Financial Development and Income Inequality: A U-shaped Relationship

This paper investigates how changes in financial development may afect income inequality. We apply the ordinary least squares method, controlling for time and country fixed efects, to an international panel dataset consisting of 195 countries and covering the period from 1990 to 2021. The findings reveal a U-shaped relationship between financial development and income inequality. The development of financial institutions initially lowers income inequality. However, any further advancement, once societies attain a certain threshold of fair distribution, leads to a worsening of income distribution. This is an interesting result as previous literature discusses positive, negative, or inverted U-shaped relationships between financial development and income inequality. For a decomposed sample of strong versus weak democracies and high-versus low-income countries, the finding of a U-shaped relationship firmly holds for strongly democratic and high-income countries.