Does Financial Deepening Improve Income Distribution? A Dynamic Panel Analysis on Developing Countries

This study examines the dynamic effects of financial deepening on income distribution of 35 developing countries during the past two decades of 1980-2000. For this purpose, three existing alternative hypotheses concerning the finance-inequality nexus are tested based on the newly assembled measure of income distribution. The empirical results based on the dynamic panel data technique of General Method of Movement (GMM) suggest that financial deepening significantly reduces income inequality in developing countries. This evidence supports the hypothesis of inequality-narrowing in general. Nonetheless, income inequality responds differently to different financial factors. While the impact is significant from the banking sector, the equity market has no important role to play in this regard. The inverted U-shape finance-inequality relationship is not observed in these nations; instead, a U-shape relationship is detected. These results show that financial deepening reduces income inequality when the private sector credit of the country is below a threshold level. Countries with private sector credit higher than the threshold, on the other hand, will tend to experience a deterioration of their income inequality.