Financial liberalization, political institutions, and income inequality

Rising income inequality coinciding with financial liberalization has stimulated extensive studies on the possible links between income inequality and different forms of financial liberalization, both inputs and outputs, since the 1990s. Nonetheless, empirical investigations remain inconclusive. To provide new and robust evidence, this study investigates the distributional repercussions of financial liberalization and the role played by democratization in this process. Focusing on the outcome measures of financial liberalization, we find, in a panel of developing and developed countries for 1989–2011, that (1) financial openness alleviates income inequality, particularly for less democratic countries; (2) stock market development mitigates income inequality, whereas its volatility exacerbates it, with both effects decreasing with democratization; (3) banking development strengthens income inequality, whereas its volatility alleviates it, with both effects again moderating with democratization; and (4) these effects are mediated by human capital accumulation and entrepreneurship development. The data thus suggest that financial reforms toward capital account openness and more liquid, stable stock markets are beneficial to income distribution, as such reforms allow more previously excluded households and firms to access financial funds and services, thereby increasing human capital and entrepreneurship, especially in less democratic countries.