Finance, Growth, and Inequality: Channels and Outcomes

Abstract

This paper assesses how financial development impacts income inequality using a data set which covers over 150 countries and goes back to before 1960. Using System Generalized Method of Moments (GMM), we find that financial development leads to a reduction in income inequality which is economically significant. A one standard deviation increase in the private credit to GDP for the median country-year observation would reduce the gini co-efficient by 10.0% (from 41.05 to 36.93). We also find that broadening access to financial services (increasing the geographic/demographic penetration of bank branches) may work faster in reducing income inequality than merely deepening the availability of credit. In addition, identifying the specific channels through which financial development impacts inequality via growth is important both for research and policy prescriptions. The existing literature on the subject has not yet attempted this important task in a cross-country setting. In the present study we consider two possible channels: (1) educational attainment, in particular the level of tertiary education; and (2) the labor channel, where we look at the relative wage difference between skilled and unskilled workers. While financial development is weakly associated with a rise in the level of tertiary education, we find that its relationship with the second channel is much stronger. Higher financial development is associated with a tightening of the wage gap between the skilled and the unskilled. Both channels are associated with inequality in an economically meaningful way.