Department of political science

Governance and income inequality

A panel data analysis on the relationship between the quality of government and
the Gini index

Kevin Ahrlind

Bachelor’s thesis, 15 hp
Political science III (30 hp)
Spring semester 2021
Supervisor: Wojciech Szrubka
Word count: 12.500
Abstract
This study investigates the relationship between quality of government and income
inequality. The purpose of this study is to understand how differences in quality of
government across states affect their income inequalities. By utilizing a theoretical
framework that incorporates Kuznets inverted U-hypothesis, quality of government
and state capacity, this study argues that a high level of quality of government and
state capacity are essential for states to handle income inequality. The method used
was a regression analysis using panel data that covers the time period from 1946
to 2020. Furthermore, pooled OLS and fixed effects model were used to study the
relationship. The results from the pooled OLS showcases that there’s a negative
relationship between quality of government and income inequality. However, when
controlling for entities by using the fixed effects model the results show a positive
relationship. In addition, an F-test was conducted to find the regression model with
the best fit where the fixed effects model showcased a superior fit to the given data
used in the study. The study suggest that further research should be done on how
income inequality and governance differs depending on the historical onset of the
countries. Moreover, further research on how decentralization or centralization of
power in a country affects income inequality is suggested.

Keywords: Income inequality, Gini index, quality of government, governance, po-

litical science, political economy, panel data analysis

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Acknowledgments
Foremost, I would like to express my sincere gratitude to my supervisor Wojciech
Szrubka for the continuous support of my bachelor’s thesis in political science. Be-
sides my supervisor, I would like to thank the rest of the working personal at Stock-
holm University for giving us students the opportunity to study and accumulate
crucial knowledge even during an on-going pandemic.

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Contents

1 Introduction 5
1.1 Purpose & research question . . . . . . . . . . . . . . . . . . . . . . . 6
1.2 Predisposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

2 Background 9
2.1 Factors of income inequality . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 Consequences of income inequality . . . . . . . . . . . . . . . . . . . 11
2.3 Measuring income inequality . . . . . . . . . . . . . . . . . . . . . . . 13

3 Previous research 15

4 Theoretical framework 18
4.1 Kuznets inverted U-hypothesis . . . . . . . . . . . . . . . . . . . . . . 18
4.2 Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.3 Kuznets inverted U-hypothesis & governance . . . . . . . . . . . . . . 23

5 Theoretical hypothesis 25

6 Data & method 26

6.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
6.2 Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
6.2.1 Logarithmic regressions . . . . . . . . . . . . . . . . . . . . . . 28
6.2.2 Regression analysis with panel data . . . . . . . . . . . . . . . 28

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 6.2.3 Autocorrelation and standard errors . . . . . . . . . . . . . . . 30
6.2.4 F-test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
6.3 Control variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
6.3.1 Quality of government . . . . . . . . . . . . . . . . . . . . . . 31
6.3.2 Real GDP per capita . . . . . . . . . . . . . . . . . . . . . . . 31
6.3.3 Index of globalization . . . . . . . . . . . . . . . . . . . . . . . 32
6.4 Descriptive statistics . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

7 Results 33

8 Analysis 38

9 Summary 41

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1. Introduction

Economic growth has been central in making it possible for millions of people to
increase their standard of living, simultaneously helping millions of people to es-
cape extreme poverty. However, this prosperous growth is not without its adverse
effects, as growth has been accelerating in the last decades so has income inequality
(Keeley 2015, 11-12). This widening income inequality is the defining challenge of
our generation, we are seeing a similar pattern in many of the rich, middle, and de-
veloping countries. According to an OECD report released 2012, income inequality
has risen globally where the top earners capture large shares of income gains while
the rest of society has only seen minimal growth (OECD 2012, 182). Similarly, a
UN report points out that income inequality has been growing globally since the
end of the 20th century and consequently it has been growing most prevalently in
emerging economies (Vieira 2012, 4). Problems with the unequal distribution of
income among a country’s citizens are that it hampers economic performance which
furthermore creates long-term problems for the state and its population. While eco-
nomic growth is central for creating a higher standard of living amongst citizens of a
country, it can be argued that the state and its government have to a certain extent
the responsibility to increase the utility of the country’s inhabitants, by overseeing
and neutralizing problems such as income inequality.
Income inequality is a field that has been well studied. However, there seems to
not be a single cause behind its increase during the last decades. Instead it can be
understood that there are a multitude of complex factors playing crucial parts in its
growth. Some scholars argue that factors such as globalization and trading are the
main elements of the growing income gap (Meshi & Vivarelli 2007: Bergh & Nils-
son, 2010). Other studies point out that the changing labour market structure is the
major cause behind the unequal distribution of income. An OECD report (Keeley

5
2015) points out that capital flows have changed amongst workers and owners, fur-
thermore the disappearance of 9-to-5 jobs and the increase in short-term work seem
to have had an effect. Moreover, state-related causes such as new tax systems seem
to play a role in this complex topic (Ibid.). Hence, the studies provide evidence that
there are more than a single factor affecting the growing income gap. Similarly, the
consequences of income inequality are diverse as the reasons mentioned. It affects
human capital, in other words, education and development of skills which are crucial
in a well functioning society (Ibid.). In addition, it has an effect on individual level,
where greater income inequality causes decreasing social cohesion and participation,
two elements that are important for inhabitants of a state (Van de Werfhorst &
Salverda 2012). Other studies show that an excessive income gap hampers eco-
nomic growth, affecting countries and millions of people in different spheres of life
(Dabla-Norris et al. 2015). Hence, it should be in the state’s interest to exercise
its power to handle the issue of income inequality and consequently, minimize the
consequences on the society and its inhabitants.

1.1 Purpose & research question

This study focuses on income inequality, with the primary goal to explain why it
differs amongst states. The income inequality will be captured by the Gini index,
sometimes called Gini coefficient, which represents the distribution of income in
any given society. A high value indicates a lower income distribution amongst the
population i.e greater income gap. On the other hand, a lower value represents a
higher distribution, representing a more even spread of income in the society. The
theoretical framework utilized in this study is built on the inverted U-hypothesis
curve proposed by Simon Kuznets in 1955 (Kuznets 1955). The curve represents
the relationship between economic growth and income distribution. It proposes that
an infant country will have an exponential development in economic growth how-
ever, the distribution of income will be skewed. After a certain time the government
should start to impose juristical and legislative actions to minimize the income gap
(Ibid.). Moreover, the study expands the theoretical framework by including the con-
cept of quality of government and state capacity to built a more robust framework.

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Quality of government represents several conditions which have to be optimized for
a government to exercise its power in an optimal way in regards to issues and public
affairs (La Porta et al. 1999). Meanwhile, state capacity represents the state’s abil-
ity to complete tasks, it should be see as power of how well the state’s agents can
get members of society to do things that they wouldn’t do otherwise (Lindavall &
Torell 2017). Moreover, this study emphasizes that quality of government and state
capacity often times come hand in hand. This study argues that the growing income
inequality is a case of the theoretical framework presented above and that without
a well-functioning government, i.e that has a high quality of government and proper
state capacity, the state cannot counteract the growing income inequality. Thus,
the study’s hypothesis is as the following: that there’s a relationship between income
inequality and the quality of government, given that quality of government which
is intertwined with state capacity increases the states commitment and means to
deal with income inequality. Hence, an important assumption of the study is that
the variable quality of government represents a well functioning state, but also a
state that thrives for finding solutions to deal with issues such as income inequal-
ity. Therefore, this study interprets growing income inequality as a problem being
rooted in the quality of how a state is governed.
The purpose of this study is to investigate variances of income inequality among
states through the time period from 1946 to 2020 and how the governance of these
states affect the difference in income inequality. The topic of income inequality is
seen as interesting and relevant since it affects individuals in all countries and states
throughout the world. Moreover, it’s regarded as interesting from a political science
perspective as the income gap differs across all states. And governments are head of
these states i.e in charge of the set of tools and means to handle income inequality
which may cause long term hazardous effects if not treated. Hence, the topic is
fascinating from a power perspective, given differences in income inequality which
orchestrate how governments are handling the issue. Thus, the research question of
this study is:

• What role does quality of government have on income inequality?

