Economic Growth, Financial Development and Income Inequality in BRICS Countries: Evidence from Panel Granger Causality Tests

The purpose of this paper is to examine the causal relationship between economic growth, financial development and income inequality for the BRICS countries, namely; Brazil, Russia, India, China, and South Africa, using annual panel data covering the period 1995-2015. We construct a composite financial sector development index for these countries by applying the principal component method on the main four proxies of financial development, that is, domestic credit to private sector to GDP ratio, domestic credit given by banks sector to GDP ratio, M2/GDP, and stock market capitalization to GDP ratio. Results of Pedroni panel cointegration and Kao residual panel cointegration tests confirm the valid long-run cointegration relationship between the considered variables. Fixed effects estimation results show that GDP per capita growth has a positive and significant effect on income inequality, while the coefficient of its squared term has negative and significant effect on income inequality. Similarly, financial development index appears to have a positive and statistically significant effect on income inequality, while its squared term has negative and statistically significant effect on income inequality. Our empirical findings support the financial Kuznets hypothesis of an inverted U-shaped relationship between economic growth, financial sector development and inequality in the BRICS countries over the study period. Our results are robust by employing POLS and GMM estimators. Results of Granger causality test shown that there is a unidirectional causality running from financial development index to income inequality, but a bidirectional causality between inflation and income inequality is found. However, there is no causal relationship between income inequality and economic growth. These findings are expected to help policymakers to reduce inequality in these countries through the improvement of taxation policies financial system.