Inequality, the middle class and economic growth in Indonesia: Evidence from cross province analysis

There have been numerous studies conducted to investigate the link between inequality and economic growth. However, typically, these studies only relate inequality and economic growth to poverty. They do not consider another factor, such as the middle class which has vital roles, especially economic roles where for example it can be potential consumers for goods and services. Especially in the case of Indonesia, there is no study that takes into account the middle class as one of determinants of economic growth. Considering this lack of study and potentially important role of the middle class, this paper tries to contribute by including the size of the middle class as one of variables while examining the inequality-growth relationship. By utilizing a panel data set from 31 provinces in Indonesia covering the years 2005 to 2010, this paper aims to examine the link between inequality and economic growth as well as between the middle class and growth across provinces in Indonesia. To meet these objectives, pooled OLS, fixed effect panel data model and dynamic panel data model are applied. Based on a dynamic panel model which is the main specification on which this paper relies, the results show that there is a positive relationship between inequality and economic growth in Indonesia, implying higher level inequality can lead to higher economic growth. On the other hand, the result does not indicate that the middle class has an effect on economic growth in Indonesia. In addition, the result also supports the empirical evidence that a large population can be detrimental for achieving higher economic growth. Nevertheless, these results must be treated with caution due to the sensitivity of the results to choice of lag length and model specification in dynamic panel data model.