This study is a panel data study where pooled ordinary least squares and fixed
effects regression model where used to estimate quality of government on income

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inequality. The two models were selected since Pooled OLS doesn’t control for
entities over time, whereas fixed effect model on the other hand does. In addition,
to find which model suits the given data sample used in the study an F-test will be
conducted to find the most suitable model of these two.
To summarize, this paper will study the income inequalities across states by utilizing
the Gini index as the dependent variable, which measures the distribution of income
across a state. The study argues that the growing income inequalities is a problem of
the governance. Hence, from a theoretical point of view it can be understood as the
problem is rooted in quality of government and state capacity which are conditioned
on the Kuznets curve. The aim of the study is to investigate the relationship between
quality of government and income inequality by using panel data analysis across a
multitude of states between the time period 1946-2020. It should be mentioned
that this paper aims to expand the existing research in the field by focusing on
how income inequality has grown over the last decades in relation to quality of
government across the globe. Most of the research done previously in the field
usually covers a certain geographic area or country during a specific set of years.
Therefore, this study argues that there’s a knowledge gap in the field in regards to
studies of income inequality and governance across vast numbers of countries and
time, a gap which this study intends to fill.

1.2 Predisposition
The disposition of this study begins with an introduction, which presents the issue
of the topic, the research question and other central features of the paper. In
the following part, the background section, detailed information regarding income
inequality is presented. In the same section, previous studies of other scholars are
presented. Moving on, the section of the theoretical framework presents the theories
utilized in the study. This is followed by a data and method section, where data,
regression models and other relevant elements are presented. In the subsequent
section, results from the regression models are presented. Thereafter, the analysis
section follows where the analysis of the results are presented. The final section,
summary section presents the study’s conclusions and ideas for future research.

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2. Background

2.1 Factors of income inequality

Income inequality has been on the rise since the last decades, according to a OECD
report (Keeley 2015) in the 1980s the richest 10% of the population in the OECD
countries earned seven times more than the poorest 10% (Keeley 2015, 3). Likewise
in the US the income inequality has grown about 20% from 1980 to 2016 (Horowitz
et al. 2020, 14). Similar patterns can be observed in many developing countries since
the 1990s during which time inequality has risen in many of the emerging economies.
Meanwhile, a certain decline in inequality has been seen in some countries (UN 2020,
21). Hence, a global pattern can be discerned where we see a growing income in-
equality across several economies worldwide. However, the factors contributing to
the rise in income inequality are many and diverse. One of these factors is glob-
alism, which has made the global economy far more integrated with technology,
information, trade and investment. Consequently, it makes the low-skilled worker
far less attractive on the world market, due to advanced skills and human capital
which are required for many of the jobs. Consequently, killing job opportunities
of some middle and low-skilled workers (Keeley 2015, 42). A study published by
Meshi and Vivarelli (2007) shows that growing income inequality seems to have
been significantly affected by globalization, especially trade. Developing countries
and middle-income countries often fall prey to growing income inequality (Meshi
& Vivarelli 2007, 20-21). Bergh and Nilsson (2010) confirm similar results where
economic globalization and trade liberalization has a positive effect on income in-
equality, hence increasing the income gap (Bergh & Nilsson 2010, 488-489).
Another factor in the growing gap in income is due to that less income goes to

9
workers, instead more capital flows toward the owners (Keeley 2015, 47). In addition,
there’s increasing evidence that the share of national income going to capital has
been rising steadily, while the share that’s going to labor has been falling. In 1990s,
66.1% of the national income was going to labor in the OECD countries, but by
the 2000s that number had fallen to 61.77% (Ibid.). As is the case with globalism,
there are multiple factors such as trade and technology playing a big part, but
it can be simply put as income that once went to the workers go to owners who
finance machines and software (ibid.). Another factor behind the increasing income
inequality we are seeing is that traditional jobs that last between 9-to-5 are in
decline. Also, the numbers of union members have also been declining since 1990s.
Hence, short-term work, or self-employment is becoming more widespread and since
the mid-1990s, it represents more than half of all new jobs created in the OECD
countries (Keeley 2015, 49).
Furthermore, the state has an important role in dealing with income inequality.
Tools such as taxes and transfers that used to secure redistribution in society have
been changing since the mid-1990s. There has been a decline in spending on unem-
ployment benefits in countries, this is mostly due to falling unemployment, meaning
fewer were claiming those benefits. Meanwhile, the rules for claiming benefits were
tightened (Keeley 2015, 54). Taxes have also been declining, although the picture
is more complex for taxes since lower tax by some experts lead to greater economic
growth. New tax systems, such as progressive tax reforms were also introduced
during the same period. However, the effect has been unclear in relation to income
inequality. According to OECD the falls in top tax rate have been seen in many
developed countries in the past few decades where the average top statutory tax
rate fell from 66% in 1981 to 41% in 2008 (Keeley 2015, 60). Similarly, tax on
property and inheritance has been on the fall in many regimes, allowing not only
high earners to develop greater income but also greater wealth and capital. As we
see with the factors presented above, the growth in income inequality is a complex
issue with several elements and components playing a crucial role in the growing
concern about this specific topic.
Yet we find ourselves in a period of economic growth that has given rise to a middle
class in possession of increasing assets, at the same time millions of people have been

10
able to escape poverty. Therefore, one wonders why the issue of income inequality
hasn’t been better met. According to some scholars, income inequality might have
a good effect on economic growth since it creates more entrepreneurs that are more
willing to take risks (Keeley 2015, 67). They mean that if there’s an overwhelm-
ing interest to curb income inequality through state tools such as taxes it might
instead harm the incentive to innovate, and so discourage entrepreneurs from taking
such risks (Ibid.). Another argument why putting too much emphasis on possible
negative outcomes of income inequality is that there might be a trade-off between
economic inequality and economic efficiency according to the American economist
Arthur Okun (Ibid.). However, these ideas have been increasingly criticized with
rising evidence that excessive inequality has a negative effect on economic growth.
According to OECD (Keeley 2015) the widening wealth gap between the individuals
in societies leads to low earning families investing far less in education and skills,
which creates a long-term problem since it hurt economic growth by reducing the
numbers of skilled workers and diminishes the numbers of highly productive workers
(Keeley 2015, 69). Likewise, a report from the International Monetary Fund, found
similar results that a higher net Gini coefficient is associated with lower economic
output (Dabla-Norris et al. 2015, 6). Thus, factors of income inequality is a highly
complex topic where several factors contributes to its growth.

