Finance and Income Inequality: Test of Alternative Theories

This paper analyzes the relationship between income distribution and financial intermediary development using panel data from both developing and developed countries between the years 1960 and 1995.

The paper suggests that relationship between financial development and income distribution is important for policy makers as they are interested to know:

• The distribution of the benefits of accelerated growth;
• The manner in which policies affect both growth and income distribution;
• Whether finance can be used as an instrument to affect income inequality and in the context for doing so.

The paper applies regression equations to explore the relationship between financial intermediary development and income inequality, and lists the following empirical results:

• Financial sector development reduces income inequality;
• Inequality is lower in countries with better-developed financial sectors;
• Inequality is generally higher in countries with smaller agricultural sectors;
• Income inequality increases during the transition from agriculture to industry.

The paper concludes:

• There is a negative relationship between financial sector development and income inequality;
• Inequality-reducing effects of financial intermediaries are muted in countries with larger modern (i.e. non-agricultural) sectors.