Effects of Financial Sector Development on Income Inequality
Authors:   , Mbona Nokulunga 
Published: December 2024

The four strands of literature on the effects of FSD on income inequality allude to conflicting theoretical predictions. The major limitation of the previous studies is that they use financial institution depth measures as a proxy of aggregated FSD indicators. Financial depth alone does not consider the complex dimensions of FSD, making it hard to conclude on FSD's effects on income inequality. As such, the grounds for further research lie in finding precise measures or rules of thumb for the impact of aggregated and alternative FSD indicators on inequality. The thesis novelty lies in the use of more recent data (from 2004- 2019) and a comparison of the estimated impacts of aggregated FSD, and alternative FSD indicators on both before and after-tax income inequality. Adding to this, fewer studies have investigated the overall impact of aggregated FSD inequality this is because the aggregated FSD index was only introduced in the year 2016- see Svirydzenka (2016). The new scientific findings of the thesis are as follows: Firstly, the aggregated financial development (FD), aggregated financial institution development (FI), and aggregated financial market development (FM) indices reduced after-tax income inequality of the 120 countries. The FD and FI indices also reduce after-tax inequality of emerging markets economies (EME). On the other hand, the results from the full sample of 120 countries using before-tax income inequality as the dependent variable suggest that increases in FD, FI, and FM indices widen inequality. In terms of the subsample results, the FD index increased the before-tax inequality of advanced markets (AM) and simultaneously reduced the before-tax inequality of low-income countries (LIC). Intuitively, the levels of FD index in LIC are far smaller than those of the AM group. As such, in advanced economies, increases in FD produce higher returns on capital, which disproportionally benefits individuals with high incomes. Secondly, since the FD index of advanced economies is already high further increases in FD can lead to increased market concentration, leading to higher executive earnings, which can widen the before-tax income inequality. The observed paradox on the effects of the FD index on the before and after-tax Gini was expected, as the after-tax Gini index represents the net basis of inequality. The narrowing effect of the FD index on after-tax inequality suggests that progressive taxation, social transfers, and public sector investment associated with the developed financial sector can narrow inequality. Secondly, the thesis demonstrates that increased access to financial institutions narrowed both the before and after-tax income inequality in the full sample of 120 countries and the after-tax inequality of LIC and EM groups. In the nonlinear model, ATM per adult has a U-shaped relationship with the after-tax inequality of the LIC group. These results reflect the levels of maintenance of ATMs, especially near rural and less economically developed cities; thus, the number of ATMs per adult may be increasing, but the number of actual functioning ATMs may be less. Access to the financial market (FMA index) also demonstrates a U-shaped effect on both before and after-tax Gini. This suggests that an increase in FMA reduces inequality up until a threshold, beyond which FMA increases inequality. Suggesting the effects of FMA are not muchly affected by tax policies. Moreover, the effects of FMA on inequality reflect how the well-off benefit from the stock market, compared to the other income groups. This reflects the use of financial products (stock) as collateral for borrowing while the individuals are not paying taxes on unsold stocks. While financial sector depth narrows income inequality in the linear model, the nonlinear model reveals that the Too Much Finance hypothesis holds, as the results confirm a U-shaped relation with after-tax income inequality. In the linear models, financial institution depth significantly narrows after-tax inequality of advanced and emerging market economies. Contrary to the GMM empirical findings on financial institution depth, the meta-summary analysis findings show that the global effect size of financial institution depth on income inequality is small and positive. The thesis also concludes that there is no evidence of publication bias on the topic of domestic credit and income inequality. The multivariate meta-regression results show strong evidence of high heterogeneity in past studies on financial institution deepening and income inequality. The findings suggest that the different signs and magnitude of financial sector depth coefficients reported in the literature come from different methodologies applied and panel studies mixing countries of different characteristics in past studies. Finally, this thesis contributes to the literature by using new 2021 micro-level data and complementary methods (the c-tree and probit model) to analyse the marginal effects of individual characteristics in the decision to use formal or informal financial sector. The findings suggest that higher education level, income levels, and regular income increase the association of using the formal financial sector. Unlike the rest of the BRICS nations, in China, individuals in the poorest income group have a positive and significant probability of using both the formal and informal sectors for credit. This highlights the increased access to credit in China through microcredit programs.