2.2 Consequences of income inequality

As previously presented there are several reasons why income inequality has been
growing in the last decades. Not only does this lead to individuals having differ-
ent consumption possibilities, it also has some several long-term effects which in
turn may hurt and harm individuals and growth. As briefly mentioned in the sec-
tion above, income inequality has a particularly significant effect on human capital.
Studies have shown that low-income families invest far less in education and skills.
Students from these backgrounds also have a greater difficulty performing well in
schools compared to the middle and well-off income population (Keeley 2015, 69-
70). This effect can also be traced to the university level where students with
socioeconomically disadvantaged backgrounds are less likely to graduate and have

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a greater tendency to endure long periods of unemployment on the labor market
(Ibid.). These consequences can be broken down to the fact that students with
well-off backgrounds generally have better learning opportunities, since they have a
greater possibility in accumulating knowledge outside formal education systems. In
addition, educational systems can also further reinforce this effect, since quality of
education depend on the socioeconomic standard of the student and its family. The
effect has been most prominently seen during the PISA 2012 test, where students
from better-off families on average are one year ahead in mathematics competence
compared to the students with worse-off backgrounds (Keeley 2015, 72-74).
Income inequality seems to have an effect on an individual level, where generally
people from countries where there’s a greater income inequality have a worse social
cohesion, which can be linked to factor such as trust, participation and well being
in the society (Van de Werfhorst & Salverda 2012, 381). There’s also a relation be-
tween income inequality and health, where countries with higher Gini coefficient i.e
high-income inequality, have populations that in larger extent rank their health as
worse than those with a lower Gini coefficient (Karlsson et al. 2009, 884). In addi-
tion, there seems to be a relationship between income inequality and a population’s
health and well-being (Pickett & Wilkinson 2014). They seem to especially have a
link through psychosocial processes related to social differentiation and relative de-
privation, where states with higher income inequality generally have a higher degree
of anxiety amongst all socioeconomic groups (Pickett & Wilkinson 2014, 323).
An already excessive income inequality might have a severe effect on economic
growth. According to a report by the International Monetary Fund a greater income
inequality is often associated with lower economic output (Dabla-Norris et al. 2015,
6-7). This association can be seen through that if the income inequality is already
on a high level it might incentivize citizens to invest less in human capital such as
education, since it might not be worthwhile (Petersen & Schoof 2015, 5). Further-
more, young and well-educated people might decide to leave the country because
of the excessive income inequality to find better opportunities to make a career for
themselves, which would also hurt the growth. A high degree of inequality might
also in the long term force the states to work on extensive redistribution programs.
This would in turn require the state to increase tax rates, which after a certain point

12
might affect the taxpayer’s interest to invest in the economy, subsequently causing
lower volumes of investment or even cause greater capital flight that would lower
economic growth (Petersen & Schoof 2015, 6). Another outcome of excessive income
inequality that might lead to sub-optimal outcomes is when economic power is used
to exercise political influence, such as that well-off individuals advocating for a tax
reductions. The associated decline in state revenues will further on have an effect on
the state’s expenditure on fields such as infrastructure and education. Consequently,
in long term dampening economic growth because of under-supplying in the public
sector, given a decline in government revenue (Ibid.).

2.3 Measuring income inequality

There are several methods of measuring income inequality. The most common meth-
ods are the Theil index, Hoover index and Gini index. However, since the study will
only include the Gini index to study income inequality, the following section will
only present the fundamental assumption of the Gini index.
The Gini index or sometimes also called Gini coefficient was invented in 1912 by
an Italian Statician called Corrado Gini. The method is a single number aimed at
measuring the degree of inequality in a certain distribution. The single number or
value can range theoretically between range 0 and 1. Where 0 stands for complete
equality, i.e all individuals have the same wealth. Meanwhile the value 1 represents
for complete inequality, where the cumulative share of income is owned by the highest
income earners (Bellu & Liberati 2006, 6). The index can also be expressed in
ratio value e.g 20 percentage of the population earns 60 percent of total income in
the economy. Furthermore, the index is built on the Lorenz curve which is a 45-
degree line that depicts perfect equality in an economy. Graphically, the closer the
Gini coefficient is to the Lorenz curve the more equal income distribution becomes.
On the other hand, the further the Gini coefficient is from the Lorenz curve the
more unequal it becomes. Mathematically, the Gini index is generally calculated by
dividing the area between the perfect line of equality and Lorenz curve (A) divided
by the entire area (A+B).

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 Figure 2.1:
Graphical representation of the Gini coefficient. The X-axis represents the share of
population, while the Y-axis represents the share of income accumulated. The
curved line between A and B is the Gini coefficient, the closer to the 45 degrees
slope it is, the more equal income is distributed. (Authors own creation)

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3. Previous research

Research concerning governance and income inequality is a topic that is of interest

to many scholars. In the study “Relationship between government quality, economic
growth and income inequality: Evidence from Vietnam” Nguyen Thanh Hung et al.
(2020) study how government quality, growth and income inequality are related in
Vietnam. Furthermore, the authors study the relationship between these variables
by using a simultaneous equation model regression where three separate regression
models are intertwined to be able to find if the dependent variables, government
quality, economic growth and income inequality potentially interact with each other
(Hung et al. 2020, 4). In addition, the dependent variables are considered to be
endogenous in each equation as a control variable, hence they are also included in
the separate regression to be able to illuminate if there’s a possibility that the equa-
tions are correlated. Other control variables included in the equations are variables
based on economic growth theory (Ibid.). The data used in the study covers the
time period 2006-2019 and was collected from Vietnam Chamber of Commerce and
Industry, Vietnam Union of Science and Technology Association, the United Nations
development program in Vietnam, and the World Bank (Hung et al. 2020, 4-5). The
results from the regressions show that there’s a simultaneous relationship between
the dependent variables i.e improving the quality of government will boost economic
growth and reduce income inequality. However, the results also show that economic
growth improves the quality of government, but it seems like there’s a trade-off be-
tween economic growth and inequality. In addition income inequality will reduce
the improvement of government quality (Hung et al. 2020, 8). Hence, Hung et
al. (2020) suggest that there’s a mutual interaction between the factors presented
and that the government should consider, evaluate and predict when implementing
policies at specific time and in a certain context given the different impacts they

15
may have.
Chiung-Ju Huang and Yuan-Hong Ho of Feng China University studies the relation-
ship between governance and income inequality in “The impact of governance on
income inequality in ten Asian countries” (2018). The authors use ordinary least
squares regression to study the impact of governance quality on income inequality
in Asian countries. The data used in the study is panel data covering advanced-
and developing economies between the time period 1996 to 2015. The advanced
economies include countries such as Japan, Singapore and South Korea, while de-
veloping countries are represented by countries as China, Indonesia and Thailand
(Huang & Ho 2018, 218-219). The dependent variable in the regression is the Gini
index followed by several control variables as economic growth, the share of elderly
in the population, two types of governance quality variables, one of which is demo-
cratic quality and the other technical quality (Ibid.). Furthermore, the authors
use a fixed effect and random model to deal with heterogeneity, they also test the
cross-sectional dependence, slope homogeneity and panel unit root. The empirical
results show that technical quality on income inequality is positive for advanced
economies, while democratic quality is non-significantly positive. Hence, improving
an advanced country’s political situation, such as accountability and voice will not
be effective to reduce income inequality (Huang & Ho 2018, 222). On the other hand,
promoting technical quality such as government effectiveness and regulatory quality
might increase income inequality. For developing countries, the effect of democratic
quality and technical quality is negative on income inequality. Therefore, promoting
accountability and political stability but also the effectiveness of government and
control of corruption will reduce income inequality (Ibid.). The authors conclude
that a high quality of governance can play an important role for improving income
equality in developing countries. However, promoting good governance in advanced
countries may not be as effective as in developing countries (Ibid.).
Having said that, the relation between income inequality and governance is not al-
ways as clear as indicated above. A study conducted by Antonio R. Andres and
Carlyn Ramlogan-Dobson (2011) found that a lower level of corruption in a state
is associated with a higher income distribution in countries in Latin America. The
authors used a four-year panel data over the period 1982-2002 for 19 Latin Amer-

16
ican countries. The regressand in the model was the Gini coefficient followed by
regressors such as corruption, natural logarithm of GDP and other closely related
variables. In addition, agricultural total output, the openness of the economy and
other state-related and macroeconomic-related variables were included in the model
(Andres & Ramlogan-Dobson 2011, 962-963). The regression model also included a
fixed-effects model to control for unobserved individual effects. The empirical results
from the study show that corruption and inequality are inversely related. Thus, cor-
ruption contributes to reducing inequality and might work as a means of pro-poor
redistribution (Andres & Ramlogan-Dobson 2011, 972). The authors explain this
outcome by saying that Latin American countries generally have a large informal
sector that provides jobs and income for the poorest in the society. Furthermore,
many of the people working in the informal sector might lack the characteristics
to hunt jobs in the formal economy for reasons such as discrimination and insti-
tutional barriers. The informal sector can also create more jobs since it generally
has a lower operational cost, hence if corruption would decrease, profits would be
reduced, the same with job opportunities with them (Ibid.). The authors also reason
that corruption is a price worth paying for lowering inequality, making a case for
the government not intervening in the informal sector because without corruption,
income gap would increase. However, Andres and Ramlogan-Dobson point out that
if corruption is allowed to grow to a certain point, it would do more harm than good
in the long run. Such as weakening institutional framework consequently creating
and consequently creating a government with low quality, which might affect several
sectors in the formal economy. A safe way to fight the inequality in Latin America
according to the author is to encourage countries to deal with corruption but also
simultaneously adopt policies that promote opportunities for the poorest groups in
the economy (Ibid.).

