Investor Protection, Risk Sharing and Inequality

This paper studies the relationship between investor protection, financial risk sharing and income inequality. In the presence of market frictions, better protection makesinvestors more willing to take on entrepreneurial risk while lending to firms. This implies lower cost of external finance and better risk sharing between financiers and entrepreneurs. Investor protection, by boosting the market for risk sharing plays the twofold role of encouraging agents to undertake risky enterprises and providing them with insurance. By increasing the number of risky pro jects, it raises income inequality.By extending insurance to more agents, it reduces it. As a result, income inequality grows with the size of the market for risk sharing until this market is big enough, then it declines. Empirical evidence from a cross-section of sixty-eight countries and a panel of fifty countries over the period 1976-2000, supports the predictions of the model and documents a new stylized fact on the link between stock market development andinequality.