Financial Development and Income Inequality: The Linear versus the Nonlinear Hypothesis

The aim of this paper is to test empirically the theoretical foundations of the linear relationship between financial development and income inequality, which is developed by Galor & Zeira (1993) and Banerjee & Newman (1993), and the nonlinear relationship, which developed by Greenwood & Jovanovic (1990). To this end, we built an international sample of 138 countries over the period (1980-2012). Our results indicate that financial development plays a positive role in reducing the social gap between the poorest and the richest classes. In addition, results show that the retention of the nonlinear hypothesis, developed by Greenwood & Jovanovic (1990), which assumes an inverted U-shaped relationship between financial development and income inequality depends on the banking variables vs. stock market variables and on the countries' income level. Within the meaning of Kuznets (1955), an inverted U-shaped relationship is consistently apparent in high income countries. The U-shaped relationship between economic development and income inequality, in the international sample, is driven exclusively by lower and middle income countries and not by high income countries, where a Kuznets relationship is established. Results also show a sensitivity to the estimation method that we adopted and to the Gini index.