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4. Theoretical framework

4.1 Kuznets inverted U-hypothesis

The theoretical framework used in this thesis is based on the Kuznets inverted-U
hypothesis which illustrates the relationship between economic growth and income
inequality (Kuznets, 1955). The inverted-U hypothesis is built on the assumption
that during the early stage of economic growth in a country the income inequality
is going to be increased due to the economic growth (Kuznets 1955, 18). This
is due to the labor force being distributed unfairly, so that the majority of the
low-income earners work in the agricultural sector while more of the high-income
earners work in the industrial sector, which creates this skewed distribution. With
the economic growth, some labor becomes placed closer to urban areas consequently
increasing the average income. However, the owners of major assets enjoy the rising
income, investing more money in cheap labor and continue to hold down the wages
of people that move into the urban areas (Kuznets 1955, 7). Because of this, the
average income grows amongst the population somewhat, but the income gap grows
significantly more, since the rich keep the asset share which grows through time.
After a significant time with proper development of the state, protective and sup-
porting legislation gets passed to counteract the extreme effect industrialization and
urbanization have on the broad masses to enable them for more adequate income
share in their growing economy (Kuznets 1955, 17). Hence, through these assump-
tions, the inverted U-hypothesis curve’s exponential growth in income inequality
loses its pace. The curve’s tilt should start to show diminishing development in
inequality, resulting in a flattening curve. After some time, the country’s living
standard increases which lead to a decline in death rate, but also to some extent

18
the birth rate. Consequently greater parts of the population move into urban areas
which in the long term results in the urban population dominating the rural pop-
ulation (Kuznets 1955, 19). As a result, the average income continues to grow. In
addition, the income gap narrows because the majority of the population now lives
in urban areas of the city.
Hence through several factors such as people relocating into urban areas for labor
and protective legislation being passed by the state and increasing standard of living
the income inequality should decrease. Furthermore, Kuznets points out several
factors why some countries don’t reach the last stage of declining income inequality.
According to Kuznets, this pattern is often seen in emerging countries, one of the
reasons is because the average income is much lower than in countries in the west
which makes it difficult for the average individual to accumulate wealth, something
the more asset-rich can do (Kuznets, 1955, 23). Another reason is that the industrial
structure and opportunities are far more limited compared to the more industrialized
countries. The last factor why some countries haven’t been able to narrow income
inequality is because of government failure, i.e that they cannot build a strong
foundation to protect and bolster the low-income class (Kuznets 1955, 24). However,
according to research, the inverted U-pattern hypothesis has fared less well in recent
years. The inequality was falling until the middle of the century as the hypothesis
predicts but, since the latter end of the 20th century, it has been on the rise, creating
a U-shaped growth instead (Keeley 2015, 65). Hence, its validity has been questioned
with time by the empirical support it seems to somewhat lack.

4.2 Governance
As presented in the section above, the hypothesis of the relationship between income
inequality and economic growth is conditioned by factors such as the governance.
Thus, without a state that has the interest and possibility to effectively handle the
adverse effects of accelerating income inequality through applying effective and op-
timized measures, the outcome shown by inverted U-hypothesis will not be fulfilled.
The concept of governance and its performance is a relatively new field that has
been accumulating greater interest in the last decades. According to La Porta et al.

19
(1999) a government can optimize its performance through several different factors
which play crucial parts in it being able to in the best way possible handle issues
and public administrative affairs.
Firstly, a government that optimizes its performance i.e possesses a high quality
of government has generally a low level of interventionist interests (La porta et al.
1999, 7). Hence, a good government should protect property rights, keep regulations,
and taxes should be light. However, the interpretation of interventionism can be
ambiguous in some areas such as taxation. On one hand, high taxation might
be a high level of intervention, but from another point of view, high taxes might
benefit public goods provided by the government (Ibid.). Another crucial factor of
a high level of quality of government is the effectiveness of the government. On
average interventionism should be associated as a trade-off with efficiency, hence
greater interventionism consequently leads to lower efficiency for the government
interventions (Ibid.). However, there are several examples that this relationship is
not always the case, it can be noted that interventionism and efficiency play a key
part in aspects of government performance. Moreover, depending on the compliance
level of the intervention, arbitrary effects such as corruption can be developed.
The third factor of quality of government is that public service is provided by the
government. Hence, government performance should be assessed by evaluating the
quality of the public goods provided by the state. Such public goods might be,
schooling and infrastructure (La Porta et al. 1999, 8). However, some countries
have private agents providing these goods, but generally, governments have come to
play a central part in delivering these goods. Thus, the high quality of these public
goods is a sign of a government that has a high quality of government. Expenditure
on transfers by the government should also be seen as an important indicator of
government performance. The expenditure on transfers should be seen as its own
consumption i.e employment in the public sector. It can be understood as when a
government’s expenditure is high, the citizens have a high level of trust and enjoy
its action, reflecting good government (Ibid.). On the other hand, a high level of
expenditure on transfers may reflect an increased level of redistribution through
distortionary taxes thus, representing a failure to protect citizens from government
interventions. That said, these factors might depend on the size of the government

20
which is more related to political interest rather than public-spirited intentions. The
last dimension of good government is democracy and political rights. Political and
economic freedom generally goes hand in hand and both are crucial of a well-doing
government. However, this relationship has been difficult to find in recent data. On
the other hand, it can be pointed out that over the long span of history, countries
with greater freedom are generally more linked to a higher quality of government
(La Porta et al. 1999, 9).
The quality of government is an important factor for the engagement and functioning
of a government. However, a government also needs the element of being able to
execute tasks and goals it has put forth. Thus, the quality of government might be
crucial, but state capacity is also another factor for a well-functioning government.
Lindvall and Teorell (2017) see state capacity as the state’s ability to get things done.
They explain that state capacity should be seen as the power of the state’s agents
to get members of society to do things that they wouldn’t do otherwise (Lindvall &
Teorell 2017, 9). Policy instruments should hence be seen as means or tools that the
state uses to exercise its power. Hence, state capacity should be seen as the strength
of the causal relationship between policies and outcome. Simply put, the higher the
state capacity is at, the more policies it adopts to be able to achieve a specific
outcome. Meanwhile, a government that has a low state capacity will have a harder
time accomplishing its desired outcomes (Ibid.). Moreover, state capacity can be
divided into two separate criteria, its autonomy and its capacity. Autonomy refers
to the extent that the state is not controlled by external forces, on the other hand,
capacity refers to the extent to which it controls the desired outcome it attempts to
achieve (Lindvall & Teorell 2017, 10). Thus, if the state can be defined as A and
society defined as B, then capacity can achieve the desired outcome if the causal
effect is α > 0. By contrast, autonomy which represents absence of external forces
controlling or affecting the state implies that causal effect from B, society to A, the
state should be β = 0 (Ibid.). In the case of democratic countries, the capacity α is
low and is matched and controlled by the causal effect in the other direction α ≈ β.
Another important dimension of state capacity is resources, which it can use to op-
timize causal effect between policies and the intended outcome. In other words: the
causal relationship is conditioned by resources (Lindvall & Teorell 2017, 13). Im-

