Finance and income inequality: What do the data tell us?

• Author: Clarke, George R. G.

1. Introduction

   Recent studies have shown that financial sector development boosts economic growth (Levine 1997b). (1) But many people worry that financial development benefits only the rich and powerful. Because financial markets are fraught with adverse selection and moral hazard problems, borrowers need collateral. The poor, who do not have this, might, therefore, find it difficult to get loans even when financial markets are well developed. In contrast, the rich who do have property that can be used as collateral might benefit as the financial sector develops. If financial development improves access for the rich, but not the poor, it might worsen inequality.

   But this might not be the case. As the financial sector grows, the poor, who were previously excluded from getting loans, might gain access to it. In this respect, finance might be an equalizer for people with talents, ambition, and persistence. Rajan and Zingales (2003, p. 92) argue that the revolution in financial markets is "opening the gates of the aristocratic clubs to everyone," as witnessed by the observation that, "in 1929, 70% of the income of the top 0.01% of income earners in the United States came from holding of capital.... In 1998, wages and entrepreneurial income made up 80% of the income of the top 0.01% of income earners in the United States, and only 20% came from capital."

   Consistent with the idea that financial development might benefit the poor, several theoretical models suggest that income inequality will be lower when financial markets are better developed (Banerjee and Newman 1993; Galor and Zeira 1993). These models show that when investments are indivisible, financial market imperfections perpetuate the initial wealth distribution, resulting in a negative relationship between financial development and income inequality even in the long run.

   Although the relation between inequality and financial development could be linear, it is also possible that different mechanisms dominate at different levels of financial sector development, leading to a nonlinear relationship between financial sector development and inequality. Greenwood and Jovanovic (1990) show how financial and economic development might give rise to an inverted U-shaped relationship between income inequality and financial sector development. In their model, income inequality first rises as the financial sector develops but later declines as more people gain access to the system.

   The relation between financial development and income distribution is important for policy makers--policy makers want to know how policies affect inequality as well as how they affect growth. Although recent work has established a robust link between financial sector development and economic growth (Levine 1997b), less work has focused on the relation between financial sector development and inequality. Understanding this relationship will allow policy makers to assess whether financial development will improve inequality and when it might be useful in doing so. Because different theoretical models give different predictions about the distributional impact of financial development on inequality, empirical investigation is needed to distinguish between the competing conjectures. (2)

   This paper analyzes the relation between the distributional impact of financial intermediary development and income distribution using data from developing and developed countries from between 1960 and 1995. Specifically, we analyze whether financial intermediary development affects income inequality and whether the impact depends on the level of financial development. Because the different mechanisms might be more powerful at different levels of financial sector development, we allow the relationship to be nonlinear. Further, because causation could run either from financial sector development to inequality or from inequality to financial sector development, we control for endogeneity using instruments for financial sector development suggested in the financial sector development-growth literature (see, for example, Levine 1997a, 1999).

   Our results show that inequality decreases as financial markets deepen, consistent with Galor and Zeira (1993) and Banerjee and Newman (1993). Although some weak evidence suggests that at low levels of financial development inequality might increase as financial sector development increases, that is, that there is an inverted U-shaped relation between financial sector development and income inequality, as suggested by Greenwood and Jovanovic (1990), this second result is not highly robust. We strongly reject the hypothesis that financial development benefits only the rich: We do not find a positive and significant relation between financial development and inequality after controlling for the endogeneity of financial sector development.

   In the next section, we briefly review the theoretical literature on the relation between income inequality and financial sector development. We then discuss the data that we use to test the theoretical hypotheses in Section 3. After discussing the empirical specification and some estimation issues in Section 4, we present empirical results in Section 5 and conclude in Section 6.

2. Theoretical Perspectives on Finance and Inequality

   Although most economists would not expect financial development to widen income inequality in the long run, the popular press, some literature, and Marxist theory often depict financiers as greedy middlemen who serve only the interest of the rich and well connected. Indeed, these views are so common that the first chapter of a recent book defending the free-market system by two famous economists, Rajan and Zingales (2003), is entitled "Does finance benefit only the rich?"

   One plausible reason why financial development might benefit the rich, especially when institutions are weak, is that the financial system might mainly channel money to the rich and well connected, who are able to offer collateral and who might be more likely to repay the loan, while excluding the poor. (3) As financial sectors become more developed, they might lend more to rich households but continue to neglect the poor who are unable to provide collateral. As a result, even as the financial sector develops, the poor remain unable to migrate to urban areas, invest in education, or start new businesses. This tendency might be reinforced if the rich are able to prevent new firms from getting access to finance, preventing them from entering, and reducing the ability of the poor to improve their economic lot. If this were the case, we would expect to see a positive relation between financial development and income inequality--at least at some levels of financial development. We call this story the inequality-widening hypothesis of financial development.

   Although the previous arguments suggest that high-income households might benefit more from financial sector development than low-income households, this is not necessarily the case. As financial markets become deeper, and access to finance improves, households that did not previously have access to finance might be the main beneficiaries. Because poor households cannot invest in human and physical capital or bear the start-up costs associated with starting a new business using only their own resources, they will be unable to do so unless they can borrow. In contrast, rich households are able to draw on their own resources for investment whatever the level of financial sector development. Therefore, capital constraints might be less binding for rich households at any level of financial sector development, and so they might gain less when these constraints are loosened.

   Several recent theoretical models have formalized this intuition, suggesting that capital market imperfections might increase income inequality during economic development. Banerjee and Newman (1993) and Galor and Zeira (1993) suggest that capital market imperfections and indivisibilities in investment in human or physical capital may lead to divergence of income for the rich and the poor even in the long run. Further, depending on the initial wealth distribution, these imperfections might mean that income inequality persists even in the long run.

   Galor and Zeira (1993) construct a two-sector model with bequests between generations, where agents who make an indivisible investment in human capital can work in a skill-intensive sector. However, given capital market imperfections, only individuals with bequests larger than the investment amount or who can borrow will be able to make this investment. This results in income inequality that is perpetuated through bequests to the next generation. In their model, an economy with capital market imperfections and an initially unequal distribution of wealth will maintain this inequality and grow more slowly than a similar economy with a more equitable initial distribution of wealth. Similarly, Banerjee and Newman (1993) construct a three-sector model, in which two of the technologies require indivisible investment. Because of capital market imperfections, only rich agents can borrow enough to run these indivisible, higher-return technologies. Once again, the initial distribution of wealth has long-run effects on income distribution and growth in the presence of capital market imperfections. With all else remaining equal, these models suggest that countries with larger capital market imperfections, that is, higher hurdles to borrow funds to finance indivisible investment, should have higher income inequality. Consequently, we should observe a negative relationship between financial development and income inequality. We call this hypothesis the inequality-narrowing hypothesis of financial development.

   Offering a related, but different, perspective on these basic ideas, Greenwood and Jovanovic (1990) present a theoretical model that has elements of both ideas. In their model, agents...