Financial development, democracy, and income inequality

Does financial development increase income inequality? This topic is theoretically and practically significant given the surge in income inequality across most economies in recent decades and the costs associated with bailing out financial institutions that were ‘too big to fail’ during the 2008 global financial crisis. As the literature has yet to reach a consensus, this study examines the impact of financial development on income inequality by introducing regime type as a conditional factor. Although democracies are expected to be redistributive, the redistributive mechanisms are nullified or even reversed under the perverse influence of capital. Democratic governments may also be less capable than autocracies of limiting the excesses of financial development. By focusing on the interactive effect between financial development and democracy, financial development is shown to increase inequality in democracies but decrease it in non-democratic regimes. Supplementary analysis shows that the development of financial institutions, particularly their depth, drives the results.