Threshold Effects in the Relationship Between Financial Development and Income Inequality

Abstract

This paper investigates the existence of nonlinearities in the relationship between financial development and income inequality, using the Instrumental Variable Threshold Regression (IVTR) introduced by Caner and Hansen (2004). It is shown, based on cross-sectional data of 60 developed and developing countries, that there is a significant financial development threshold effect in the finance-inequality nexus. Particularly, our findings are consistent with the Greenwood and Jovanovic hypothesis of an inverted U-shaped relationship between banking sector development and inequality. However, there is no evidence for an inverted U-shaped relationship between stock market development and inequality. Besides, our estimates lead to inconclusive results regarding the impact of stock market development on income distribution in low and lower-middle income countries. Our results show that under the lower regime, the weight of the market is very light and its contribution to income distribution does not matter, while under the higher regime market expansion leads to more inequity.

Keywords: Financial development, income inequality, IV threshold regression, panel data

JEL Classification: O16, O15, C36, C33