Finance and Income Inequality: What Do the Data Tell Us?

Although there are distinct conjectures about the relationship between finance and income inequality, little empirical research compares their explanatory power. We examine the relationship between finance and income inequality for 83 countries between 1960 and 1995. Because financial development might be endogenous, we use instruments from the literature on law, finance, and growth to control for this. Our results suggest that, in the long run, inequality is less when financial development is greater, consistent with Galor and Zeira (1993) and Banerjee and Newman (1993). Although the results also suggest that inequality might increase as financial sector development increases at very low levels of financial sector development, as suggested by Greenwood and Jovanovic (1990), this result is not robust. We reject the hypothesis that financial development benefits only the rich. Our results thus suggest that in addition to improving growth, financial development also reduces inequality.