21
portant resources for the state are revenue, human capital, and information policy
instrument can also be divided into separate categories, with coercion, incentives,
and propaganda as the means which the government can use to affect the outcome
(Lindvall & Teorell, 2017, 14). Coercion is the crudest policy instrument that the
state can utilize since it uses means of violence however, it can be seen as being
a relatively simple policy to exercise. On the other hand, it has many limitations.
Most importantly it’s impossible to use coercion when the desired outcome is dif-
ficult to observe. This is because it can be difficult to observe if the society really
does comply or not, or if just some section of the society is prone to these kinds of
measures. To use incentive efficiently, the state needs to accumulate detailed infor-
mation about the population such as motivation and income so it can in an effective
manner deploy an incentive that incentivizes the population. Policy instruments
that can provide such incentives are mainly tax-transfer systems since, most impor-
tantly, the state needs resources that can be distributed, such as money (Lindvall
& Teorell 2017, 16). The best incentive systems that can be deployed are generally
self-sustaining and don’t need any monitoring, which coercive policies would need.
Hence, by rewarding citizens when they act to fulfil the outcome they desire they
get rewarded automatically. The last category, propaganda can be used effectively
if the state can access means of communication and knowledge transfer. Further-
more, it also needs to have a good model for the citizen’s psychological dispositions.
Compared to coercion and incentive, it can be more efficient since it requires no
information about whether the citizens actually act towards the desired outcome
or not. However, it’s a fairly difficult instrument to use, especially in pluralistic
societies where the state doesn’t control the means of communication (Lindvall &
Teorell 2017, 16-17). Simply put, state capacity is the state’s ability to get things
done, it also represents the causal link between policy instrument and desired out-
come. Given that it isn’t controlled by external forces and it can achieve the desired
outcome, the state can be seen as having a high capacity. Furthermore, the policy
instrument can be divided into several branches where some are direct, while other
branches use more indirect methods to persuade the population towards achieving
the optimal outcome.

22
4.3 Kuznets inverted U-hypothesis & governance
Given the theoretical onsets presented above, this study argues that Kuznets in-
verted U-hypothesis is conditioned by the quality of government but also by the
state capacity. Especially, if the quality of government and state capacity is high,
the government should be able to deploy countermeasures to handle income inequal-
ity. However, if the opposite is true then the government will not be able to deal
with income inequality. Specifically, that without a government that has high qual-
ity, the countermeasures to deal with income inequality will not be efficient. Thus,
as the inverted U-hypothesis states, in the early stages of economic growth, the
income gap will grow steadily (Kuznets, 1955). However, after a significant time
conditional on quality of government and state capacity, the government should, if
quality and capacity is high provide policy and legislation to redistribute the income
throughout the economy in a more optimizing manner. Hence, as La Porta et al.
(1999) states crucial elements such as, limited interventions, high level of efficiency,
public services, government expenditure and freedom must be optimized.
However, if state capacity isn’t optimized in the first case, a high quality of govern-
ment cannot be achieved. This is because state capacity as previously mentioned
measures the causal effect between policy instruments and the desired outcome
(Lindvall & Teorell 2017). Thus, a government that has a high ability to accomplish
its task will generally represent a higher level of governance, because without the
ability to fulfil the tasks, the crucial elements in dimensions of quality of government
wouldn’t be optimized.
The relation between state capacity can therefore be understood as the quality of
government being conditioned on state capacity. Without a government that has
the ability to strive to successfully reach desired outcomes will not consequently be
able to provide governance on a good standard. On the other hand, the concept
of state capacity is crucial for the specific legislation and policy implementations
needed to transfer and redistribute capital flow within a society since state capacity
itself measures the state’s ability to get things done. Hence, given that the state
can achieve the optimal outcome without being affected by external forces such as
corruption and that the policies themselves are in this specific case high incentivizing

23
by a transfer system that rewards resources as a trade-off, optimal legislations or
policies should be able to be implemented to decrease income inequality. Therefore,
the relationship between state capacity can be seen as somewhat more complex
than just a causal relation in one direction. A government that can maintain a high
level while having a high state capacity can hence through legislations, taxes, and
subsidies transfer and redistribute the capital flow within the society. Consequently,
increasing the income of the lower percentiles in the state simultaneously boosts the
economic output of the state as the U-hypothesis claims (Kuznets 1955).
On the other hand, if the criteria for high quality of government and state capacity
cannot be reached according to the standards of La Porta et al. (1999) and Lindvall
and Teorell (2017) the inverted U-hypothesis would have a far more difficult time
achieving a smaller income gap amongst the percentiles in the society.
Without a government that protects private property, provides public goods and
services to its citizens through government expenditure, and in an efficient manner
intervenes in the society, a proper redistribution wouldn’t be achieved. Moreover, a
government that lacks capability in creating effective policies but also not accom-
plishing its desired goals through the implementation of the policies would also hurt
the process. Leading to poorer groups of the state experiencing a small or no income
growth. Meanwhile, the better-off groups would stay in their steady-state or increase
their gap leading to no significant decrease in inequality would being seen amongst
the groups. Thus, the theoretical framework of this study emphasizes that inverted
U-hypothesis is conditioned by the quality of government and state capacity and
depending on if the quality and capacity is high, the outcome i.e income inequality
will be affected.

24
5. Theoretical hypothesis

This study will utilize a statistical hypothesis where a null hypothesis and an alter-
native hypothesis will be in use to test if there’s a significant relationship between
the variables of interest. In this study, the critical value that will decide if the null
hypothesis can be rejected or not will be at a 10% level. Hence, if the critical value
standard of this study is met at the population mean µ, it is said to be statistically
significantly different from null hypothesis. The null and alternative hypothesis can
be written as the following:

H0 = µ = 0 vs H1 = µ 6= 0

Where the null hypothesis represents that there’s no relationship between the income
inequality and quality of government. Meanwhile, the alternative hypothesis states
that there’s a relationship between income inequality and quality of government.

25
6. Data & method

6.1 Data
The data for this study is collected from the Quality of Government Institute at
Gothenburg University. The data set includes 350 variables from 75 different data
sources all related to the topic of good governance and quality of government. The
specific data set used in this study is a panel data set that includes variables and
observations from 1946 to 2020 across a multitude of countries. The units in the
data is country-year based. It can further be mentioned that the data set is fairly
balanced. However, it has some missing observations across entities during some
years, particularly in the early years of the data set. In regards to reliability, the data
set has collected its variables through international organizations and universities,
thus reliability of the data set should be regarded as high. Given the wide range of
countries and years the data set includes, the study can ensure that the results are
not just regional tendencies during a specific year.

