Institutional Quality and the Income Inequality Paradox: Exploring the Inequality Dynamics in Latin America

As countries incorporate technological advancements into their production processes, they achieve higher GDP levels, driving economic prosperity. However, the unequal distribution of income has raised concerns about income inequality. While many studies have focused on income as a determinant of inequality based on Kuznets' hypothesis, recent research has begun exploring the impact of institutional quality (IQ) on income distribution. Within this framework, this study examines the effects of IQ improvements on income distribution across three specific income groups using the Common Correlated Effects Mean Group (CCEMG) technique for 17 Latin American countries from 1996 to 2023. The findings indicate that improvements in IQ have worsened income distribution in favor of the P90 group (top 10% income share). When assessing the effects of individual IQ components, corruption, government effectiveness, rule of law, and voice & accountability were found to have significantly negative effects on income distribution. Additionally, this study reveals that the relationship between IQ and income inequality is inverse U-shaped: while IQ improvements initially exacerbate income inequality, once a certain threshold is exceeded, they contribute to a more equitable distribution of income. However, IQ improvements did not have a significant impact on the P99 group (top 1% income share) or the B50 group (bottom 50% income share).