Equities and Inequality

This paper studies the relationship between the development of stock markets and income inequality. It shows that introducing equity financing in an economy with safe and risky sectors, where debt is initially the only financial instrument and where market imperfections generate credit rationing in the risky sector, raises both income dispersion in general and income differentials between skill groups. While the latter increase with stock market capitalization, income dispersion rises until the equity market reaches a certain size, then it declines. Equities play the twofold role of allowing some credit rationed agents to finance risky enterprises, and providing insurance through risk sharing. The degree of investor protection ultimately determines the size of the equity market and the extent of risk-sharing. By increasing the number of risky projects, better investor protection widens income dispersion. On the other hand, by improving risk sharing, it tends to reduce inequality. This tension explains the inverted-U shaped relationship between income inequality and stock market development. Empirical evidence on a panel of fifty-two countries spanning the years 1976-2000 supports the predictions of the model