6.2 Method
This study utilized ordinary least squares regression analysis to study the relation-
ship between income inequality and governance. The relation between these vari-
ables can be estimated through the ordinary least squares estimator. The estimator
chooses a regression coefficient so that the predicted regression line fits the observed
data as close as possible. The closeness is measured by the sum of squared mistakes
made in predicting the outcome variable, Yi given the control variable, Xi (Stock
& Watson, 2015, 116). Thus we can calculate the intercept of the regression line,

26
β0 and slope of the regression line β1 . The residual or error term, ε represents the
difference between outcome variable, Yi and the OLS predicted outcome value, Ŷ
(Stock & Watson 2015, 117).
There are some central assumptions of the linear regression model that need to hold,
otherwise the assumptions estimates will not give useful estimates. Since this study
will utilize multiple control variables the assumptions presented will cover multiple
regression analysis. However, the assumptions are much alike to the assumptions
for linear regression with single control variable. The first least-squares assumption
is that conditional distribution of the error term, εi given the control variables,
X1 , X2 ...Xk has a mean of zero (Stock & Watson 2015, 199). Simply put, the other
factor in the error term should be unrelated to control variables when they take on a
value. The second assumption is that the variables are independently and identically
distributed, i.i.d across observation. In other words that the observations have the
same probability distribution as the others and all are mutually independent (Stock
& Watson 2015, 199). However, since this study is working with panel data, the
assumption will be somewhat relaxed. The third assumption is that large outliers
are unlikely, this is because the OLS estimator of the regression can be sensitive
to large outliers thus affecting the output (Ibid.). And the last assumption, no
perfect multicollinearity, that no regressor i.e control variable should be perfectly
linear with other ones. The mathematical reason for this problem is that perfect
multicollinearity produces division by zero in the OLS formula making it impossible
to compute the OLS estimator (Stock & Watson 2015, 200).
The reason why this study will also utilize multiple regression is to control for
possible omitted variable bias. The bias occurs when the following conditions are
true: (1) when the omitted variable is correlated with the control variable, Xi and
(2) when the omitted variable is determinant of the outcome variable, Yi (Stock &
Watson 2015, 185). Since the control variable Xi , is correlated with the error term,
εi the first least-squares assumption will be violated, because the conditional mean of
εi given Xi is nonzero. In other words, since the least-squares assumption is violated
the OLS estimator is biased and will not give useful estimates (ibid.). Hence, by
including several X-variables as the case of multiple regression analysis we control
for possible omitted variables by holding other factors in the regression constant. In

27
other words, a regression with a single regressor is vulnerable to omitted variable
bias and multiple regression makes it possible to mitigate such bias in the estimates
by including these omitted variables in the regression (Stock & Watson 2015, 206).
In the context to the topic of the study, several control variables for the reasons
mentioned above.

6.2.1 Logarithmic regressions

The regression model will also include natural logarithm, therefore, the function will
be a nonlinear regression function. By using logarithms, changes in variables can
be converted into percentage changes (Stock & Watson 2015, 269). Moreover, log-
transformed variables is a convenient way of transforming highly skewed variables
into more normal distribution and reducing heteroskedasticity (Benoit 2011). The
types of nonlinear regression used in this study are log-linear regression, where 1 unit
change in Xi is related to a 1% change or 0.01 unit in Yi . And log-log regression
where 1% change or 0.01 unit in Xi is associated with 1% change or 0.01 unit change
in Yi (Stock & Watson 2015, 276). Hence, the study has logarithmized the outcome
variable that represents income inequality, Gini coefficient and the control variable
real GDP per capita to reduce skewness and heteroskedasticity of the variables. The
logarithmisation of the Gini index might sound unintuitive however, since we are
interested in how income inequality is affected by the quality of government, exact
value of the Gini index is not sought after since, the paper studies if the relationship
is positive, negative or non-significant. Additionally, it reduces heteroskedasticity
and skewness as previously mentioned above.

6.2.2 Regression analysis with panel data

This study will use panel data or so-called longitudinal data for studying the topic.
The difference between cross-sectional data and panel data is that panel data consist
of observation on the same entities, i at two or even more time periods, t (Stock &
Watson 2015, 351). The regression will cover observation through different entities
and time periods. This study will utilize two different panel data analysis models to
study the relationship between income inequality and governance. The first model

28
is a pooled ordinary least squares model where observations in the different entities,
i and the different time periods, t will not be controlled, hence the structure of the
observations given entity and time is irrelevant (Wooldridge 2010, 191-193). Our
second panel data analysis model is a fixed effects model, its main characteristic
is that it controls for omitted variables in the panel data when the omitted vari-
ables vary across the entities but don’t change over time (Stock & Watson 2015,
357). Moreover, compared to the pooled OLS model fixed effects regression has n
different intercepts for each entity. These intercepts are represented as binary vari-
ables and absorb influences of omitted variables that differ between entities but are
constant over time (ibid.). Hence, the main regressions in the study are the following:

Pooled ordinary least squared model:

Ln(Gini)it = β0 + β1 QOGit + β2 Ln(GDP/capita)it + β3 Globalizationit + εit (6.1)

Fixed effects model:

Ln(Gini)it = β0 + β1 QOGit + β2 Ln(GDP/capita)it + β3 Globalizationit + αi + εit

(6.2)
Where the outcome variable is Ln(Gini)it with entity i and time t, and the control
variables is represented with the coefficient β with entity i at time t. αi is the entity
fixed effects, lastly εit represents the error term at entity i, at time t. Since this
study is interested in explaining how the main regressor, the quality of government,
affects the outcome variable, the Gini index in a clear and comprehensive way, the
study will execute the regression presented above where some and non of the other
regressors are excluded. The control variables will be added for the opposite reason,
to estimate the change in the outcome variable of a change in one control variable
while holding the other regressors constant (Stock & Watson 2015, 192). Note that
the pooled ordinary least squared model and fixed effects model will still be in use.

29
6.2.3 Autocorrelation and standard errors
In some instances, the regressions can be autocorrelated, i.e when the value of the
outcome, Yi in one period is correlated with its own value in the next time period
(Stock & Watson 2015, 528). Then the heteroscedasticity robust standard error
formula is not valid because it’s derived under the false assumption of no possible
autocorrelation. To deal with this issue this study will utilize a clustered standard
error, a type of standard error that is heteroskedastic and correlated over time called,
heteroskedasticity and autocorrelation consistent standard error, HAC. Clustered
standard errors allow for heteroskedasticity and autocorrelation within a certain
entity however, it treats the errors as uncorrelated across entities. The clustered
standard errors allow for heteroskedasticity and autocorrelation in a way that’s
consistent with the second central assumption of fixed effects regression (Stock &
Watson 2015, 367). Thus, clustered standard errors will be utilized for the fixed
effects model.

6.2.4 F-test
To compare which of the statistical models presented above have the best fit for the
given data set an F-test will be conducted. To be able to conduct the F-test the
F-statistics will be used to test the joint hypothesis that all the slope coefficients
are zero. The null hypothesis and alternative hypothesis are the following:

H0 = β1 = 0...βk = 0 vs H1 = βj 6= 0 atleast j, j = 1...k

As the hypotheses state above, if all regressor coefficients are set to the value zero,
then the null hypothesis is true and the restricted regression i.e pooled OLS has
a better fit. However, if the alternative hypothesis is true then the unrestricted
regression i.e fixed effects model is a better fit, due to the sum of squared of residuals
being sufficiently smaller in the second than in the first regression model (Stock &
Watson 2015, 227).

30
6.3 Control variables
In the following section the control variables included in the regression models will
be presented. The two additional control variables except the quality of government
variable are selected given the relevance they have to the topic of income inequality.

6.3.1 Quality of government

The first regressor included in the study is the quality of government, measured by
International Country Risk Guide. The quality of government variable is a mean
value of the ICRGs variables corruption, law and order and bureaucracy quality.
The corruption variable is the assessment of corruption within the political sphere,
while law and order are assessed separately. Law is an assessment of strength and
impartiality of the legal system and order is assessment of popular observance of the
law (Dahlberg et al. 2021, 98). Bureaucracy quality represents institutional strength
and quality of a government. The ICRG quality of government is measured from
scale 0 to 1 where a high value represents better governance (Ibid.).

