Finance and Income Inequality: Test of Alternative Theories

Although theoretical models make distinct predictions about the relation between financial sector development and income inequality, little empirical research has been conducted to compare their relative explanatory power. We examine the relation between financial intermediary development and income inequality in a panel data set of 91 countries for the period of 1960-95. Our results provide evidence that inequality decreases as economies develop their financial intermediaries, consistent with the theoretical models in Galor and Zeira (1993) and Banerjee and Newman (1993). Moreover, consistent with the insight of Kuznets, the relation between the Gini coefficient and financial intermediary development appears to depend upon the sectoral structure of the economy: a larger modern sector is associated with a smaller drop in the Gini coefficient for the same level of financial intermediary development. However, there is no evidence of an inverted-U shaped relation between financial sector development and income inequality, as suggested by Greenwood and Jovanovic (1990). The results are robust to controlling for biases introduced by simultaneity.