by 0.08%, whereas when the income share of the poorest 20% of population increases by 1%, the GDP increases by 0.38%. Some studies find that inequality has a negative impact on growth due to poor human capital accumulation and low fertility rates . . . while [others] point out that inequality creates political instability, resulting in lower investment. . . . [Some economists] argue that widening income inequality has a negative impact on economic growth because it negatively affects social consensus or social capital formation. One important research topic is the correlation between democratization and income redistribution. [Some scholars] explain that social pressure for income redistribution rises as income inequality increases in a democratic society. In other words, when democratization extends suffrage to a wider class of people, the increased political power of low- and middle-income voters results in broader support for income redistribution and social welfare expansion. However . . . if the rich have more political influence than the poor, the democratic system actually worsens income inequality rather than improving it.

Question 1 of 4

According to the incentive or moral hazard argument, which one of the designs below is most consistent with the claim that some inequality can raise growth?

  1. A.

    A regime that concentrates stock ownership in relation to corporate governance.

  2. B.

    Wages are determined by tenure rather than output to ensure equity.

  3. C.

    Rents protected by market power that enlarge top incomes without linking pay to results.

  4. D.

    Pay rewards on verifiable performance for highly productive workers.

Answer

D

Explanation

The moral hazard/incentive argument states that compensation must be linked to observable performance and individual effort to elicit optimum effort and motivation. Rewarding verifiable performance directly connects pay to output, aligning with this incentive structure.

Question 2 of 4

Which one of the options below best summarises the passage?

  1. A.

    The passage argues that income inequality accelerates economic growth while also emphasising the significance of concerns regarding human capital accumulation, fertility rates, and political instability.

  2. B.

    The passage confines its discussion to financing gaps and corporate control while undercutting cross country evidence and overlooking the significance of concerns regarding human capital accumulation, fertility rates, and income redistribution under democratisation.

  3. C.

    The passage outlines investment, incentive, and governance channels through which income inequality may support economic growth and reports short-term gains while noting long term drawbacks.

  4. D.

    The passage claims that evaluating the effect of income inequality on economic growth without considering both short- and long-term consequences is misguided.

Answer

C

Explanation

The first paragraph outlines three channels (investment/sunk costs, incentive alignment, corporate governance) through which inequality may boost growth in the short run, while the rest of the passage covers negative long-term impacts and counterarguments.

Question 3 of 4

The primary function of the three-part case for a positive income inequality–economic growth link in the first half of the passage is to show that:

  1. A.

    inequality can aid short-term growth in settings with high sunk costs, incentive alignment, and concentrated ownership.

  2. B.

    dispersed ownership speeds corporate decision-making and removes free rider problems.

  3. C.

    inequality boosts growth in every period and type of economy, regardless of finance or governance conditions.

  4. D.

    mature stock markets make wealth concentration unnecessary, yet they might still be harmful to investment.

Answer

A

Explanation

The three arguments explicitly detail high sunk costs, incentive/effort alignment, and concentrated stock ownership, explaining why inequality can foster short-term growth under those conditions.

Question 4 of 4

The passage refers to "democratization". Choose the one option below that comes closest to the opposite of this process.

  1. A.

    The coalition imposed term limits and strengthened judicial review in order to further entrench autocratic rule.

  2. B.

    Corporate donations were capped and parties received public funding which was portrayed as establishing an oligarchy.

  3. C.

    Municipalities adopted participatory budgeting and recall elections which a press release called totalitarianism.

  4. D.

    After the emergency decree, the regime shifted toward authoritarianism as suffrage narrowed and opposition parties were deregistered.

Answer

D

Explanation

Democratization extends suffrage and expands political participation. The opposite process involves shifting toward authoritarianism, narrowing suffrage, and deregistering opposition parties.

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