6.3.2 Real GDP per capita

The second regressor is real gross domestic product (GDP) per capita. It represents
a country’s economic output per person and is frequently used as a variable that
represents growth and is included in the studies covering the same field (Andres &
Ramlogan-Dobson 2011; Huang & Ho 2018; Hung et al. 2020). Furthermore, real
GDP per capita differs from GDP per capita. By being adjusted for inflation, the
real GDP capita in this study is collected by the Maddison project (Dahlberg et al.
2021, 106). Moreover, by including the GDP per capita variable we can test if the
inverted U-hypothesis holds (Kuznets 1955). It should be noted that the author of
the study has decided to logarithmize the variable due to its skewed distribution, see
appendix for the graphical distribution of the variable. Thus, a percentage relation
will be attained since the outcome variable, the Gini coefficient is logarithmized.

31
6.3.3 Index of globalization
The last control variable included in the regression is an index of globalization col-
lected by ETH Zurich. The globalization index is the weighted average of economic,
social and political globalization. Economic globalization represents financial flows
such as the trade of goods and services. Meanwhile, social globalization represents
interpersonal contact, flows of information, internet access and cultural proximity.
Political globalization contains variables focusing on memberships of international
organisations and treaties. The index of globalization ranges from 0 to 100 where a
higher value indicates a higher degree of globalization (Dahlberg et al. 2021, 64-65).

6.4 Descriptive statistics

In this section, all the variables included in this study is presented. Note that
logarithmized Gini index and GDP per capita will be included in the table.

Table 6.1: Descriptive statistics

Obs Mean Std.Dev. Min Max

Gini 1.626 38.81488 9.345682 22.2 65.8

QOG 4.939 0.5445757 0.2205877 0.0416667 1.00

GDP/capita 9.559 10206.25 12745.63 0.00 156299

Globalization 8.348 50.06059 16.82437 14.14902 90.98389

Ln(Gini) 1.626 3.630687 0.2360832 3.100092 4.18662

Ln(GDP/capita) 9.557 8.603126 1.147036 5.921578 11.95953

32
7. Results

In the following section the results from the panel data regressions are presented.
The first table presents the results from the pooled OLS model and the following
table presents results from the fixed effects model.
.
Table 7.1: Pooled OLS model

(1) (2) (3)

Quality of -0.563*** -0.380*** -0.314***
government (0.0261) (0.0370) (0.036)

-0.0534*** 0.0390***
Ln(GDP/capita)
(0.00778) (0.0118)

-0.00777***
Globalization
(0.000761)

3.957*** 4.353*** 3.960***

Constant
(0.0162) (0.0599) (0.00695)

Standard errors Standard Standard Standard

Observations 1429 1425 1425
R-squared 0.246 0.270 0.320
Adjusted R-squared 0.245 0.269 0.318
Standard errors in parentheses.
*p <0.05, ** p <0.01, ***p <0.001

In model (1), the main relationship between the logarithmized Gini index and quality
of government is presented. The result shows that the relationship is -0.563 (SE

33
0.0261) hence, the effect of one additional unit increase in quality of government leads
to -56.3% decrease in the Gini coefficient. Moreover the result is significant on a 99%
level i.e we can reject the null hypothesis, which states that there’s no relationship
between Gini index and quality of government on a 99% level. The constant also
tell us that if quality of government would take the value 0, the logarithmized
Gini coefficient would take the value 3.957 (SE 0.0162) its also significant on 99%
level. Moreover by looking at, the R-squared and the adjusted R-squared value we
can interpret how much of the variation in the outcome variable is explained by
the control variables (Stock & Watson, 2015, 196-197). Furthermore, adjusted R-
squared is generally used for multiple regression compared to the ordinary R-squared.
The main difference is that when a new variable is added in a model, generally the
R-squared value increases. If the R-squared would have been used to analyse the
multiple regression an inflated estimate would be given (ibid.). Therefore, by using
the adjusted R-squared we can correct, or in other terms deflate the value. In model
(1) the R-squared value is 0.246 in other words, the control variable is able to explain
24,6% of the variation in the outcome variable.
In model (2) we control additionally for logarithmized real GDP per capita, by
keeping it fixed we can see that the relationship between Gini coefficient and quality
of government is somewhat reduced to -0.380 (SE 0.0370). On the other hand, if we
keep quality of government fixed we can see that one percent increase in real GDP
per capita leads to decrease of the Gini index by -0.0534% (SE 0.00778). According
the relationship given we can see that the inverted U-hypothesis (Kuznets 1955) seem
to hold given the results from model (2). However, the relationship is fairly weak.
Moreover, we find that both results for quality of government and real GDP per
capita are significant on a 99% level. Additionally, the constant takes on the value
4.353 (SE 0.0599) and it is significant on a 99% level. Since model (2) is a multiple
regression we now interpret the value from the adjusted R-squared. The value given
is 0.269 the two control variables are able to explain 26.9% of the variation in the
dependent variable.
In model (3) all the control variables from the regression model are included. Given
that real GDP per capita and index for globalization are fixed we see a -0.314 (SE
0.0363) decrease. In other words, holding all control variables fixed i.e ceteris paribus

34
except quality of government we see a 31.4% decrease in the Gini coefficient given
one unit increase in quality of government. Moreover, compared to the model (2)
we find the relationship between real GDP per capita being reversed. Hence, it
seems to now have a positive relationship instead of the previous negative relation
show in the model prior, given that quality of government and index of globalization
are fixed. Thus, by one percent increase in real GDP per capita we see a 0.0390%
increase in the Gini coefficient. In addition, index of globalization seem to have a
negative relationship given that we control for the other control variables where one
unit increase in globalization leads to decrease in the Gini coefficient by -0.7% (SE
0.000761). Hence, the more globalized a country becomes, the lower the income
inequality becomes, although the effect is minimal. Lastly, the constant takes on
the value 3.960 (SE 0.0695) and its significant on 99% level. Lastly, the adjusted R-
squared value given for model (3) is 0.318 i.e 31,8% of the variation in the outcome
variable can be explained by the control variables included in the final pooled OLS
model.

35
 Table 7.2: Fixed effects model

(1) (2) (3)

Quality of 0.186** 0.155* 0.152*
government (0.0636) (0.0703) (0.0697)

-0.0570* -0.0483
Ln(GDP/capita)
(0.0229) (0.0352)

-0.0004257
Globalization
(0.00129)

3.520*** 4.074*** 4.022***

Constant
(0.0372) (0.228) (0.282)

Standard errors Clustered Clustered Clustered

Observations 1429 1425 1425
R-squared 0.918 0.921 0.921
Adjusted R-squared 0.910 0.914 0.914
Standard errors in parentheses.
*p <0.05, ** p <0.01, ***p <0.001

In the table above the regression outputs from the fixed effects model are presented.
In the model (1) similarly to the pooled OLS model, a bivariate model between
the logarithmized Gini index and quality of government is showcased. The result
illustrates the coefficient 0.186 (SE 0.0636). Thus it can be interpreted as, one unit
increase in quality of government leads to an increase of the Gini coefficient by
18.6%. Moreover, the result is significant on a 95% level i.e we can reject the null
hypothesis on a 95% level. The constant takes on the value 3.520 (SE 0.0372) and
its significant at a 99% level. The R-squared value from the bivariate fixed effects
regression is 0.918. Hence, 91.8% of the variation in the logarithmized outcome
variable is explained by the control variable.
Model (2) showcases the same regression but with another control variable included,
making the regression into a multiple regression. Given that we control for the addi-
tional variable, logarithmized real GDP per capita, we find that the result becomes
0.155 (SE 0.0703) it can be interpreted as, a unit increase in quality of government

36
increases the Gini coefficient by 15,5%. On the other hand, if we keep quality of gov-
ernment fixed we get the result -0.0570 (SE 0.0229) for real GDP per capita. Hence,
we see that logarithmized real GDP per capita increases by one percent we see a
-0.0570% decrease in the logarithmized Gini index. Furthermore, the variables are
both significant at a 90% level. The constant takes the value 4.074 (SE 0.228) and is
significant on a 99% level, it represents the value logarithmized Gini coefficient takes
if all control variables take on the value 0. In addition, the adjusted R-squared gives
the value 0.921. Thus 92,1% of the variation in the outcome variable is explained
by the two control variables included in the model (2).
Model (3) as in a pooled OLS regression model, we include all the control variables
in the regression. Given that we control for logarithmized real GDP per capita and
index for globalization we find the relationship between quality of government and
logarithmized GDP per capita being 0.152 (SE 0.0697) it can be interpreted as one
unit increase in quality of government leads to 15.2% increase in the logarithmized
Gini index. The output is significant at a 90% level. The other control variables
both show a negative relationship, given that we control for the other variables and
keeping them fixed. However, both the logarithmized GDP per capita and index
for globalization fail to reject the null hypothesis, in other words the relationship is
non-significant. In addition the constant takes on the value 4.022 (SE 0.282) and its
significant on 99% level. Finally, the adjusted R-squared value of model (3) is the
same as in the model (2) 0.921. Hence, 92.1% of the variation in the Y-variable is
explained by the control variables.

37
8. Analysis

The pooled OLS regressions showcase a negative relationship between quality of

government and income inequality in all three regressions. Where in model (1) the
coefficient value presented is -0.563 (SE 0.0261) in model (2) -0.380 (SE 0.0370)
lastly in model (3) -0.314 (SE 0.0363). The effect seems to diminish when more
additional control variables are included in the model. These results are on par with
some of the previous studies made on the topic that there’s a negative relationship
between the variables. Hung et al. (2020) conclude that there’s a negative relation
between quality on government and income inequality through economic growth.
Meanwhile, Huang and Ho (2018) points forth that there’s a similar relationship in
developing countries in Asia.
Differently from pooled OLS, the fixed effects regressions conducted in the study
illustrate a positive relationship between the main regressor and the regressand.
Where results from model (1) give the coefficient 0.106 (SE 0.186), model (2) 0.155
(SE 0.0703) and model (3) 0.152 (SE 0.0697). Moreover, the relationship isn’t as
highly significant as in the pooled OLS, where all of the models including the control
variables show significance at a 99% level. Hence, when controlling for entity fixed
effects we see a weaker significance level on all of the main regressors compared to
the pooled OLS. However, when controlling for additional control variables in both
pooled OLS and fixed effects model we see a weaker relationship between the main
regressor and regressand given that we keep the other control variables fixed. It can
be further noted that the results from the fixed effects model somewhat correspond
with the result from Antonio R. Andres and Carlyn Ramlogan-Dobson (2011), where
a positive relationship could be derived, in this case between corruption and income
inequality. However, it should be taken into account that comparing the results from
previous studies with the results from this study should be seen as guidance in the

38
 Figure 8.1:
Graphical comparison of the bivariate regression pooled OLS and fixed effects
model. The negative sloped line represents the pooled OLS regression, meanwhile
the positively sloped lines with separate intercepts is the fixed effects model
regression.

topic of income inequality and governance and not as concluding results, it should
instead illustrate the complexity of the field of the study. Moreover, to answer the
theoretical hypothesis presented in the study we can conclude that we can reject the
null hypothesis in all regressions in the pooled OLS and the fixed effects model, i.e
we find a relationship between quality of government and income inequality given
the results presented.
Furthermore, an F-test is conducted to find which of the models have the best fit
relative to the data used in the study. The results showcase that all models reject
the null hypothesis, where model (1) and (3) reject the null hypothesis on a 1%
level, while, model (2) rejects it on a 5% level. What this tells us is that the fixed
effects model has in a general, a better fit to the data used in the study compared to
the pooled OLS. In other words, the model which keeps entity effects fixed and has
separate intercept for each entity compared to the pooled OLS that has one single

39
intercept shows that it has a better fit compared to the latter.
Given the conducted F-test, which provides information that the fixed effects model
has a better fit relative to the data, this study will conclude by addressing that
when controlling for fixed effects in the regressions we find that higher quality of
government lead to a higher income inequality. However, this doesn’t make the
pooled OLS results illegitimate, instead it provides evidence of the complexity of
the topic studied. In addition, it shines light on how different statistical methods
can give unique results, depending on what is included in the model and through
utilizing different test methods we can find what model fits the data best.

40
9. Summary

The aim of this study was to investigate how the quality of government affects
income inequality across states. More specifically, the research question set up in the
introduction was, what role does quality of government have on income inequality?
The study considers being able to answer the research question. The results from the
study indicate that there’s a significant relationship between quality of government
and income inequality, in other words, we can reject the null hypothesis and retain
the alternative hypothesis. The study also finds that there’s is a positive relationship
between the main control variable and outcome variable given that we control for
entity fixed effects. On the other hand, the pooled OLS used in the study showcases
a negative relationship, however, an F-test concludes that the fixed effects model
has a better fit for the data used in the study. Thus, the pooled OLS model is
rejected in favor of the fixed effect model. The results from the fixed effects model
indicates that the development of income inequality through the time period 1946-
2020 is positive. The results is somewhat consistent with the report from OECD
(Keeley 2015), which states that the income inequality has been on the rise from
a time dimensional perspective. However, the report doesn’t take the quality of
government into account only the income inequality through time. Furthermore, the
results are somewhat consistent with research done by Antonio R. Andres and Carlyn
Ramlogan-Dobson (2011). However, the authors study the relationship between
corruption and income inequality in South America. Moreover, the results illustrate
somewhat different conclusions from previous studies in the field of income inequality
and governance, which mainly point out a negative relationship. Therefore, it can be
said that this study’s main contribution is the new results of the positive relationship
between income inequality and governance. Which has been showcased through the
incorporation of the extensive data from 1946 to 2020 that covers countries across

41
all continents. However, comparing the different outcomes of the studies should
be taken with a pinch of salt since the studies oftentimes cover different geological
areas, time periods and utilizes different methods and variables, such as different
variables that measure quality of government differently. In other words, the results
should illuminate the complexity of the topic of income inequality and governance
rather than rejecting other studies results.
It should be noted that this study has some limitations. Firstly, since the data used is
panel data from the period 1946 to 2020, it’s somewhat inconsistent across countries
in the early period of the data, since the availability of observations are limited in
many of the developing countries from that period. Secondly, since the measurement
of quality of government and index of globalization is built on subjective perception,
there’s a chance that the data poses a risk of interpretation or even bias, consequently
raising questions of the internal validity and reliability of the study. On the other
hand, external validity of the study can be considered to have high validity given
the observations it includes throughout a broad time span across a multitude of
countries from several continents. As previously mentioned, the data set might be
somewhat limited in the early years, however, it shouldn’t affect the external validity
given the wide data set.
Hence, despite some of the limitations presented above, the study argues that the
panel data covers a sufficient time period which perhaps isn’t perfect, although
it covers a broad time period across different states. In addition, the variables
which are subjectively collected are captured through different indicators giving
the variables a broader sense of notion and security from skewed interpretations.
Moreover, major international organisations and universities are often in charge of
collecting the variables. Therefore, the reliability of the data set and its variables
included in the model should be on a high level.
Additional recommended future studies in the field of income inequality and gover-
nance would preferably be how income inequality and quality of government differ
depending on the historical onset of the countries studied. Subsequently, further re-
search on how decentralization or centralization of power in a country affects income
inequality is suggested.

42
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I
Appendix

Figure 1:
Gini index histogram

Figure 2:
Logarithmized Gini index histogram

II
 Figure 3:
Real GDP per capita histogram

Figure 4:
Logarithmized real GDP per capita histogram

III